Federal Reserve keeps an eye on the rising assets prices

The low rates have increased home prices, consumer and business spending. Sales of homes and autos have set records and the median price of an existing home soared to an all-time high of $218,000 in July. The investors become overconfident in the stability of the economy and they are encouraged to take more risk.

 The Fed Chairman, Alan Greenspan said that Federal Reserve is paying closer attention to the rising values of assets such as stocks, bonds and homes, as low interest rates encourage more risk-taking,

“Global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them,” Greenspan said at a Kansas City Fed symposium in Jackson Hole, Wyoming devoted to examining his record. “Our forecasts and hence policy are becoming increasingly driven by asset price changes.”

Greenspan presided over the longest economic expansion in history and kept inflation in check. He also took a hands-off approach to a surging stock market in the 1990s and has done the same recently as house prices have soared.

However, a growing chorus of economists is criticizing the Fed chairman for remaining sanguine in the face of what they say is a dangerous bubble in the housing market that poses risks to the economy.

Greenspan warned that increases in asset prices “can readily disappear” if investors who are now confident of long- term economic stability become more cautious. “Such an increase in market value is too often viewed by market participants as structural and permanent,” Greenspan, who is scheduled to retire as Fed chairman in January, said. “History has not dealt kindly with the aftermath of protracted periods of low risk premiums.”

And this isn’t all. Here are some issues discussed by the American economists and bank’s chiefs.
 
1. “More Balanced”

Stephen Roach, the chief global economist at Morgan Stanley, New York said that "Greenspan’s remarks appear to be more balanced than in the past. He is moving into closer alignment with what has become accepted practice in most central banking circles. Missing, however, is what a central bank should do in order to avoid the pitfalls of excess dependence on overvalued assets.’’

The Fed’s interest rate-setting Open Market Committee discussed housing valuations at its June 29-30 meeting and concluded that it was wrong for the central bank to use interest rates to try to influence asset prices.

Blinder, a Princeton economist and former Fed vice-chairman who has often been critical of Greenspan, today defended the Fed chairman’s hands-off approach to asset bubbles.

In a 94-page paper that was the keynote at the Jackson Hole conference, Blinder noted the Fed chairman first suggested the stock market was ``irrationally exuberant’’ in December 1996, a level to which it never returned, even after the 2000 crash.

"Imagine the macroeconomic opportunities that might have been lost,’’ Blinder said, if the Fed "had raised interest rates to burst the bubble in 1995 or 1996.’’

2. Market Rates

Kurt Karl, chief economist at Swiss Reinsurance in New York outlined in an interview that "we have a housing valuation issue. The time is now for raising interest rates and defusing these problems potentially by slowing down the economy a bit and avoiding a big necessary increase later and a consequential recession.’’

Long-term interest rates have fallen in the last year even as the Fed has raised its benchmark short-term rate. The yield on the 10-year note, to which many mortgages and consumer and business loans are tied, was 4.18 percent today, half a percentage point below where it was when the Fed began raising rates in June 2004.

3. Flexibility

Kurt Karl also expects the Fed to raise the target rate to 4.5 percent, from the current 3.5 percent, by the middle of 2006 before stopping. "There is a risk that they will go beyond 4.5 percent,’’ he said.

On the other hand, Greenspan said the economy must avoid protectionism and larger budget deficits, which would reduce the flexibility it needs to withstand any sudden reduction in asset prices.

"If we can maintain an adequate degree of flexibility, some of American’s economic imbalances, most notably the large current- account deficit and the housing boom, can be rectified by adjustments in prices, interest rates and exchange rates rather than through more wrenching changes in output, incomes and employment,’’ Greenspan said.

4. Asset Inflation

Roach and David Rosenberg of Merrill Lynch & Co have criticized the Fed chairman for not responding to rising house prices, which Greenspan acknowledges are evidence of "froth’’ in some regional markets.

"It’s obvious that asset inflation has emerged as a chief policy concern,’’ said David Rosenberg, Merrill Lynches chief economist for North America, in an interview. "It complicates the policy picture going forward.’’

Paul Kasriel, director of economic research for Northern Trust Securities in Chicago, said Greenspan has made mistakes.

"We have experienced asset bubbles, and we now have an economy that is more highly leveraged than it ever has been in the post-World War II period,’’ Kasriel said in an interview before the speech. "Greenspan has been instrumental in bringing about this high leverage.’’

Greenspan’s comment that investors are overconfident in the stability of the economy, thereby bidding up asset prices, reflects his "risk management’’ approach to monetary policy.

In January, Greenspan is preparing to leave the office. He described his philosophy of central bankin: policymakers should look at forecasts produced by economic models, while also considering departures from those forecasts and the possible consequences. They should act to prevent the direst consequences, said Greenspan.

5. Falling Prices

As an example, he offered the Fed’s discussions about deflation, or a fall in consumer prices, in 2003. While the possibility was "very small,’’ Greenspan said, "because the implications were so dire should that scenario play out, we chose to counter it with unusually low interest rates.’’

Greenspan outlined the evolution of monetary policy in the , from early trade-offs between inflation and employment to his current approach. He also noted a change in policy to target real, or inflation-adjusted, interest rates as central bankers learned the importance of limiting expectations of future inflation.

The importance of expectations has also played a role in the Fed’s slow move to greater openness during his tenure, he said. While the central bank’s policy making Open Market Committee began announcing its policy decisions in 1994, it wasn’t until 1999 that it regularly offered an assessment of the economy, and 2003 that it began releasing a record of its vote.

6. Transparency

"We have moved toward greater transparency at a "measured pace" in part because we were concerned about potential feedback on the policy process and about being misinterpreted — as indeed we were from time to time,’’ Greenspan said.

Greenspan credited his predecessor, Paul Volcker, who chaired the Fed from 1979 to 1987, with doing the "very heavy lifting against inflation,’’ which exceeded 10 percent at the start of Volcker’s tenure.

Under Greenspan, the Fed’s "major contribution’’ over the past decade "was to recognize that the and global economies were evolving in profound ways’’ and to adopt anti-inflation policies to suit the new circumstances.

Greenspan said his concluding remarks tomorrow will deal with his experience "living inside’’ the Fed, as well as "some of the unresolved challenges facing policymakers in the years ahead.’’

Greenspan Legacy

“History will show Alan Greenspan did an outstanding job,” said Michael Moskow, president of the Fed Bank of Chicago. “He’s just steeped in economics. He knows the data better than probably just about anyone else I know.”

During Greenspan’s tenure the economy improved. Economic growth averaged 3.3 percent during the last nine years and consumer prices, excluding food and energy, rose by 2.2 percent. During the first half of Greenspan’s tenure, growth averaged 2.7 percent growth and inflation was 4 percent.

Greenspan, 79, maneuvered the economy through two stock-market collapses, in 1987 and 2000, and two recessions in 1990-91 and in 2001. The expansion between those downturns was the longest in history. Greenspan cut interest rates to blunt risks from the Sept. 11, 2001, terrorist attacks, the unraveling of the $125 billion hedge fund Long-Term Capital Management in 1998 and the Asian and Russian financial crises of the late 1990s.

The policy making Federal Open Market Committee (FMOC), led by Greenspan, has spent the last year reversing interest rate cuts that took its benchmark rate to the lowest level in 40 years in 2003. The FOMC has raised the federal funds rate 10 times in the last 13 months, to 3.5 percent from 1 percent, and said August 9 it may continue to increase rates "at a pace that is likely to be measured.’’