Stein Endorses Feroli Warning That Fed Risks Market TumultJoshua Zumbrun
Federal Reserve Governor Jeremy Stein endorsed a warning by economists that raising the main interest rate may cause a financial-market convulsion similar to the “tantrum” that occurred last year after the Fed said it was considering trimming its bond purchase program.
“Whenever the decision to tighten policy is made, then the instability seen in summer of 2013 is likely to reappear,” economists including Michael Feroli, the chief U.S. economist for JPMorgan Chase & Co. in New York and a former Fed economist, said in a paper released today. “Risks of instability have not been eliminated.”
Stein lined up behind Feroli’s argument in comments on the paper during a conference in New York, saying “monetary policy makers cannot wash their hands of what happens” in financial markets when they begin withdrawing stimulus.
The discussion adds to a Fed debate on whether to give more weight to concerns over financial stability when changing so-called forward guidance or monthly bond buying known as quantitative easing. Feroli presented the paper to the U.S. Monetary Policy Forum, a gathering including Stein and at least six other Fed policy makers.
“Our analysis does suggest that the unconventional monetary policies, including QE and forward guidance, create hazards by encouraging certain types of risk-taking that are likely to reverse at some point,” said Feroli and his co-authors Anil Kashyap of the University of Chicago, Kermit Schoenholtz of New York University’s Stern School of Business and Hyun Song Shin of Princeton University.
Not everyone at the conference agreed the risk of market convulsions is severe. The rise in interest rates during mid-2013 didn’t cause lasting economic damage, Ethan Harris, co-head of global economics research at Bank of America Corp. in New York, said at the conference.
“In my mind, this was a nice stress test and we passed pretty well,” he said. The Fed’s decision not to trim bond buying, rather than creating too much turmoil, showed the markets how the central bank would decide whether to taper, he said.
“Strong growth: Yes,” Harris said, referring to how the Fed decided not to wind down purchases before seeing signs the expansion was strengthening.
Stein said “there is no general separation principle for monetary policy and financial stability.” He has repeatedly argued that the Fed must take into account the risks its stimulus may pose to financial stability.
Minneapolis Fed President Narayana Kocherlakota, who votes on monetary policy this year, also spoke about Feroli’s paper at the conference, saying the Fed should do more to reduce unemployment.
“It’s preferable to mitigate such risks using supervisory tools,” Kocherlakota said, referring to potential market instability. Still, “supervision may leave behind residual systemic risk,” he said.
The central bank cut its target interest rate to nearly zero in December 2008 and has said it will probably leave it there “well past the time” that the unemployment rate falls below 6.5 percent. Joblessness declined to 6.6 percent in January.
To speed the economy’s recovery, the Fed also created three unprecedented bond purchase programs, pushing its balance sheet to a record $4.16 trillion. In December, the Fed began slowing its current asset-purchase program, now at a pace of $65 billion per month.
“These threats are not easily controlled with other tools,” the economists said of the risks from withdrawing stimulus. Central bankers must consider the “trade-off between more stimulus today at the expense of a more challenging and disruptive policy exit in the future.”
Chicago Fed President Charles Evans and Philadelphia’s Charles Plosser plan to speak on a separate panel at the conference.
St. Louis Fed President James Bullard, Boston’s Eric Rosengren and Fed Governor Jerome Powell are also attending the conference. Stanley Fischer, President Barack Obama’s nominee to be the new vice chairman of the Fed, and Loretta Mester, the incoming president at the Cleveland Fed, are at the gathering.
The economists said in their paper their analysis “neither invalidates nor validates the course the Federal Reserve has actually taken.”
The paper examines financial trends in mid-2013, when markets suffered a rout amid a Fed debate over when to slow the monthly pace of bond purchases. Former Fed Chairman Ben S. Bernanke told Congress on May 22 that the central bank could scale back stimulus in the “next few meetings,” and on June 19 he said the Fed might start trimming purchases later that year and end them around mid-2014.
The yield on the 10-year Treasury note climbed from as low as 1.62 percent at the start of May to 3 percent by September. The national average 30-year fixed-rate mortgage rose from as low as 3.35 percent in May to 4.58 percent in August.
The yield on the 10-year Treasury note rose 0.02 percentage point to 2.66 percent at 3:35 p.m. in New York, while the Standard & Poor’s 500 Index increased 0.2 percent to 1,856.98.
The authors studied financial markets to conclude that even without huge amounts of debt in the financial system, significant financial instability can occur, and the economy can suffer damage.
“The lack of leverage does not rule out a meaningful impact on the real economy through financial instability,” they said. “When bond yields soar, lending rates to households and firms will also be affected. These shocks could have a direct impact on GDP growth through subdued investment and consumption,” they said, referring to gross domestic product.
“To be sure, excessive leverage was implicated in the recent crisis,” they said, referring to the financial crisis spurred on by the collapse of a debt-fueled housing bubble. “However, it does not follow that future bouts of financial instability will operate only through the same mechanism that was present in 2008 and 2009.”