Yellen Faces Test Bernanke Failed: Ease BubblesRich Miller
Janet Yellen probably will confront a test during her tenure as Federal Reserve chairman that both of her predecessors flunked: defusing asset bubbles without doing damage to the economy.
The central bank’s easy money policies already have led to pockets of frothiness in corporate debt and emerging markets. The danger is that unwinding such speculative excesses will end up shaking the financial system and hurting growth.
Yellen is “going to be trying to do something that no one has ever done,” said Stephen Cecchetti, former economic adviser for the Bank for International Settlements, the Basel, Switzerland-based central bank for monetary authorities. She needs “to ensure that accommodative monetary policy doesn’t create significant financial stability risks,” he said in an interview.
Investors got a taste of the hazards in recent days when news of a slowdown in China’s economy, coupled with expectations of reduced stimulus from the Fed, helped trigger a rout in emerging markets that had been pumped up by easy money imported from the U.S. Emerging-market stocks dropped yesterday by the most in five months, dragging U.S. shares with them. The MSCI Emerging Markets Index has lost 7.1 percent this year.
The turbulence in the financial markets probably won’t deter the Fed from deciding this week to reduce its monthly bond purchases by another $10 billion, according to economists at Goldman Sachs Group Inc., JPMorgan Chase & Co. and Credit Suisse in New York. It is currently buying $75 billion per month.
While the Standard & Poor’s 500 index has fallen in recent days, it’s only 3.6 percent off its record high set on Jan. 15. “It would be very abnormal if we didn’t have consolidating moves in the assets that have gone up so much,” Lloyd Blankfein, chief executive officer of Goldman Sachs, told Bloomberg Television on Jan. 24.
Yellen faces two challenges in dealing with bubbles: she has to identify and deflate them before they get too big and dangerous; and she has to manage monetary policy without causing them to burst in a way that causes havoc in financial markets and undercuts the expansion.
The trouble is that the tools she has for the first task, such as raising capital standards for banks or requiring homebuyers to put down more of their own money, are largely untested in the U.S. They are potentially cumbersome to put in place with multiple regulatory bodies involved and could prove politically unpopular.
And the difficulties of her second brief were underscored by the fallout in financial markets last year after Fed Chairman Ben S. Bernanke merely suggested in May that the central bank might scale back its asset purchases.
Neither Bernanke, whose eight-year term ends Jan. 31, nor his predecessor, Alan Greenspan, had much success in dealing with bubbles. Greenspan presided over a stock market boom that went bust, pushing the economy into recession in 2001. He then watched as housing prices surged to unsustainable levels, peaking as Bernanke took over in 2006. Bernanke initially played down the economic impact of declining property prices, saying in March 2007 that the fallout was “likely to be contained.” He proved to be wrong as the U.S. at the end of that year entered its worst economic contraction since the Great Depression.
President Barack Obama spoke repeatedly last year about the need to avoid what he called “artificial bubbles.” He praised Yellen for “sounding the alarm early about the housing bubble” when he announced her nomination for the job of Fed chairman on Oct. 9. “She doesn’t have a crystal ball, but what she does have is a keen understanding about how markets and the economy work,” he said.
The Fed is devoting “a good deal of time and attention to monitoring asset prices in different sectors” to see if bubbles are forming, Yellen, currently Fed vice chairman, told the Senate Banking Committee on Nov. 14.
“By and large,” she said, “I don’t see evidence at this point in major sectors of asset-price misalignments, at least of a level that would threaten financial instability.”
The first test of the Fed’s loose monetary policy probably will come from a buildup in financial excess, rather than from an unwelcome rise in inflation, said Anil Kashyap, a professor at the University of Chicago Booth School of Business. Under the Fed’s favorite measure, inflation stood at 0.9 percent in November, less than half the central bank’s 2 percent target.
“They’ll have to worry about financial-market disruption more than they will about inflation,” said Kashyap, who was chosen by the American Economic Association to respond to Bernanke’s valedictory address to the group on Jan. 3.
The Fed’s zero-interest-rate policy is prompting investors to take greater risks with their money. The extra yield that buyers demand to own older, smaller junk bonds that trade infrequently shrank to an average 0.25 percentage point in the first half of this month from more than 1 percentage point a year ago, according to Barclays Plc data.
