And under Ben Bernanke, an important point, the FOMC became a collegial democracy. It’s not anymore that monarchy it used to be under Alan Greenspan. And each one of the twelve members is strong, opinionated, smart, and they have their own voice. And under Janet Yellen, the genie is out of the bottle. She’s by definition a very consensual person. So it’s going to be truly a committee decision. Of course, she has more weight than the rest of the committee but she cannot impose her will.
So I think the changing composition of the FOMC might lead them to start sooner and go faster especially if they worry about financial stability. This is the other risk that I worry about. Asset bubbles are another factor that may be considered by some members of the FOMC in terms of when to start and how fast to hike.
OR: Do you think the market understands that it’s consensual now?
Roubini: They do understand that this is consensual and, in some sense, they are worried about that because there is a bit of a cacophony of views. And every time even one of the non-voting members speaks, then that can move the market. One of the reasons why Ben Bernanke – and he told me this personally – decided a few years ago to have a press conference was that he was frustrated by this cacophony of all these different views of all the different FOMC members. He wanted to say, “Okay, at the press conference, I’ll tell you at least what’s the central view of the FOMC.”
That has been only a partial success because everybody who is a member of the FOMC still gives speeches. They never coordinate with each other. Maybe the members of the Board do a little bit but not the regional Fed governors, and this noise continues. So markets are more worried about the fact that there is not one voice but there are twelve or seventeen voices within the Fed, and they don’t know how to read who says what and what it means and who has the most impact.
OR: Do you think there is any probability that they will get this just right or is it almost a certainty that will either be too early or too late? How could anybody calibrate to that extent?
Roubini: It’s certainly a knife’s edge. One of the risks we spoke about was exactly that they start too soon and they normalize too fast. The other risk is actually I think a greater risk, that they go too slowly and they create a huge bubble. That’s already starting with frothiness in a number of financial markets. If you think about the risk of going too slowly, we’ve had now five years of zero policy rates, we’ve had QE 1, QE 2, operation twist, QE 3 is not going to be over until the end of this year, then they’re going to stay on hold at least through the middle of next year.
And then, they officially said based on the mean forecast of FOMC members that it is going to take them through the end of 2018 at the earliest to normalize from zero to four. That’s three years and a half. Last time around between ‘04 and ’06, it took them two years between the middle of ‘04 and the middle of ‘06, a too little, too late, measured pace, twenty-five basis points every meeting, preannounced. And you created the mother of all bubbles, subprime, then housing, then credit, then equity, and then the financial bubble, and that boom in a bubble went into a bust.
This time around, they’re not going to even start hiking until at least the middle of next year, and it is going to take them not two years, but three-and-a-half up to four years to go from zero to four percent. Last time around the increase was from 1% to 5.25%, the previous time was until 6.5%, but this time around it will be to 4%.
So the risk in my view is not that there is a bubble today, there is already frothiness, but that exiting so slowly is going to create a bubble in credit, in the equity market, possibly even again in housing twelve months from now, twenty-four months from now. And then as we saw last time around, the boom in a bubble eventually leads to a bust and then a crash with a lot of collateral damage. I think that’s a big risk. Again, not over the next twelve months but, I would say, if you look at the twenty-four months horizon, the risk that we have another boom and bust, I think is something that markets are not considering seriously right now.
I worry that if this loose monetary policy and the exit from it is going to be continuing, the risk is that, give it twenty-four months, this frothiness goes into an outright bubble in credit, in real estate and in equities. And eventually, if that were to occur, with a lot of leverage in the financial system and the real economy, then we’re maybe two years away from that being a real boom that eventually in the next thirty-six months could lead to a debt bust and a crash. It’s certainly, a risk that markets are underestimating. We’re just repeating the same mistake of the last decade. It’s something you have to worry about certainly.
OR: Does the credit market scare you right now?
Roubini: It does. If I look at junk bond issuance, last year was at a rate above 2007, and it’s not just the issuance but the spreads have narrowed very much, well beyond even what’s justified by low default rates. And now, all sorts of practices that we thought were very risky like payment-in-kind toggles and covenant-light clauses are coming back really as much as it was in 2007. And now, we have all this M&A activity, we have all these leveraged loans. So I would say one of the places where I see this frothiness in full scale is certainly in some of the credit markets right now. You know with policy rates at zero and long rates so low, lots of people are borrowing lots of money in terms that are not justified by medium-term fundamentals, and that eventually it could lead to a massive correction. Again, not anytime soon but once the Fed starts raising rates a bit faster, that’s where maybe the trigger for that big correction could be. I am speaking about 2016 probably rather than next year.
Europe and the Euro
OR: Let’s talk about Europe for a second. You indicated you think that the tail risk there is dramatically reduced but the euro and its problems still exist. Do you think there is a real deflationary problem going on there and how do you see Europe playing out of the next couple of years?
Dr. Nouriel Roubini is the co-Founder and Chairman of Roubini Global Economics.
