Stein Sees Signs of Excessive Risk Taking in Some Markets
Federal Reserve Governor Jeremy Stein said some credit markets, such as corporate debt, are showing signs of potentially excessive risk-taking, while not posing a threat to financial stability.
“We are seeing a fairly significant pattern of reaching- for-yield behavior emerging in corporate credit,” Stein said today in a speech in St. Louis.
Central bank officials, including Kansas City Fed President Esther George, are voicing increased concern that record-low interest rates are overheating markets for assets from farmland to junk bonds. Stein today cited leveraged loans and the junk bonds as areas that have been “very robust of late.”
The Fed should be open to using policy tools such as interest rates to safeguard stability, Stein said, while not suggesting the central bank take any such action now.
“I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability,” he said. “It will be important to keep an open mind” on using such tools, said Stein, a former Harvard University economist who specializes in banking and finance.
Chairman Ben S. Bernanke has argued for a clear separation between oversight and interest rate policy, saying regulation should be used to deal with asset-price bubbles. Last month he said he considers supervisory tools “the first line of defense” against such bubbles.
“Supervision by itself is not enough because it is within the regulatory perimeter” in which the Fed focuses primarily on banks, said Viral Acharya, a finance professor at New York University’s Stern School of Business who has served as an adviser to several Fed district banks.
“People say interest rates are a blunt tool,” he said. “But the flip side is that it is very pervasive,” reaching across markets where the Fed may have no regulatory authority.
Stein’s speech reflects the Fed’s post-crisis focus on financial-stability research, including monitoring markets outside its regulatory reach, subjecting banks to stress tests and considering the use of policy tools in new ways to curb risk. For example, the Fed should consider using shifts in the composition of its balance sheet to reduce risks if necessary, he said.
Stein, 52, said a decline in the quality of debt through greater subordination or less use of protective covenants may also signal investors are reaching for yield. He indicated that Fed officials are distinguishing between risks in a particular market and broader systemic risks that could harm banks or disrupt the flow of credit in the economy.
“Even if it does not bode well for the expected returns to junk-bond and leveraged-loan investors, it need not follow that this risk-taking has ominous systemic implications,” he said. “Even if at some point junk-bond investors suffer losses, without spillovers to other parts of the system, these losses may be confined and therefore less of a policy concern.”
The Standard & Poor’s 500 Index, which last week reached a five-year high, fell 0.3 percent to 1,507.44 at 3:18 p.m. in New York. The benchmark 10-year Treasury yield was little changed at 1.95 percent, according to Bloomberg Bond Trader prices.
Stein, who joined the Fed in May 2012 for a term lasting through January of 2018, said in an audience question period that it’s not clear low interest rates caused the house-price bubble from 2002 to 2006. “It is hard to find a smoking gun” that proves the case, he said.
Regulation may work in some instances in addressing systemic-risk issues. Still, monetary policy shouldn’t be ruled out, Stein said to a St. Louis Fed conference on household finances.
“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,” he said. “Changes in rates may reach into corners of the market that supervision and regulation cannot.”
Stein backed the Federal Open Market Committee decision last week to continue purchasing securities at the rate of $85 billion a month to try to bolster growth and reduce unemployment. The Fed said economic growth “paused in recent months, in large part because of weather-related disruptions and other transitory factors,” while “the housing sector has shown further improvement.”
Stein didn’t comment on the U.S. economy or current monetary policy.
George dissented last week from her first FOMC vote on policy, citing concern that “continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations,” according to a Jan. 30 FOMC statement.
Prices “of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels” and may signal market imbalances, George said in a speech Jan. 10.
“It is well documented that holding rates low for a long period tends to increase the search for yield,” said Douglas Elliott, a Brookings Institution fellow who was a managing director at JPMorgan Chase & Co. from 2006 to 2009.
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