Federal Reserve Governor Jeremy Stein said monetary policy should be less accommodative when bond markets are overheated even if it raises the risk of higher unemployment.
The remarks suggest financial stability should receive strong consideration as the Fed pursues its two mandates -- stable prices and maximum employment -- because financial crises can do so much damage to jobs and growth.
“All else being equal, monetary policy should be less accommodative -- by which I mean that it should be willing to tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level -- when estimates of risk premiums in the bond market are abnormally low,” Stein said. He didn’t comment on the current stance of policy.
The Fed governor took office on May 30, 2012, and has been one of the Fed Board’s intellectual leaders on the relationship between monetary policy and financial stability. Stein previously was an economics professor at Harvard University in Cambridge, Massachusetts.
In February last year, Stein argued that there may be times when central bankers should raise interest rates in response to rising financial risk because, unlike supervision and regulation, higher borrowing costs get “in all of the cracks,” or markets the Fed may not regulate.
Stein said pursuing lower levels of unemployment with low interest rates may also entail costs if they raise financial instability that could affect jobs and growth at later time if yields shoot back up.
“There is a cost to be weighed alongside the benefit” of an accommodative policy, Stein said yesterday at a forum on monetary policy at Georgetown University in Washington. Financial stability matters “insofar as it affects the degree of risk around the employment leg of the Federal Reserve’s mandate.”
Fed officials have raised financial-stability concerns at their meetings in recent months, minutes show, as they continue to hold the benchmark lending rate near zero for a sixth consecutive year.
The central bank is also keeping yields low on longer-term Treasury securities and mortgage-backed securities through a direct-purchase program which it slowed to a $55 billion monthly pace at its meeting this week. Those purchases have pushed total assets on the Fed’s balance sheet up to a record $4.22 trillion.
As one measure of financial overheating, Stein pointed to risk premiums on longer-term debt, or the component of the bond’s yield that compensates investors for owning a longer-term security as opposed to a short-term security.
He said that in the spring of 2013 in the U.S. when yields on U.S. 10-year notes were around 1.6 percent, estimates of the term premium were around negative 0.80 percentage point. “Applied to this period, my approach would suggest a lesser willingness to use large-scale asset purchases to push yields down even further,” he said.
U.S. 10-year yields rose sharply from the lows of May 2013 when then-Chairman Ben S. Bernanke told the Joint Economic Committee of the U.S. Congress that month that the Fed would consider reducing monetary accommodation in steps as the labor market improved.
Stein said the “dark side” of collapsed risk premiums occurs if they return to normal abruptly in a way that causes “larger economic effects than the initial compression.”
Fed Chair Janet Yellen signaled in a press conference this week that the benchmark policy rate could begin to rise about six months after bond purchases end in the second half of this year.
Treasuries fell this week, with the two-year note poised for its biggest tumble in nine months, as traders adjusted to signs the Federal Reserve may raise benchmark rates sooner and at a quicker pace than anticipated.
Yields on the note, which are sensitive to changes in Fed policy, stood at 0.42 percent in late trading yesterday in New York compared with 0.36 percent March 17.