Fed Bubble Agonistes Persists as Zero Rates Prompt Debate
Financial-market bubbles are proving a more pressing threat than inflation to Federal Reserve officials who’ve bought trillions of dollars in bonds and kept the target for short-term interest rates near zero since 2008.
“There is a threshold out there somewhere” where markets will become too frothy or the balance sheet becomes too large and the central bank will have to react, said Michael Gapen, a former member of the Fed board’s Division of Monetary Affairs and now a senior U.S. economist at Barclays Plc in New York. “The problem since the beginning of quantitative easing three is there isn’t significant enough clarity for what is the stopping rule.”
Policy makers and regulators see worrisome signs. The Fed and Office of the Comptroller of the Currency are recommending lenders strengthen underwriting standards for leveraged corporate loans, as the amount of this high-risk debt approaches levels not seen since before the financial crisis and their quality deteriorates.
Kansas City Fed President Esther George, who has dissented against every Federal Open Market Committee decision this year, has highlighted an increase in farmland prices as a concern, and Richard Fisher, president of the Dallas Fed, has pointed to rising home prices in Dallas and Houston as a sign of a U.S. housing bubble. Fed Governors Jeremy Stein and Jerome Powell also have warned this year that some bond yields might be too low for the risk investors are taking.
Fed Vice Chairman Janet Yellen named financial stability as the central bank’s third mandate -- along with stable prices and full employment -- when she accepted her Oct. 9 nomination as chairman. This means well-functioning markets for raising money through sales of bonds or stocks and a sound banking system that can transmit the Fed’s interest-rate policy to all borrowers in the economy.
“One scenario to be worried about may simply be a sharp increase in market-wide rates and spreads at an inopportune time, such that it becomes harder for us to achieve our dual-mandate objectives,” Stein said Sept. 26 in Frankfurt. That “may be among the most relevant” risks to financial stability “when thinking about the costs and benefits of our current highly accommodative policies.”
If the Senate confirms Yellen’s nomination, she will inherit a Federal Open Market Committee divided on how to confront this issue. Members disagree over how to use monetary policy and regulatory tools in response to too much risk-taking, leaving investors uncertain about when the Fed will curtail debt purchases or even raise its benchmark interest rate. Ben S. Bernanke’s term ends Jan. 31.
“We are getting a peek into the discussion as the committee assesses the financial-stability risks of further asset purchases,” said Laurence Meyer, a former Fed governor and now a senior managing director at Macroeconomic Advisers LLC in Washington. “Supervision and regulation is the first line of defense.” The second line “is to pray.”
That’s because if regulation doesn’t work, the FOMC must weigh two risks: Using monetary policy to slow a bubble and potentially harming growth or doing nothing and risking future damage to financial stability, Meyer said.
Policy makers currently are falling short of their employment and price goals, with joblessness at 7.2 percent -- compared with 5 percent when the 18-month recession began in December 2007 -- and annual inflation rates missing their 2 percent target by a half percentage point or more every month since November, based on the personal-consumption-expenditures price index.
U.S. central bankers begin a two-day meeting today to discuss their $85 billion in monthly purchases of mortgage-backed securities and Treasuries. Bernanke said Sept. 18 that “the first increases in short-term rates might not occur until the unemployment rate is considerably below 6.5 percent.”
FOMC members have gone from being troubled in April about too-easy financial-market conditions to worrying in early September they’ve become too tight after Bernanke outlined a timeline for a potential reduction in the pace of bond buying.
At the April 30-May 1 FOMC meeting, “a few participants expressed concern that conditions in certain U.S. financial markets were becoming too buoyant,” according to the minutes from the gathering. In June, “a few stated their view that a prolonged period of low interest rates would encourage investors to take on excessive credit or interest-rate risk and would distort some asset prices,” those minutes show.
They decided at the September meeting to postpone a trim in their stimulus after yields on U.S. 10-year government bonds rose to almost 3 percent at the beginning of the month from 1.63 percent in early May on expectations of a pullback.
Yields on the benchmark 10-year note have fallen to 2.52 percent on expectations policy makers again will push back plans to taper their bond buying after the federal government partially shut down for 16 days and U.S. payrolls rose last month less than economists projected.
Prospects for continued stimulus also have sent stocks in the U.S. to record highs, with the Standard & Poor’s 500 Index at 1,762.11 (SPX) yesterday. The index is up 23.6 percent this year, which would be the best annual gain since a 26.4 percent surge in 2003.
“Quantitative easing is designed to force investors to take risk,” said Marvin Goodfriend, a former Richmond Fed policy adviser who is now an economics professor at Carnegie Mellon University’s Tepper School of Business in Pittsburgh.
The Fed won’t pare its $85 billion in monthly asset purchases until the March 18-19 meeting, and even then the monthly pace will be $70 billion, according to the median estimate in a Bloomberg News survey of economists.
Policy makers began the purchases as an emergency measure in 2008 to help restore market function and liquidity. The second and third rounds were aimed at stimulating demand for higher-yielding assets by lowering interest rates on government and mortgage-backed securities. QE3 began in September 2012 when there was no crisis and thus “quickly ran into side effects,” promoting risk-taking in financial markets, Goodfriend said.
Fed officials disagree on how to address this. Yellen and William C. Dudley, president of the New York Fed and vice chairman of the FOMC, prefer to lean against bubbles using regulation rather than interest rates, their speeches show.
“Most central bankers view monetary policy as a blunt tool for addressing financial-stability concerns, and many probably share my own strong preference to rely on micro- and macroprudential supervision and regulation as the main line of defense,” Yellen said in an April 16 speech in Washington.
Dudley said in a 2010 speech he didn’t rule out using tighter credit to reduce leverage in the financial system, while saying monetary policy is “inferior” to regulatory tools in responding to bubbles.
By contrast, Stein has argued the Fed should consider raising interest rates to fight bubbles when regulation or the central bank’s supervisory reach fall short.
“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 in a Feb. 7 speech in St. Louis.
In Denver on Sept. 26, George noted “some excess” in the leveraged-lending market, which “bears watching,” along with the price of farmland.
“The notion of bubbles and fueling bubbles is a very live issue,” St. Louis Fed President James Bullard said in a Sept. 20 interview at Bloomberg’s headquarters in New York. “I don’t think, intellectually, that the committee has come to a good explanation of what we want to do or how we want to react to bubbles.”
The Fed’s attempts to deflate the high-yield, high-risk debt markets through talk has failed so far to produce results. In March, the Fed’s Board of Governors, Federal Deposit Insurance Corp. and OCC issued unenforceable guidance on junk-rated bank loans, urging lenders to adhere to high underwriting standards.
The Fed and OCC now have sent letters to some of the biggest banks asking them to avoid originating corporate loans that can be considered “criticized” -- debt classified by regulators as having some deficiency that may result in a loss -- according to nine people with knowledge of the matter. Forty-two percent of so-called leveraged loans have been placed in that category this year.
A Moody’s Investors Service index of covenant quality, or investor protections, on bonds sold by North American companies rose to a record 4.05 last month from 3.85 in August. A reading of 5 is the weakest and 1 is the strongest.
While the process of “incorporating financial stability into the design of central-bank policy” is progressing, it’s “still in its infancy,” said Lawrence Goodman, president of the Center for Financial Stability in New York.
Such stability doesn’t “factor heavily into the Fed’s macro policy until it is staring into the abyss of market turbulence,” Goodman said.
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