During the presser following last June’s FOMC meeting, Ben Bernanke cautioned that another round of QE shouldn’t be undertaken lightly because it may have “various costs and risks associated with it with respect to market functioning, with respect to financial stability, with respect to the exit process”.
The next round was launched in September, of course — after (though certainly not just because of) Fed staff economists presented an analysis to the FOMC concluding that there was “substantial capacity for additional purchases without disrupting market functioning”.
Yet the vague concerns were never clarified beyond what was written in the minutes, and we were left uncertain about just what it was that Fed members worried about. Our own guesses included a lack of liquidity in Treasury auctions, MBS settlement fails, and a shortage of collateral for short-term lending markets.
These were all mainly short-term worries, however. (For the record, the first two guesses above haven’t materialised as problems, while the third has been unhelpful and a genuine nuisance to repo markets, but not a threatening systemic issue.)
It is the longer-term concerns about the impact of QE on financial stability that lately have come to the fore, highlighted by the emergence of Jeremy Stein as the Fed’s resident minder of asset bubbles and recent public comments by FOMC members that LSAPs might end sooner than expected.
We’ve noted a couple of times that it would be a mistake to assume that such talk indicates an impending hawkish shift by the Fed. But it’s reasonable to wonder how much of an impact these worries will ultimately have on when and how the Fed will end asset purchases (or taper them off) and on its exit strategy. Bernanke conceded as much while speaking to Congress during his recent semi-annual appearance before Congress.
So these issues likely have been discussed throughout the FOMC meeting that started Tuesday, and Bernanke will surely face questions about them during the presser Wednesday afternoon.*
And in a timely note, Lew Alexander of Nomura has a comprehensive look at the impact of monetary policy on systemic risk, concluding…
… we do not expect concerns about financial stability to be the primary factor that brings asset purchases to an end.
– First, financial conditions are an important transmission channel for monetary policy. Within limits, robust risk appetite is natural and a desirable consequence of the FOMC’s accommodative policies.
– Second, policymakers have non-monetary tools to address excessive risk taking. The Federal Reserve and other regulatory agencies have supervisory and regulatory powers, recently enhanced by the Dodd-Frank Act, to contain risk taking that threatens financial stability. There is likely to be a relatively high bar for using monetary policy to address imbalances in the financial system, particularly if those imbalances are relatively narrow in scope.
– Third, while signs of “irrational exuberance” are evident in some parts of the financial system, signs of a buildup of financial imbalances system wide that is big enough to warrant a preemptive change in monetary policy have yet to emerge. …
Chairman Bernanke has noted that Federal Reserve policy makers are monitoring interest rate risk, and other forms of risk taking, in the financial system closely. He has also argued, however, that a premature increase in interest rates could be a significant setback to the FOMC‟s objectives for monetary policy. (He has also argued that in the future the FOMC can also use forward guidance on interest rate policy and its balance sheet to respond to any disruptive increase in interest rates.)
Looking beyond interest rate risk, Federal Reserve officials will have to decide how to respond to the patterns of risk taking that are emerging in the economy not only in the context of the FOMC but also in their capacity as regulators and supervisors. In the near term, given what is happening in specific markets and the economy as a whole, we believe that Federal Reserve officials are more likely to address any emerging financial imbalances with micro-prudential tools, as needed, rather than use financial stability as the primary reason to limit their asset purchases.
In other words we continue to expect that the outlook for the labor market — reflecting both the actual performance of the labor market and the outlook for growth — will be the primary factors that ultimately drive decisions regarding the FOMC asset purchases.
The bulk of the note is dedicated to arguing the third point. It draws on a combination of this excellent report by NY Fed economists, Jeremy Stein’s recent speech, and empirical research by economists at the Bank for International Settlements and the IMF on economic indicators that lead financial crisis.
We’ll have more from the note in future posts, but if you want to go straight to the source, it’s in the usual place.
* If you’re looking forward to the Fed presser as much as we are, join us for US Markets Live starting at 2:25pm EST, five minutes before it begins.
Policymaker potency and the next US crisis: Part 1 – FT Alphaville
Policymaker potency and the next US crisis: Part 2 – FT Alphaville