Boston Fed President Eric Rosengren has been concerned about a potential asset bubble in commercial real estate since late 2015. And he says that the problem of asset prices has gotten worse, not better.
“For a while, real estate looked like the only asset class that was showing signs of having substantial variation from what the average valuation had been, but I think we’re starting to see more asset markets have that characteristic,” he says.
This makes life hard for the central bank. For instance, it makes it more difficult for the central bank to engineer a soft landing for the economy, Rosengren said. It also means the Fed cannot pause in its gradual pace of rate hikes and should even pick up the pace a bit this year. The U.S. central bank might have to raise rates four times in 2018, he said, more than the median forecast of Fed officials or the two hikes the market expects.
MarketWatch spoke with Rosengren as he was preparing to give his first speech of the year on the economic outlook. In his remarks, he said low inflation has so far allowed the Fed to pursue very gradual rate hikes.
Here’s the edited interview.
MarketWatch: Asset valuations have continued to rise after you last voiced concern last year. What’s your latest view?
Rosengren: Nothing has changed dramatically, prices are still edging up, so valuation concerns are still there. I would say what has changed a little bit is, for a while, real estate looked like the only asset class that was showing signs of having substantial variation from what the average valuation had been, but I think we’re starting to see more asset markets have that characteristic.
Economists are not very good at predicting how large deviations will be. And there are some underlying reasons for why you might see valuation differences. One would be that if you really think we’re in a low-interest-rate environment. That means valuations, will, on average, be higher. So the question is, do you think that is a permanent phenomenon or a temporary phenomenon? And obviously when you are talking about stocks, but also to some extent commercial real estate, the tax code matters, and we’ve just had a tax code change. So those kinds of effects can have an impact on valuation. But I would say that real estate, like other asset classes, are now showing to be a bit higher than what they’ve been historically and that continues to be a little bit of a concern for me.
MarketWatch: The Fed’s rate hikes to date haven’t tightened financial conditions at all.
Rosengren: That’s accurate. Financial conditions have not tightened significantly with the increase in short-term interest rates. Part of that is the stock market has gone up quite a bit and exchange rates and some of these other variables are being affected by a stimulative fiscal policy. So even while we’re tightening with monetary policy, in some sense we have a more stimulative fiscal policy and over the course of the year people didn’t know what, if any, tax change would occur. And now we know a tax change has actually occurred, so we now have a stimulative environment from the fiscal policy side that we didn’t necessarily know was going to happen, so short-term interest rates have tightened but the long rate
is a little less than 2.5% right now. I would expect over time that it will gradually increase as we unwind our balance sheet and as it becomes clear that inflation really is picking up towards our 2% goal and that the tight labor markets are starting to have an impact on wages and prices over time.
MarketWatch: Do you think the Fed should raise rates at a faster pace than gradual?
Rosengren: The [Fed forecasts] in December had three tightenings. I actually think we’ll probably need a little bit more than that. I’m hopeful that we can continue to do it gradually. Doing it gradually probably requires us to continue to be doing it though. So if we were to slow down for some reason, I would be worried that at some point we would have to start moving more quickly. I would be worried about moving quickly at a time when asset prices were already at very high valuations. I think being able to do it more leisurely is one reason why we haven’t had as much of a slowdown and probably has reduced the probability of having a recession. In addition, fiscal policy being so stimulative is a period where you wouldn’t expect an economic downturn either.
MarketWatch: Is the Fed, in a sense, going to keep raising rates until it sees a tightening of financial conditions?
Rosengren: No, I wouldn’t phrase it that way. Our dual mandate goal would be that we have to get to 2% inflation and get to what we believe is a sustainable unemployment rate. The unemployment rate right now is at 4.1% so we’re already lower than where we think we need to be. My own view is what the sustainable unemployment rate would be more like 4.7%. If you look at the Blue Chip forecasts, which just came out, they are actually getting it down to 3.7% in 2019. So we are actually moving in the opposite direction. I do think that we have to gradually tighten and I don’t want to overshoot on the unemployment rate so much that it becomes very difficult to get back to a sustainable unemployment rate without having a recession.
