Fed Skeptics' Latest Bugaboo: 'Instability'

Evan Soltas is a contributor to Bloomberg View.
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After four years of being wrong, you might think the "inflation-is-nigh" crowd would be a little out of breath and much embarrassed. No, they've just moved on, notes the Atlantic's Matt O'Brien, to another phantom menace: financial stability.

"The Fed should start tapering this summer before financial market distortions become even more damaging," wrote economist Martin Feldstein. "Central banks cannot do more without compounding the risks they have already created," said Stephen Cecchetti, an economist at the Bank for International Settlements. Other fearmongers include Fed governors Jeffrey Lacker and Jeremy Stein.

Easy money from the Federal Reserve, they now say, threatens the financial system by encouraging irresponsible lending and by inflating asset prices to artificial highs (stocks, bonds, commodities and housing are usually mentioned). The bubbles will pop eventually, wrecking the economy all over again. To avoid financial instability, just as with (nonexistent) inflation, we need to raise interest rates now.

But their new argument is as flawed as the old one.

It just doesn't fit well with the evidence. Even if the financial system could be stronger, there's no sign that the Fed's easing is blowing up an irresponsible credit bubble.

A real threat to financial stability requires widespread overleveraged borrowers, exposed lenders or loose lending standards. None of those are concerns right now. If they were, raising interest rates wouldn't be the best way to fix them.

First, borrowers aren't overleveraged, nor are they heading in that direction. Despite yesterday's unexpectedly high consumer-credit figure, the U.S. private sector as a whole is still choosing to pay down debt.

It has cut its burden by 55 percent of gross domestic product since 2009. Households now pay an average of 10.5 percent of their income in debt service, down from 14 percent before the recession and the lowest in at least 30 years. The average ratio of debt to equity in U.S. nonfinancial corporations has fallen from 72 percent to 57 percent, according to the International Monetary Fund.

Second, the balance sheets of American financial institutions are much improved -- and, with tighter regulation on banks' capital ratios, are set to get even stronger. For bank holding companies, Tier 1 capital ratios (a standard measure of a bank's ability to absorb losses) have already risen several percentage points since the crisis.

Third, credit standards are tight. The median credit score on a new prime mortgage stood at 770 in March, according to a May speech from Federal Reserve Governor Elizabeth Duke. That's up nearly 50 points from before the recession. Loan originations to people with lesser credit are down by 60 percent or more.

Only 10 percent of new loans now go to people with below-average credit scores. Data from the Fed's quarterly survey of loan officers confirm that credit standards, tightened amid the recession, haven't loosened for households or businesses. The new "qualified mortgage" standard from the Consumer Financial Protection Bureau will continue these trends.

Nor is it clear why policymakers should respond to a threat to financial stability with tighter money. What about so-called "macroprudential" financial regulation? As Neil Irwin put it in the Washington Post, why fumigate the entire economic house for "a small patch of mold"? There are more direct and effective alternatives.

The tight-money crowd should stop saying monetary policy is a threat financial stability. It could be, but it's not right now. They need to pay some more attention to the stability (or rather, flimsiness) of their own arguments.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Evan Soltas at esoltas@gmail.com