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Tarullo Backs Option of Using Rates Against Price Bubbles

Federal Reserve Governor Daniel Tarullo
Federal Reserve Governor Daniel Tarullo said that Fed monitors have seen some evidence of increasing risk, while adding in a response to an audience question that U.S. central bankers should be concerned about their policy impact on emerging markets, which are “such a big part” of global growth and capital flows. Photographer: Pete Marovich/Bloomberg

Federal Reserve Governor Daniel Tarullo said central bankers must preserve the option of using interest rates to lean against dangerous financial bubbles even as they strengthen supervisory tools to curtail systemic risk.

“Monetary policy action cannot be taken off the table as a response to the build-up of broad and sustained systemic risk,” Tarullo said today at a conference of the National Association for Business Economics in Arlington, Virginia.

An array of other tools, such as rules that would force banks to raise capital in times of overheating markets, could “reduce the number of occasions on which a difficult trade-off between financial stability considerations and near-term growth or price stability aims will need to be made,” he said.

A plunge in emerging-market stocks this year rekindled concerns about financial instability, with the MSCI Emerging Markets Index falling 8.6 percent through Feb. 5 before paring losses to 4.4 percent for the year as of yesterday.

The Standard and Poor’s 500 Index briefly hit a record yesterday before closing at 1,847.61 for a 0.6 percent increase. The S&P 500 today was little changed at 1,847.69 at 12:07 p.m. in New York. The benchmark for U.S. equities last year rose 30 percent in its biggest annual gain since 1997.

Tarullo said that Fed monitors have seen some evidence of increasing risk, while adding in a response to an audience question that U.S. central bankers should be concerned about their policy impact on emerging markets, which are “such a big part” of global growth and capital flows.

Risk Appetite

“High-yield corporate bond and leveraged loan funds, for instance, have seen strong inflows, reflecting greater investor appetite for risky corporate credits, while underwriting standards have deteriorated, raising the possibility of large losses going forward,” Tarullo said, noting that regulators issued guidance on the high-yield loans in March.

“Valuations do appear stretched for farmland, although recent data are suggesting some slowing, and for the equity prices of some small technology firms,” he said.

Tarullo said he has an “open mind” on whether the Fed should try to encourage lending by reducing the interest rate it pays banks on excess reserves.

“There’s been a good bit of back and forth on whether the rate should be lowered now, in an effort to push more lending out the door,” Tarullo said in response to an audience question. “I’ve got an open mind on that.”

Worst Downturn

Fed officials began debating how to handle asset price bubbles years before the collapse in U.S. home prices in 2007-2008 led to the worst economic downturn since the Great Depression.

Former Fed Chairmen Alan Greenspan and Ben S. Bernanke favored using supervision rather than monetary policy to deter excessive risk-taking, saying an increase in the main interest rate to deflate bubbles may harm the broader economy.

Fed Governor Jeremy Stein broke with that consensus a year ago, saying in a speech that in some circumstances “it might make sense to enlist monetary policy tools in the pursuit of financial stability.”

“Supervisory and regulatory tools remain imperfect in their ability to promptly address many sorts of financial stability concerns,” Stein said in a Feb. 7, 2013 speech at the St. Louis Fed. “While monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation -- namely that it gets in all of the cracks.”

Sow Seeds

Tarullo said the “potential quandary” today is that “very accommodative monetary policy that contributed to the restoration of financial stability could, if maintained long enough in the face of slow recovery in the real economy, eventually sow the seeds of renewed financial instability.”

On the other side, he said, raising interest rates too early could “choke off the recovery just as it seems poised to gain at least a bit more momentum.”

Central bankers are still missing on their goals for stable prices and full employment despite record stimulus.

The unemployment rate stood at 6.6 percent in January, above Fed officials’ 5.2 percent to 5.8 percent estimate for “full employment,” a level that represents full use of labor resources. Inflation rose 1.1 percent last year, below the Fed’s 2 percent target.

‘Famously Underdiagnosed’

Tarullo said the housing bubble was “famously underdiagnosed by policy makers and many private analysts.” Bernanke and Tarullo transformed regulation, giving Fed Chair Janet Yellen an improved internal process to monitor financial institutions and markets.

The Fed conducts an annual capital adequacy test of the largest banks, and a committee of economists, payment systems experts and supervisors monitors risks ranging across the institutions. Bernanke created the Office of Financial Stability Policy and Research with about two dozen staff members focusing on risk analysis.

More recently, supervisors have also been studying how a rising interest-rate shock would impact the financial system.

“Our analysis to this point (undertaken outside of our annual stress test program) suggests that banking firms are capitalized to withstand the losses in asset valuations that would arise from large spikes in rates, which, moreover, would see an offset from the increase in the value of bank deposit franchises,” Tarullo said.

That finding helps explain “the lack of widespread stress during the period of May through June 2013 when interest rates increased considerably,” he said.

Voiced Concern

Fed officials at their Dec. 17-18 meeting voiced concern about price-earnings ratios on some small capitalization stocks, the rise of margin credit, and declining credit quality on some high-yield loans, according to minutes of the Federal Open Market Committee gathering.

At their January meeting, FOMC participants discussed ways to more tightly link monetary policy with their goals for financial stability, according to the minutes.

“Several participants suggested that risks to financial stability should appear more explicitly in the list of factors that would guide decisions about the federal funds rate” after unemployment falls below the FOMC’s 6.5 percent threshold, prompting consideration of raising the main interest rate, according to the minutes.

Download: Fed Governor Daniel Tarullo Speaks at NABE

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