Tighter Fed Policy Deflates Asset Bubbles

In its attempt to combat soaring inflation, the Federal Reserve has raised the fed funds rate target from 0.00%/0.25% in January to 3.75%/4.00% today.  While inflation remains elevated, the Fed’s actions have had a major impact in deflating asset bubbles that swelled during the pandemic.  As a result, housing prices are falling for the first time in 10 years.  Also, the cryptocurrency market has shrunk by more than two-thirds, and technology stocks have tumbled by more than -50%.

Housing prices in the past several years have soared due to ultra-low borrowing costs and a surge in demand for properties outside of urban areas during the pandemic.  However, home prices are beginning to fall for the first time in 10 years as mortgage rates have more than doubled this year.

Some of the largest speculative excesses seen during the pandemic were centered on cryptocurrencies.  However, the surge in interest rates has taken the froth out of crypto prices, with Bitcoin (^BTCUSD) down more than -63% this year.  Once valued at $3 trillion, the cryptocurrency market has shrunk by over two-thirds.  Fed tightening and the collapse of several crypto firms, most notably FTX.com, have led to some deflation of the crypto bubble.

A surge in technology stocks during the pandemic sent the Nasdaq 100 Stock Index ($IUXX) (QQQ) to an all-time high in November of 2021. However, Fed tightening has led to a -50% decline in technology stocks this year as stocks of technology companies that prospered during the era of pandemic lockdowns have plunged, wiping out trillions of dollars in market capitalization and deflating the tech bubble.

The full effect of the Fed’s aggressive rate-hike regime may not yet be evident.  Not only are more interest rate hikes in the pipeline, but the Fed continues to shrink its balance sheet through quantitative tightening. The Federal Reserve has long shied away from using monetary policy to address asset bubbles.  Still, its rate hikes have had the effect of deflating the bubbles of many risk assets.

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