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Federal Reserve Sounds Alarms On The Economy

An asset bubble, business debt, Brexit, and trade tensions were cited as risks to economic growth.

The economy seems to be humming along despite the topsy-turvy stock market, but the Federal Reserve released a report yesterday that sounds cautionary alarms on a number of financial indicators. The report warns that adverse shocks could lead to a decline in asset prices that could be “particularly large.”

The 46-page Financial Stability Report focuses on four particular vulnerabilities to the economy as well as geopolitical risks. The Fed says that asset values are elevated compared with historical norms in several markets and business debt is above historical levels. On the other hand, debt in the financial sector is low and banks have sufficient liquidity to prevent runs.

With respect to asset values, the report points out that both financial instruments, such as stocks and bonds, and real estate are at elevated levels. Even after November’s market declines, “equity price-to-earnings ratios have been trending up since 2012 and are generally above their median values over the past 30 years,” the report notes. Both commercial and residential price-to-rent ratios have been increasing since the end of the recession. Farmland prices have decreased slightly but remain high compared to historical values.

“House prices have risen substantially since 2012,” the Fed says, “although the rate of price appreciation appears to have slowed significantly in recent months.” The tax reform law’s limit on property tax deductions may play a role in the slowdown in rising home values.

More alarming is that business debt levels are high and the Fed notes “signs of deteriorating credit standards.” Of particular note, the report points out that “debt has been growing fastest at firms with weaker earnings and higher leverage.” In other words, companies who are doing the most borrowing are those with the least ability to repay their debt.

The Fed cites three current geopolitical risks to the economy. First, European instability and the effects of Brexit could affect US exporters and financial institutions that participate in European markets. Second, the Fed points out increasing debt in China and other emerging markets “that could be difficult to service in the event of an economic downturn.” In China, where the economy is slowing, “private credit has almost doubled since 2008, to more than 200 percent of GDP.”

The Fed also waves a caution flag at trade tensions and uncertainty that stems from the trade war. It is this trade uncertainty that could cause some investors to become more risk-averse. “The resulting drop in asset prices might be particularly large, given that valuations appear elevated relative to historical levels,” the Fed warns. A collapse in asset prices could lead to difficulties in finding business funding since commercial debt levels are already high.

A final note of caution regards rising interest rates. Interest rates have been kept low since the 2008 financial crisis, but the Fed has recently started bring rates back to normal levels. “Markets and institutions that may have become accustomed to the very low interest rate environment of the post-crisis period will also need to continue to adjust to monetary policy normalization by the Federal Reserve and other central banks,” the Fed warns. “Even if central bank policies are fully anticipated by the public, some adjustments could occur abruptly, contributing to volatility in domestic and international financial markets and strains in institutions.”

The impact of interest rate policy can be seen in yesterday’s stock market rally after Federal Reserve Chairman Jerome Powell said that rates were near the neutral point, “neither speeding up nor slowing down growth,” and that “we may go past neutral, but we’re a long way from neutral at this point, probably.” Powell’s hint that rate increases were nearing an end sparked a 600-point surge in the Dow.

While the Fed report does not warn of unavoidable financial problems, it does list valid concerns about continued economic growth. Over the past few months, several financial outlets have noted that early indicators point toward a possible looming economic slowdown. In August, Forbes noted that commodity prices and asset values usually peak before a recession and interest rates “act oddly.” Earlier this week, the Wall Street Journal said that “economic indicators are flashing yellow” with a slowing housing sector, a collapse of domestic energy prices after a strong first half of 2018, and a “global economy [that] has lost momentum.” Morgan Stanley analysts say that a correction is due and put the chance of recession in 2019 at 15 percent, rising to 30 percent in 2020 as the business cycle enters the “stall/overheating phase.”

On the other hand, Stephen Moore, a former economic advisor for the Trump campaign, argues that fears of slowing growth “should be greeted with a collective yawn.” Moore acknowledges the risk of the trade war but says, “if/when Trump prevails and gets the concessions from China, the market upside is gigantic.”

The bottom line is that the business cycle will eventually come to close and growth will stop as the economy enters a correction. This will happen no matter which party is in office or who occupies the White House. What goes up, must come down.

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