Last summer’s “taper tantrum”—when markets suddenly got worried that the Federal Reserve was about to start reducing its monthly purchases of bonds—ended fairly uneventfully. But a research paper presented today at a conference in New York suggests that it was a loud and clear warning to the Federal Reserve of the dangers of unconventional monetary policy. Such measures as buying bonds and giving “forward guidance” on rate policy “can build future hazards by encouraging certain types of risk-taking that are not easily reversed in a controlled manner,” the paper says.
The paper was presented at one of the year’s most important conclaves on U.S. monetary policy, the U.S. Monetary Policy Forum, and the discussion of it was probably the most thorough airing yet of the lessons from the bond market’s taper tantrum.
Although the topic was interest rates, the tone was occasionally more like an argument between parents over how to deal with a kid’s temper tantrums. Was it a mistake to let her eat all that sugary stuff, and should we give her what she wants now, or let her cry it out? One questioner from the audience, Antulio Bomfim, co-head of monetary policy insights at Macroeconomic Advisers, made the connection explicit by referring to his parenting strategies with his 2-year-old.
The paper, “Market Tantrums and Monetary Policy,” carried weight because it was written by four luminaries: Michael Feroli, chief U.S. economist at JPMorgan Chase; Anil Kashyap, a professor at the University of Chicago Booth School of Business; Kermit Schoenholtz, a professor at New York University Stern School of Business; and Hyun Song Shin, a professor at Princeton University.
They argued that overborrowing isn’t the only risk the Federal Reserve needs to pay attention to—financial markets can spin out of control even when they aren’t juiced up with borrowed money. They said the bond market’s tantrum last summer is a good example. Interest rates had gradually fallen as mutual funds bulked up on bonds but then shot up when sentiment changed and everyone tried to bail out at once.
“It can reverse very abruptly,” said Shin, the paper’s main presenter. “Absence of leverage does not ensure financial stability,” added Schoenholtz. “The longer policy dampens instability, the larger the risk of a snapback.”
In a sign of the forum’s importance, the two people assigned to discuss the paper were both sitting Fed officials: Narayana Kocherlakota, who is president of the Federal Reserve Bank of Minneapolis, and Jeremy Stein, a member of the Board of Governors in Washington. Kocherlakota said the paper makes a valuable point, but right now the need to prop up the economy with easy money outweighs concerns about destabilizing markets. “I think we have two to three years to be thinking about this problem,” he said. He amended that later in the morning, saying, “Three years might be a long time to wait and see, but definitely two years.”
Stein, who has been publicly worrying about Fed-induced gyrations for more than a year, called the paper “timely and insightful.” He said that hypothetically speaking, if one were worried about investors all trying to get out of bond funds at the same time, one could impose an “exit fee.” Apparently sensing apprehension in the room, which was filled with Wall Street bigs, he quickly added, “I’m not advocating this.”
Not everyone in the audience thought the taper tantrum was much to worry about. “What happened last year was encouraging,” said Ethan Harris, who is co-head of global economics research at Bank of America Merrill Lynch Global Research. He noted that banks kept lending and the housing market stood up despite the bond market’s panic. “It was a nice stress test, and we passed pretty well.”
Chicago’s Kashyap said that the crisis may lie in the future when the Fed finally starts to raise interest rates. “The jury is still out.” And the Fed’s Stein said there’s no way to know how close the market came to a true meltdown last summer. “It’s very hard to learn from one trigger point.”