Concern has been growing among Federal Reserve officials that the Fed’s low interest rate policies are causing excessive risk-taking in search of higher yields, but that doesn’t mean the Fed is about to abandon its employment goals and tighten monetary policy to avoid financial instability.
For awhile, it was just “hawks” in the ranks of Federal Reserve Bank presidents who were warning that the Fed’s easy money measures risk generating new asset bubbles. For instance, Kansas City Federal Reserve Bank President Esther George says the Fed “must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances,”
“Prices of assets such as bonds, agricultural land and high-yield and leveraged loans are at historically high levels,” notes George, the lone dissenter when the Fed’s policymaking Federal Open Market Committee reaffirmed its aggressively expansionary monetary measures Jan. 30. “A sharp correction in asset prices could be destabilizing and cause employment to swing away from its full-employment level and inflation to decline to uncomfortably low levels.”
Lately, more mainstream voices have chimed in. Fed Governor Jeremy Stein surprised many by cautioning against credit market “overheating,” particularly in the junk bond market and funds that invest in them. He warned “a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to ‘reach for yield.’” And he said “waiting for decisive proof of market overheating may amount to an implicit policy of inaction…”
In the past, the Fed party line has been that the best way to curtail such behavior is through regulation, and indeed the Fed got a mandate to do just that in the Dodd-Frank legislation. Monetary policy, it was thought, is too “blunt” a tool to curb credit market excesses.
But Stein opened the door to using monetary policy to calm frothy markets. While it may not be a precise instrument, it has the merit of “get(ting) in all of the cracks,” he said.
Fed Governor Sarah Bloom Raskin, New York Fed President William Dudley and Boston Fed President Eric Rosengren have raised concerns about bank lending, short-term wholesale funding and money market funds.
Further fuelling speculation that financial stability threats might hasten Fed tightening, minutes of the Jan. 29-30 FOMC meeting revealed “many participants… expressed some concerns about potential costs and risks arising from further asset purchases.” And they said “a number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred.”
Legitimate as such fears are, the odds of financial risks significantly swaying the course of monetary policy in the foreseeable future are small.
The FOMC has said it will keep buying Treasury and mortgage backed securities (now at an $85 billion monthly pace) until it sees “substantial” improvement in the labor market outlook. Chicago Fed President Charles Evans, another voter, says the FOMC needs to be “highly confident” about that.
Even after it stops buying bonds and the economy has strengthened, the FOMC vows to keep policy “highly accommodative” “for a considerable time.” And it plans to hold the federal funds rate near zero until the unemployment rate drops to 6.5%, provided forecasted inflation doesn’t exceed 2.5% and inflation expectations are “well-anchored.”
With unemployment near 8% and inflation running around 1.5%, financial imbalances would have to become much more threatening to divert the FOMC from its paramount goal of reducing joblessness. Fed Chairman Ben Bernanke made that clear enough in presenting the semi-annual Monetary Policy Report to Congress.
“Although a long period of low rates could encourage excessive risk-taking, and continued close attention to such developments is certainly warranted, to this point we do not see the potential costs of the increased risk-taking in some financial markets as outweighing the benefits of promoting a stronger economic recovery and more-rapid job creation,” he said.
Bernanke said the FOMC “takes very seriously… the possibility that very low interest rates, if maintained for a considerable time, could impair financial stability.” But he said risk-taking actually can help “reduce risk in the system, most importantly by strengthening the overall economy, but also by encouraging firms to rely more on longer-term funding, and by reducing debt service costs for households and businesses.”
The FOMC is unlikely to make any meaningful policy shift in the next few months. To even think about scaling back asset purchases, i.e., to determine there has been “substantial” improvement in the jobs picture, most policymakers want to see the unemployment rate drop closer to 7% — and not in a context of falling labor force participation. They also want to see a sustained period of 200,000 monthly non-farm payroll gains, coupled with above-trend GDP growth.
Given ongoing fiscal wrangling in Washington, with all the uncertainty it causes, among other headwinds, it is difficult to imagine the FOMC discussing possible cutbacks in QE3 until sometime this summer at the earliest. Unless the economy surmounts the fiscal problems and other “downside risks” and does a lot better than expected, we’re probably looking at closer to the end of the year or perhaps beyond.
Steve Beckner is senior correspondent for Market News International. He is heard regularly on National Public Radio and is the author of “Back From The Brink: The Greenspan Years” (Wiley).