Federal Reserve chair Jerome Powell, like his peers at other major central banks around the globe, has gotten his wish: Investors have gone from fearing a once-in-a-generation recession to feasting on risk. But now policy makers have another problem—the potential that investors will get so carried away that they rip a new hole in the economy.
Reason for concern can be found just about everywhere. Armchair investors have flocked to trading apps, snapping up everything from Tesla stock to bitcoin. A survey by pension consulting firm Mercer found that European institutions have made big shifts over the years to assets that are seldom traded and harder to value—things like real assets, which include real estate and natural resources, and private-equity investments in non-public companies. And though tech stocks drove the equity markets through multiple record highs in 2020, Wall Street analysts say it’s not the time to pull back on them.
Welcome to the high-risk economy. With interest rates on government bonds hovering around record lows—and not expected to go anywhere anytime soon—investors of all kinds are scrambling for riskier assets that offer growth. It all adds up to a world in which investors are, seemingly permanently, taking ever more risk.
Traditionally, the main tool for dealing with booms and bubbles is to raise interest rates. But central banks have little scope to do that this time around. They’ve engineered a market rally as a way to recover the jobs and incomes that are still being destroyed by the Covid-19 pandemic. The hope is that capital will flow to companies so they can refinance their debts and stay in business, and will work its way to entrepreneurs building startups that generate jobs. Policy makers are wary of doing anything that could choke off an economic recovery in the wake of the pandemic.
The Fed “wants to run the economy somewhat hot, as does the Biden administration, to redistribute the gains of growth to workers through higher wages,” says Sebastien Galy, senior macro strategist at Nordea Asset Management. It’s likely “that the Fed will be running behind the curve as inflation picks up,” he added.
Tobias Adrian, director of the monetary and capital markets department at the International Monetary Fund, recently acknowledged that low interest rates could be making the financial system more vulnerable. He thinks central banks need to focus more carefully on risk-taking. The Fed, for example, has a dual mandate from Congress, and is charged with keeping prices stable and maximizing employment. But Adrian suggests they add a third consideration: the tradeoffs between encouraging a binge on risky assets like stocks, housing, and junk bonds and the potential for that to boomerang and destabilize the financial system.
The chief global strategist at Morgan Stanley Investment Management is even more direct: Ruchir Sharma says everything is rallying and it’s all because of central banks. He wrote in the New York Times in October that prices have risen to levels only seen in bubble years like 2008 and 2000. “Central banks have been lowering interest rates for decades, hoping to stimulate economic growth, but much of that newly issued money keeps flowing into financial markets,” Sharma wrote. That process has only accelerated during the coronavirus pandemic. Monetary policymakers “need to take the menace of asset price inflation more seriously and to give the threat of stock, bond, and especially housing bubbles more weight.”
While some researchers are ringing alarm bells, analysts both at money managers and top-tier investment banks say now is not the time to be squeamish about dialing up the risk. In their outlook for 2021, strategists at BlackRock suggest central banks aren’t going to let interest rates perk up next year, even as vaccines hopefully begin to contain the coronavirus pandemic, inflation starts to pick up, and the economy snaps back. They recommend US stocks and junk bonds.
When central bankers influence interest rates, they’re influencing all asset prices, as Treasury yields are a key input for stock valuation models. The lower that risk-free rate, the more valuable the cash flow from corporations becomes.
“If you think about any risk price in any financial model, the risk-free rate always features in it,” says economist Allison Schrager, a former Quartz contributor who’s now a senior fellow at the Manhattan Institute. “If you artificially lower the return on the risk-free asset below what the market clears you create distortions, and you create bubbles. If you are moving that price away from its market value, you are inherently distorting markets—every price in the financial market.”
Of the many markets that look overheated, the one for IPOs is probably where the warning lights are brightest. Airbnb CEO Brian Chesky was speechless this month when Bloomberg Television informed him that the property-sharing firm’s stock had doubled in price in its first day of public trading. New listings have jumped about 36%, on average, during their first day of trading, according to data compiled by University of Florida professor Jay Ritter. That’s the highest average of any year since the dot-com bubble.
Per Roman, managing partner and co-founder of investment firm GP Bullhound, which invests in pre-IPO tech firms, said he’s concerned some new listings won’t be able to justify their stock prices. “Clearly there is evidentially a lot more demand than there is supply of shares of companies with this growth caliber,” he said. “It means we’ve entered a whole new era when it comes to what these companies could be worth. For me, it looks worrying.”
The problem with allowing bubbles to foment isn’t lost on policy makers. Eric Rosengren, president of the Boston Federal Reserve, recently observed that popped financial bubbles don’t just show up on hedge funds’ profit and loss statements—they can also hit the poorest and most vulnerable people the hardest. He argues that the pandemic’s damage to the consumer-discretionary sector, which includes businesses like hotels and retail and employs a lot of low-wage people, was exacerbated because the industry had become heavily indebted over the years, which was enabled in part by zealous risk-taking by investors.
“If the results harmed only shareholders, one could argue that they should be free to take that risk,” Rosengren said during a virtual conference in November. “The fact is that customers, suppliers, and employees are also hurt by risk-taking behavior.”
If central banks have little leeway to raise rates to combat bubbles, that leaves macro-prudential policy, which is a fancy way of saying rules that try to tame crazy risk-taking. “Easy monetary policy requires more guardrails protecting against rising financial stability risks,” not less, Rosengren argues. Otherwise, recessions could be deeper and fall even more disproportionately on the people who can least afford it, he says.
For decades, ever lower interest rates have been the answer to recessions. There’s growing sense that that policy has been maxed out, and now we’re stuck with a high-risk economy until policy makers—or the markets—find a new way forward.