And I would put financial conditions – that is not a goal of monetary policy – but it makes it harder to start tightening if you have to do a lot of tightening, and if you really have to slow down the economy. If you think that potential GDP is growing around 1.75%, well if you want to get the unemployment rate to gradually go up, you are going to have to be seeing some 1.5% [GDP prints] and some lower numbers than we’ve been seeing. When we see those numbers it is possible that you get more of a slowdown than you’re anticipating, and that can be particularly true, I think, if financial markets are a little bit too ebullient. So I think financial conditions and financial stability issues complement some of the concerns I would have about whether we’re getting to an unsustainable level of unemployment rate over time.
MarketWatch: Some colleagues want the pace of rate hikes to slow down – and point to the flattening of the yield curve as a signal to go slow.
Rosengren: We’ve intentionally pushed long-term rates down by having a big balance sheet. We’ve chosen a path which will not disrupt financial markets which means that our balance sheet comes down quite slowly. Until we have more normalized the balance sheet, it is not surprising that long rates are lower than they otherwise would be and it is not just what the U.S. is doing, it is what Japan and Europe are doing. So they are still expanding their balance sheets, even though we’ve been pulling back, and so that also is pushing down long-term rates as well.
It isn’t surprising to me that we’re tightening up at the short-end but the fact that monetary policy both here and abroad has been pushing down on the long rate means that this is going to be a little bit different exit strategy than what we’ve historically seen. We haven’t had a bloated balance sheet around the world in previous periods. People who are taking a lot of meaning from the slope of the yield curve, I think, need to consider what it means to be in a different monetary policy framework — which is that Europe, Japan and the United States have a balance sheet that intentionally was suppressing long rates. So the signal value probably isn’t quite the same, but it is a reason to your earlier question about why financial conditions haven’t tightened more because the balance sheets are likely to only come down gradually over time. Now you could do it differently, and if you want to see the long end of the market go up quickly I can certainly imagine policies of central banks in some part of the world deciding to sell long-term securities would have the impact of pushing up the yield curve. I’m not advocating that. But I think it is an intentional policy. It is not as if this is an unanticipated outcome.
MarketWatch: And you think that inflation will move higher?
Rosengren: Just having the data from the spring time roll off – we had the wireless prices changes, there were a couple other changes in prices that I think were tied to individual markets that really were not tied to overall inflation and so I think once we get to the spring time we’re going to be seeing numbers much closer to 2%. In addition, we have pretty tight labor markets already, and if we continue to grow faster than potential, those labor markets are going to get even tighter. If we start seeing unemployment rates below 4%, that’s a pretty tight labor market. You’re already hearing lots of stories, I think, in some of the tight markets about the difficulty of getting labor and one way to respond to that is to offer higher wages to try to attract people either in the local market or from outside the local market. These things take time. They don’t happen overnight. That’s why there are long and variable lags in monetary policy. I do expect that over time it will have that impact. We’ll see more wage pressures and we’ll see with time more inflation.
MarketWatch: There has been a lot of discussion in recent weeks about a new framework for monetary policy. Where do you stand?
Rosengren: I think there are some advantages of having a Fed-led discussion about how we should think about the framework. My own view is that we would be better off having a little more flexibility than having a specific inflation target. I would much rather have an inflation range – something more like 1.5%-3%. And that during times where interest rates were likely to be low because labor force growth was quite low and productivity was quite low, that would be a time that I would actually like a higher level of inflation so I would like to be higher in the range during that period. And during periods of very high productivity then we could be lower. And the reason for that is – and it is partly a financial stability concern – that the current framework where we have low productivity and low population growth and not much immigration, is an environment where we are going to hit the zero lower bound too frequently. And I do think that has significant consequences – both because monetary policy becomes less effective when we can’t move short-term interest rates, and I also think that it changes investor and household behavior when you start having periods of prolonged interest rates that are very low and unchanged. So I would like to avoid those kind of outcomes occurring in future recessions and so I think it is a good time to be discussing what is the right framework to reduce that probability. Inflation would still be, I think, in a range that it wouldn’t be affecting decision-making by households or firms but would give you a little more flexibility to reduce the probability that you hit zero during recessions. So if we were to have a recession right now, most recessions we move interest rates by much more than 300 basis points. If you look at where the [Fed forecasts] in December had the fed funds in the long run, [2.8%] it is low enough that more than likely in most recessions we’d hit zero. That is a concern.