The Case for Not Worrying So Much About Fed-Generated Financial Instability

David Wessel

There is a steady drumbeat from some corners of Wall Street and some academic economists that the Federal Reserve’s very low interest rates and unconventional monetary policy, inevitably, will create bubbles and financial instability somewhere. Keeping interest rates on Treasurys and bank deposits so low, the logic goes, is inducing investors and financial institutions to “reach for yield,” which is another way of saying that the quest for higher returns is leading them to take excessive risks.

Gabriel Chodorow-Reich, a young Harvard University economist, says, basically, not to worry.

In a paper, “Effects of Unconventional Monetary Policy,” to be presented Thursday at a Brookings Papers on Economic Activity conference, Mr. Chorodow-Reich looks closely at how life insurers, big commercial banks, money market mutual funds and defined-benefit pension plans responded to the Fed’s extraordinary polices of the past several years — pushing short-term rates to zero, promising to keep them there for a long while and printing trillions of dollars to buy long-term Treasurys and mortgages.

His bottom line: These unconventional monetary policies didn’t result in life insurers or commercial banks becoming riskier, despite the widespread belief to the contrary. Fed policies did prompt higher cost money market mutual funds to take on more risks in 2009-2011, though not subsequently, and defined-benefit pension plans with larger unfunded liabilities or an older average age of beneficiaries to seek riskier investments after 2009.

“In the present environment,” he says, “there does not seem to be a trade-off between expansionary [monetary] policy and the health or stability of the financial institutions studied.”

He acknowledges that there are other channels through which Fed policy may lead to unwelcome financial instability, such as abrupt changes in financial circumstances that lead asset managers to all sell assets at the same time. Indeed, the centerpiece of the University of Chicago Booth School’s U.S. Monetary Policy Forum conference this year was a paper warning that changes in Fed policy can prompt huge and disruptive runs on bond mutual funds.

As then-Fed Chairman Ben Bernanke noted in May 2013 congressional testimony: The Fed’s policy-making Federal Open Market Committee takes “very seriously … the possibility that very low interest rates, if maintained too long, could undermine financial stability. For example, investors or portfolio managers dissatisfied with low returns may reach for yield by taking on more credit risk, duration risk or leverage.” Fed governor Jeremy Stein has been particularly outspoken about this possibility.

But Mr. Chodorow-Reich notes that those same Fed policies also make the overall economy stronger, boosting the value of financial institutions’ portfolios and making them less risky, not more risky. That’s been particularly true for life insurers, with their big portfolios of stocks and bonds, and for commercial banks.

Very low interest rates do pose a challenge for money market mutual funds. To keep investors earning a positive after-fee yield, many have waived management fees, creating a temptation to reach for yield, because each basis point in higher yield reduces the amount of fees the fund must waive. The economist finds that money market mutual funds with higher costs did buy riskier, higher yield securities in 2009-2011, but not thereafter. “With so little difference in yields on assets in which money market funds are permitted to invest, there is now very little reaching for yield. He notes, though, that if higher-yielding securities become available again, perhaps the result of Europe’s sovereign-debt crisis, money market funds could, again, take more risks to boost returns.

Mr. Chodorow-Reich finds that defined-benefit pension plans (the ones that pay retirees a fixed pension based on wages and years of service) with larger unfunded liabilities or with a large number of current beneficiaries relative to total plan participants did reach for yield in 2009 and the following couple of years, but he finds little evidence of that in 2012. As with banks and life insurers, the favorable effects of unconventional monetary policy on the stock market have improved the pension plans’ financial health and, therefore, reduced the temptation to invest in riskier securities.