Financial market froth bothers the Fed

Hilsenrath writes that the debate at the Fed has turned to asset market dynamics, and the possibility that current policy will create future financial instability.

Behind the Fed’s growing unease is a deep change at the central bank since the 2008 financial crisis. Many economists used to regard financial crises as problems of developing economies, and they saw asset bubbles as problems best dealt with after they burst.

Now, Fed Chairman Ben Bernanke said in an appearance at the University of Michigan last month, the Fed “needs to think about financial stability and monetary, economic stability as being in some sense the two key pillars of what the central bank tries to do.”

Of late, the view in financial markets has been unsettling: Banks and investors are holding riskier debt. Companies are issuing record amounts of junk bonds. And exotic corners of mortgage securities and corporate loan markets are growing.

Fed officials aren’t convinced these recent signs point to any immediate danger to the U.S. financial system. But they are debating whether Fed programs could lead to future financial turbulences and whether the programs will be more difficult to unwind later, as they grow.

The Fed has said that short-term rates would stay low until unemployment falls to 6.5%, from its current level of 7.9%, as long as inflation remains low, and that the bond-buying programs would continue until substantial job market improvements. But officials have always hedged these forecasts, saying they could change with any emerging threats to the financial system.

The same low interest rates intended to trigger spending, investment, growth and hiring are also spurring a race by investors to find higher returns that, by nature, carry higher risks.

Everyone assumes Jon speaks to Bernanke, and the article goes on to talk about Bernanke’s career long effort to spot financial instabilities (an effort the Fed stepped up under him chairmanship, after they missed the biggest financial bubble since the 1920s), so my guess is that the Fed has a keen interest in the re-rating of risk assets that has occurred over the prior two quarters.

This may mean an earlier end to the current policies than I was expecting (it seems that reducing the quantity of purchases is truly up for debate at the March meeting). I think this would be an unwise step.

As surely as the FOMC’s easy money policies supported valuations when existential risks were high, the maintenance of these policies must be boosting valuations now that these existential risks have subsided (for now, at least). It is, however, difficult to judge how much of the recent re-rating is due to the passing of specific risks (EU breakup, debt-cieling, fiscal cliff etc), and how much is due to faith in the new policy rules central banks are operating under — call it the support of ‘whatever it takes’ policy.

These are key questions, as if the re-rating mostly reflects faith in new policy rules, then an early unwind would be a disaster.

The market will tank if the ‘policy rule’ everyone assumes the Fed is operating under is revised to something less accommodative. However, it is not the change of policy nor the change of a narrow policy rule per se that is most damaging — it is the credibility loss, and what that means for forward guidance.

The BIG change last year was the new monetary policy rule (not considering tightening until sub 6.5% unemployment, or over 2.5% inflation). As you can see from the above plot, this much easier than prior Taylor-type rules (I’ve assumed 6.5% unemployment, and 2.5% inflation, and the old policy rule has weights: 1.5x inflation + 2x NAIRU gap, with NAIRU at 5.6%).

This is a BIG change, and the change has been effective in convincing the market that future policy would be more inflationary, which helped to boost the economy right now.

While stopping bond buying is not a tightening (the fed thinks it is the stock of bonds that does the easing, and not the flow) the equity market dive following the release of the January meeting minutes this week suggests that the debate has occurred earlier than the market expected.

Right now, i think the best thing would be stable policy – to keep up MBS and UST purchases, at the current rate, for all of 2013. If the Fed whip-saws the market on the new policy rule, it will be that much harder to get the market to buy into whatever the next (new) policy rule may be. This will be a problem if the FOMC wishes to use the expectations channel to ease policy once again.