Bernanke, 60, has set out a two-stage process for identifying potentially dangerous buildups in speculation. First, officials try to pinpoint asset markets where prices are grossly misaligned. Then they consider whether a sudden drop in those prices would be amplified throughout the financial system, as happened during the housing bust. Such intensification could occur if the investors holding those assets were highly leveraged, illiquid or interconnected with others.
The Fed’s “first, second and third lines of defense” for dealing with such imbalances is to rely on supervision, regulation and so-called macro-prudential policies, such as mortgage loan-to-value restrictions, Bernanke told the Brookings Institution in Washington on Jan. 16. Only as a last resort would it consider raising interest rates.
The central bank already is using its annual stress tests of the nation’s biggest banks to build up the resilience of the financial system and discourage excessive risk-taking.
Stress testing “can potentially revolutionize bank supervision,” said former Bank of England Deputy Governor Paul Tucker, “though it will take some while to play out.”
One downside, according to Kashyap: the tests only cover banks, not other institutions such as money-market mutual funds where many of the risks may end up residing.
Bernanke himself has acknowledged other difficulties with the Fed’s approach: some of the tools still are being developed and may not be easy to implement quickly.
That’s because they aren’t entirely under the purview of the Fed -- the Securities and Exchange Commission oversees money-market funds, for instance. Even inside the central bank, there are governance issues: The Fed’s board in Washington deals with capital standards while the Federal Open Market Committee, which includes regional Fed bank presidents as well as board members, is responsible for monetary policy.
The Financial Stability Oversight Committee, headed by Treasury Secretary Jacob J. Lew, was created in 2010 to deal with jurisdictional issues. “Turf battles” probably still will delay action, said Cecchetti, a professor at Brandeis International Business School in Waltham, Massachusetts.
In a sign of the tensions, SEC Commissioner Michael Piwowar complained yesterday that banking regulators were crowding out the agency in decisions that affect capital markets. The FSOC “represents an existential threat” to the SEC, he told the U.S. Chamber of Commerce in Washington.
Former Treasury Secretary Lawrence Summers voiced doubts about the ability of policy makers to spot crises before they happen and the efficacy of the tools they intend to employ to head dangers off. “I worry about macro-prudential complacency,” the Harvard University professor told a panel at the World Economic Forum in Davos, Switzerland, on Jan. 24.
As Yellen prepares to ascend from her current post as Fed vice chairman on Feb. 1, she does have one big thing going for her. The economy just wrapped up its best six-month performance since the recession ended in June 2009, according to estimates by economists at Goldman Sachs and Morgan Stanley in New York.
Further gains are forecast for 2014. Yellen, 67, told Time magazine earlier this month that she is looking for gross domestic product to expand by 3 percent or more this year, after averaging about 2.5 percent so far during the recovery.
Faster growth would still pose some tricky issues for the Fed in its dealings with financial markets. Bernanke and his colleagues have tried to hold down long-term interest rates by promising to keep the short-term rate they control near zero for a long time. If the economy picks up steam, investors may begin to doubt that commitment and push up bond yields in response, triggering reverberations elsewhere.
The Fed’s forward guidance strategy already has “crumbled,” said Marvin Goodfriend, a former central bank official who is now a professor at Carnegie Mellon University in Pittsburgh. At 6.7 percent, the unemployment rate is just above the 6.5 percent threshold that the central bank had set for the start of its discussions on raising rates. Yet it’s still buying bonds in an effort to ease financial conditions.
Bernanke and his colleagues have sought to de-emphasize the significance of the jobless marker by saying that they expect to hold the overnight federal funds rate near zero “well past the time that the unemployment rate declines below 6.5 percent.”
The trouble with such less specific forward guidance is that it hasn’t worked in the past, said Roberto Perli, a managing director at Cornerstone Macro LP in Washington.
While investors have evinced less angst about Yellen taking over than they did when Bernanke succeeded Greenspan in 2006 or when Greenspan stepped in for Paul Volcker in 1987, “the markets will always test the mettle of a new Fed chairman in one way or another,” former Fed No. 2 official Alan Blinder said.
Cecchetti agreed with Yellen that there aren’t many signs now of dangerous financial imbalances. Yet that’s not a reason to sound the all-clear.
“We’re into the sixth year of zero interest rates,” he said. “You do worry that there’s got to be something going on that maybe you’re missing.”