NEW YORK (TheStreet) -- Janet Yellen isn't the first Federal Reserve chair to make a highly scrutinized statement about stock values. Famed Fed Chair Alan Greenspan proclaimed the stock market over-valued because of "irrational exuberance" in 1996. Yellen's "quite high" remark this week in conversation with IMF Managing Director Christine Lagarde doesn't rise to the level of Greenspan's eloquence but is being similarly parsed.
The question is, why? Why is the Chair of the Board of Governors of the Federal Reserve System making comments about the condition of markets?
To be fair, Yellen has made several other statements about the condition of the stock market, it's just that the remarks made yesterday seem to be stronger than the ones made before.
Furthermore, it seems as if central banks have accepted the fact that they need to guide the market a little more. This is the whole reason behind the idea of forward guidance as a policy tool, where the central bank actually produces its expectations about the future course of the economy, prices and interest rates. What's the difference between predicting interest rates or predicting whether or not the stock market might be over valued?
The difference is that making statements like Yellen did yesterday or releasing information on expectations about future interest rates or real GDP causes there to be greater volatility in financial markets. When the central bank makes statements about the future, it creates expectations. These expectations are so important because the Fed can seriously impact financial markets through its actions. If these expectations are broken or if the Fed changes its policies, then market participants must scramble around to find out what the new expectations could be. Uncertainty dominates the market, and uncertainty results in volatility.
Further, Yellen, like Greenspan before her, could be wrong. When Greenspan made his statement in December of 1996, the Dow Jones Industrial Average was in the 6,000s -- it was four years until it topped around 14,000 before the dot-com crash. The NASDAQ Index was around 1,300 and wouldn't peak near 4,000 until three years later.
Yet, Yellen's comments have led stocks to slump and to talk of bubbles.
This question is certainly on the minds of a lot of people these days: Are we in an equities bubble? (I have just written about the issue, myself.)
The problem with attempting to identify a financial market bubble is that a bubble is not a bubble until it breaks. For a well thought out discussion of bubbles is in the well-received book "House of Debt" by Atif Mian and Amir Sufi.
Mian and Sufi argue that asset-price bubbles are almost always driven by an expansion in credit; credit is advanced by people who are optimistic about the success of the asset that is being invested in; lenders can experience optimism that can sometimes seem to be overly enthusiastic and this optimism can grow. The investors, however, must continue to be able to get finance to sustain their optimism. Given the uncertainty there is always the possibility that the unexpected will happen. This is when expectations are broken and the bubble pops. But, given the uncertainty of the situation, the bubble may not pop and the market may be able to work itself out of any over valuation that might exist.
Therefore, the existing situation could continue for an extended period of time even if stocks are overvalued. To her credit, Yellen quickly added to her comment that "the Fed's view that risks to financial stability remained modest despite years of near-zero interest rates."
Should the latter comment -- that risks to the systems stability are modest -- be more correct as time passes, Yellen will officially join her predecessor Greenspan in an ever-growing club: Markets observers who were sometimes wrong.