Although the Federal Reserve Board (FRB) is charged with a dual mandate of price stability and full employment, another element they pay attention to is risk taking. In the words of former FRB Chairman Alan Greenspan, “… we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”*
The purpose of capital markets is to allocate money efficiently. By allowing investors to decide where to allocate their money, the thinking follows, they will seek to maximize their risk adjusted return. They won’t be foolish with their own money.
History shows us mixed results on that front. In his seminal classic “Extraordinary Popular Delusions and the Madness of Crowds” Charles McKay details several financial bubbles including the Mississippi Scheme, the South Sea Bubble and Tulipmania. His book, first published in 1841, has since been revised to include other financial bubbles.
In his “irrational exuberance” speech December 5, 1996, chairman Greenspan shared his concerns about the financial market’s valuation. “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”* I remember that night. The S&P 500 futures were down limit, meaning stock prices declined substantially and trading was halted until the next morning. After a few anxious days, the NASDAQ bull market continued and ultimately peaked in March 2020.
What does that have to do with today?
In 2021, interest rates were zero, the economy was in lock down, stock trading was free, sports were cancelled so the only gambling game left in town was the stock market. The money seemed to flow to the riskiest assets. GameStop, Robinhood, AMC, NFT’s, and Crypto currencies all had stellar returns that year. There is, however, a difference between prudent risk taking and foolish behavior. Because the later can have an undesirable effect on the economy, the Fed needs to be concerned with it, as former Chairman Greenspan noted.
In addition to fighting inflation, higher interest rates hurt the value of the riskiest assets the most. By taking some “irrational exuberance” out of the financial markets, the FRB is hoping to return to disciplined investing. At PWS, we commit to doing our part, as always.
*“The Challenge of Central Banking in a Democratic Society” December 5, 1996