As the Federal Reserve throttles back on its bond buying and reduces monetary stimulus, the stage may be set for another bond market “tantrum” that could do more economic damage than last summer’s yield spike, the Fed was warned Friday.
But, in its efforts to signal that interest rates will remain very low well into the future, the Fed could be breeding threats to longer term financial stability by encouraging risk-taking in search of higher yields, an array of Fed officials were told at the annual U.S. Monetary Policy Forum.
The Fed should not assume that the economy is secure from financial instability because bank leverage has been reduced; nor should it rely on its “macro-prudential” tools for containing risk, a group of prominent authors said in a paper presented at the forum, sponsored by the University of Chicago Booth School of Business.
Monetary policy may have to be used to address such problems, contend Michael Ferolli of JP Morgan Chase, Anil Kashyap of the University of Chicago, Kermit Schoenholtz of New York University, and Hyun Song Shin of Princeton University.
But monetary policy itself – particularly so-called “forward guidance” on the future path of the federal funds rate – can exacerbate financial instability by sending signals to investors that the Fed will stay “highly accommodative,” the economists warn.
Since the Fed’s policymaking Federal Open Market Committee ran out of room to cut the federal funds rate in December 2008, it has been relying on “quantitative easing” and forward guidance, but Feroli and his colleagues warn such “unconventional” monetary stimulus tools “can build future hazards by encouraging certain types of risk-taking that are not easily reversed in a controlled manner.”
The paper is set to be discussed by Fed Governor Jeremy Stein and Minneapolis Federal Reserve Bank President Narayana Kocherlakota, who have been outspoken about these issues themselves. Also scheduled to speak at the Forum are Chicago Fed President Charles Evans and Philadelphia Fed President Charles Plosser. Other Fed officials are in attendance.
In the summer of 2013, after then Fed Chair Ben Bernanke had announced the FOMC would likely begin reducing asset purchases “later” in 2013 and end them by mid-2014, bond yields leaped. The 10-year Treasury note yield went from below 1.5% in the Spring to more than 3% in early September, leading the FOMC to delay “tapering” until December.
This “market tantrum,” as the authors call it, did not seriously hurt the U.S. economy in the second half of last year, they say, because “even though Treasury bond yields rose sharply, the extent of overall financial distress was relatively modest by historical standards.”
The next “tantrum,” which could result from anticipation of Fed rate hikes, may have more serious consequences, Feroli and his colleagues warn, because levels of “stress” are now higher.
“Our results suggest that bond markets could experience another tantrum – along the lines of that seen during the summer of 2013 – as extraordinary monetary accommodation in the United States is withdrawn,” they write, adding that this could occur “even in the absence of excessive leverage, because of the return – chasing behavior of certain classes of unlevered investors.”
The economists contend “there is sufficient justification for policymakers to factor in the risks to the real economy associated with a market tantrum when determining the appropriate degree of accommodation.”
Citing the Cleveland Fed’s Financial Stress Index, they write, “Looking forward … it is far from clear that conditions in a wide range of markets, including those in Europe and in emerging markets, will be relatively benign when investors conclude that the Fed is contemplating a rise in the policy rate.”
And they caution that “ongoing regulatory developments could magnify the potential for spillover to the real economy from a future bout of market distress.”
“The Dodd-Frank legislation, the Volcker Rule, higher capital standards, and elevated liquidity requirements all have altered the behavior of leading financial intermediaries compared to historical experience…,” they say. “The phase-in of these regulations will continue over the next few years, potentially reducing the ability for the dealer community to serve as a buffer during periods of market stress.”
Ironically though, Fed efforts to prolong low rate expectations and encourage continued investor risk-taking could make matters worse, the economists suggest.
They present two possible scenarios in which “central bank actions might lead to unwarranted compressions of risk premia and excessive accumulations of risk positions by investors that would later have to be unwound.”
In both scenarios, their theoretical “tantrum” trigger is “signals by the central bank that would remove uncertainty about an exit scenario, resulting in another doubling down on risk-taking” by money fund managers and others trying to maintain their performance rankings.
In one scenario, the Fed responds to disappointing economic data by using its forward guidance to further postpone rate hike expectations. “Such a commitment could lead to another wave of reaching for yield, but the success of the policy – measured in terms of accommodation – would likely require creating a bigger imbalance that ultimately would be unwound.”
Feroli and company say “it takes increasingly strong policy promises to keep pulling investors into risky positions as the central bank is driven into the corner … in an effort to encourage greater risk-taking behavior.”
In the second scenario, the economy improves, but the Fed does not respond by moderating monetary stimulus. “In this circumstance, the Fed would find itself with a tradeoff similar to what it faced last September,” they write.
“Allowing market rates to rise would, all else equal, tend to slow the economy,” they continue. “The same concerns that crept into the policy discussion in the September 2013 non-taper decision will be raised again.”
“At that juncture, keeping the forecast liftoff date (rather than advancing it) would itself be a form of easing,” they go on. “As in the first scenario, it might take some very strong statements to convince investors of the Fed’s commitment to stimulus. Again, the Fed would be pushing risk managers to reach further for yield, setting the stage for a larger future reversal.”
The economists draw five more general conclusions:
* “First, in contrast with the common presumption , the absence of leverage may not be sufficient to ensure that monetary policy can disregard concerns for financial stability.
* “Second, the usual macroprudential tool kit does not address instability driven by non-leveraged investors.
* “Third, forward guidance encourages risk taking that can lead to risk reversals….
* “Fourth, financial instability need not be associated with the insolvency of financial institutions.
* “Fifth , the tradeoffs for monetary policy are more difficult than is sometimes portrayed. The tradeoff is not the contemporaneous one between more versus less policy stimulus today, but is better understood as an intertemporal tradeoff between more stimulus today at the expense of a more challenging and disruptive policy exit in the future.”