The Fed and Financial Stability: Three Questions

Not so long ago, the Federal Reserve focused on moving short-term interest rates up and down in its quest to keep prices stable and, sometimes, to keep unemployment low. It supervised banks, but mainly to make sure individual banks weren’t reckless. A lasting consequence of the global financial crisis is the expansion of the Fed’s mandate: It is now one of the chief guardians of financial stability.

There is, obviously, good reason to think a lot more about maintaining financial stability. What’s not so obvious is how to do that. It’s subject that central bankers, academics and financial-market players are discussing a lot these days.

Here are three of the big questions floating around:

Is it all about leverage?

One reason Fed Chairman Ben Bernanke and others weren’t alarmed when the housing bubble began to burst is that they had seen little economic harm done when the tech-stock bubble burst in 2000. After the fact, many concluded the reason the housing bust was so devastating was that the there was a whole lot more leverage — or borrowing — in housing, both by individuals and by investors. So much of the post-crisis regulation revolves around reducing leverage or requiring leveraged institutions to build bigger capital cushions to absorb losses.

The centerpiece of last week’s U.S. Monetary Policy Forum, convened in New York by the University of Chicago Booth School of Business was a paper by four economists (one from Wall Street, three from academia) that argued, “financial market disruptions can arise without any leverage or actions taken by leveraged intermediaries.” Their primary example was “the taper tantrum,” the sharp flows out of bond mutual bonds that followed Mr. Bernanke’s surprise warning last spring that the Fed was thinking about scaling back its bond-buying.

The big (and largely unanswered) question is whether such bond-market tantrums hurt the economy.) “Market tantrums that don’t have macroeconomic impact shouldn’t be a concern of policy,” said Kim Schoenholtz of New York University, one of the authors. But soaring bond yields translate into higher borrowing costs for households and firms, and that could dampen consumption and investment. With so much more money in bond funds and the like, that impact could be bigger in the future than in the past, noted Princeton’s Hyun Song Shin, another co-author.

The four economists didn’t estimate the size of the macroeconomic effect of market tantrums could be; nor did they offer any ideas on what the Fed should do about the risks posed by unleveraged institutions. But just as Paul Tucker, formerly at the Bank of England, has, they offered an important warning: The next financial crisis might very well originate not in the banks or other highly regulated financial institutions but elsewhere in the financial system.

Is the Fed’s current policy sowing the seeds of the next financial crisis?

The Fed cut short-term interest rates to zero in late 2008 and, when that proved insufficient, it embarked on an unprecedented monetary experiment. Among other things, it vowed to keep short-term rates near zero into 2015, provided the economy performs as it expects.

“The worry,” Fed governor Daniel Tarullo said in a recent speech, “is that the actual extended period of low interest rates, along with expectations fostered by forward guidance of continued low interest rates, may be incentivizing financial-market actors to take on additional risks…thereby contributing to unsustainable increases in asset prices and a consequence buildup of systemic vulnerabilities.”

By keeping rates low for a long time to help a struggling economy, to restore financial stability and to push investors into riskier investments, the Fed could, as he put it, “sow the seeds of renewed financial instability.” But raising rates prematurely to reduce the risks of a financial blow up could choke off the recovery “just as it is poised to gain at least a little bit more momentum.”

While there is widespread acknowledgment of this tension, there is widespread disagreement on how much of an issue this is right now.

“Easy monetary policy can create the risk of financial stability,” Narayana Kocherlakota said at the Monetary Policy Forum. “It is preferable to mitigate such risks using supervisory tools, but I have to admit supervision may lag residual systemic risk.” (In other words, the Fed should first deploy all its regulatory tools to avoid financial excess and another big bust, but those tools may not suffice and the Fed may have raise interest rates to reduce the risk of a future financial crisis, a point Fed Governor Jeremy Stein has made.) Mr. Kocherlakota made clear his view that with inflation so low and unemployment so high, financial instability isn’t a current concern of his. Rather, he said, the Fed should think hard about it now; it might be an issue two or three years from now. Others find that view complacent.

What happens when the Fed steps on the brakes?

There are two competing explanations of the bond market’s Spring 2013 taper tantrum.

One is that it was all about miscommunication between the Fed and the markets. Once the markets understood that the Fed distinguished between tapering its bond purchases (taking its foot slowly off the gas pedal) and raising rates (putting its foot on the brakes) everything calmed down. The other is that the tantrum was a dry run, a harbinger of market turmoil to come.

Fed officials clearly favor the first version. They hope that their repeated explanations will keep markets calm and that the economy doesn’t surprise them too much on the upside or the downside (despite recent history to the contrary.) They take comfort from the calm reaction to the Fed’s decision to begin tapering in December.

Anil Kashyap, a University of Chicago professor and one of the Monetary Policy Forum co-authors, doubts 2013 was a good test: The Fed rattled the markets with taper talk in the Spring, then undid that by not tapering in September and then coupled the December taper decision with a strengthening of its “forward guidance,” the vow to keep short-term rates low for a long time.

What happens, he wondered, when the Fed actually does tap the brakes? Recent history – both the U.S. bond market in the spring 2013 and the turmoil in emerging markets in the past several weeks – indicates that the market reaction may be swift and strong, he said.