Fed moves spark bubble fears

(breakingviews.com) -- The Federal Open Market Committee in its statement November 4 left unchanged the language that its ultra-low rates would be kept for "an extended period". By not even signaling an end to the current era of easy money, the central bank runs the risk of further inflating asset and commodity prices and sinking the dollar.

The Fed's mandate is to keep inflation and employment stable. It's hard to see how avoiding bubbles -- and the crashes that accompany them -- shouldn't be central to its mission.

By the Full Employment and Balanced Growth Act of 1978, the Fed must maintain long-run growth, minimize inflation and maintain price stability. As the events of 2007-09 demonstrated, in order to achieve these goals it helps to avoid bubbles, the bursting of which makes prices unstable and causes unemployment.

Fed Chairman Alan Greenspan used to claim that it was impossible to recognize a bubble in progress, but that does not preclude the Fed's responsibility to prevent them from developing.

Currently, stock prices are up 50% from their lows, oil prices are above $80 a barrel and the gold price has surged to close to $1,100 an ounce. Global monetary conditions have been exceptionally accommodative for over a year, with Chinese M2 money supply up 29.3% in the year to September, for example.

All of which suggests the substantial probability of a bubble developing, whether or not it can be detected in progress. The bursting of such a bubble, at a time of large global budget deficits, could prove highly destructive to economic growth and employment.

So the Fed's lack of action -- either in word or deed -- seems incautious. It may believe that raising interest rates would abort the incipient U.S. economic recovery and that removing quantitative easing could cause a liquidity crisis given the huge U.S. budget deficit.

However, removing the language promising to keep interest rates low for an "extended period" could have no real economic effect, but would warn the markets that the Fed is aware of the potential bubble. Sometimes two words can make all the difference.