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01 31 2016 | by Victor Xing | Economics

Did Federal Reserve’s easy policy create distortions?

Federal Reserve policy and the high yield debt bubble

The ultra-accomodative Federal Reserve policy (in the form of financial repression) has indeed created distortions in the financial market, which was then transmitted into the real economy by investors “reaching for yield.”  The following chart shows investor behavior amid rates “lower for longer” – oil prices began to fall in 3Q 2014:
Federal Reserve monetary policy and high yield bond demand
Federal Reserve balance sheet vs. 5 year rates and high yield OAS
Investors poured liquidity into the high yield debt market (shown as tightening high yield OAS) as low interest rates induced a scramble up the risk ladder (in buying low quality bonds, equities, distressed assets).  This was an expected response and intended result, as policymakers sought to boost consumer sentiment via wealth effect.  The avalanche of available liquidity also discouraged saving, thus “brought forward” future spending (at the cost of retirees who relied on incomes from their savings account and high quality fixed income investments).

The boom and bust in oil investments

Given energy companies’ pronounced presence in the high yield market (reached 20% in 2014), the aforementioned surge in policy-induced high yield funding also helped financed the U.S. shale revolution.  The below articles captured energy companies’ initial rush to issue debt (to an enthusiastic credit market), as well as the subsequent decline in oil prices that decimated investors and pushed up funding cost for energy producers:
The below chart illustrates U.S. oil production (in gold) vs. FED’s balance sheet (in blue), and how overproduction from accommodative monetary policy resulted in the sharp decline in oil prices, creating a systemic risk that was again transmitted from financial and commodity markets to the real economy (in job losses and slow growth in Texas and other oil producing states, as well as the decline in headline inflation, pushing the Federal Reserve further from the price stability objective):
Federal Reserve balance sheet and oil production
FED balance sheet vs. oil production and oil prices
It is also a factor that few investors and policy analysts anticipated Saudi’s response to let oil prices fall to punish U.S. shale producers for upsetting the status quo.  Many expected Saudi Arabia to would step in to stabilize energy prices.

The Federal Reserve and macroprudential measures

The Federal Reserve has always been mindful of potential imbalances and distortions, or commonly referred to as financial stability risk.  However, the majority of policymakers (certainly the “core” group within the FOMC led by Chair Yellen and New York Fed President Dudley) believe that monetary policy is not a suitable tool to address financial stability risk.  Rather, they argued, macroprudential policies (financial regulation) would be the preferred instrument to combat stability risk – please see addendum below.

Unfortunately, the energy rout and its effects on global financial markets originated in the commodity sector, and it would have occurred regardless the readiness of macroprudential measures (financial regulations).  It highlights a risk transmission channel that is very different than 2008, and that monetary policy should indeed respond to financial stability risk:

  • Energy investment bubble (in the real economy) fueled by investor risk-taking (induced by monetary policy)
  • Price decline from overproduction made energy investments unsustainable in the real economy (bubble burst)
  • Bust in the real economy transmit risk back into the financial sector as investors were forced to reduce risk exposure (painful unwind)
  • Higher funding cost as a result of weaker investor sentiment
  • [Unique effect specific to this scenario] Low energy prices inadvertently offset Federal Reserve’s progress toward its price stability objective

In conclusion, imbalances and distortions can take many forms, and few expected low oil prices to act as a catalyst to result in an unwind in risky investments (the usual suspect has been higher rates).  Accommodative Federal Reserve policies have indeed distorted financial markets and sectors within the real economy, but policymakers had expected the benefit (stronger employment and higher inflation) to exceed the cost, but the latest developments indicated that distortions in financial markets and the real economy may actually undo progress made toward maximum employment and price stability since 2008.

In her July 2014 speech, Chair Yellen outlined her view on financial stability risk as well as preference to utilize macroprudential measures to minimize the likelihood of changing monetary policy to address financial stability concerns.  This view is still valid as of 1Q 2016.

In light of the considerable efforts under way to implement a macroprudential approach to enhance financial stability and the increased focus of policymakers on monitoring emerging financial stability risks, I see three key principles that should guide the interaction of monetary policy and macroprudential policy in the United States.

First, it is critical for regulators to complete their efforts at implementing a macroprudential approach to enhance resilience within the financial system, which will minimize the likelihood that monetary policy will need to focus on financial stability issues rather than on price stability and full employment. Key steps along this path include completion of the transition to full implementation of Basel III, including new liquidity requirements; enhanced prudential standards for systemically important firms, including risk-based capital requirements, a leverage ratio, and tighter prudential buffers for firms heavily reliant on short-term wholesale funding; expansion of the regulatory umbrella to incorporate all systemically important firms; the institution of an effective, cross-border resolution regime for systemically important financial institutions; and consideration of regulations, such as minimum margin requirements for securities financing transactions, to limit leverage in sectors beyond the banking sector and SIFIs.

Second, policymakers must carefully monitor evolving risks to the financial system and be realistic about the ability of macroprudential tools to influence these developments. The limitations of macroprudential policies reflect the potential for risks to emerge outside sectors subject to regulation, the potential for supervision and regulation to miss emerging risks, the uncertain efficacy of new macroprudential tools such as a countercyclical capital buffer, and the potential for such policy steps to be delayed or to lack public support.14Given such limitations, adjustments in monetary policy may, at times, be needed to curb risks to financial stability.15

These first two principles will be more effective in helping to address financial stability risks when the public understands how monetary policymakers are weighing such risks in the setting of monetary policy. Because these issues are both new and complex, there is no simple rule that can prescribe, even in a general sense, how monetary policy should adjust in response to shifts in the outlook for financial stability. As a result, policymakers should clearly and consistently communicate their views on the stability of the financial system and how those views are influencing the stance of monetary policy.

To that end, I will briefly lay out my current assessment of financial stability risks and their relevance, at this time, to the stance of monetary policy in the United States. In recent years, accommodative monetary policy has contributed to low interest rates, a flat yield curve, improved financial conditions more broadly, and a stronger labor market. These effects have contributed to balance sheet repair among households, improved financial conditions among businesses, and hence a strengthening in the health of the financial sector. Moreover, the improvements in household and business balance sheets have been accompanied by the increased safety of the financial sector associated with the macroprudential efforts I have outlined. Overall, nonfinancial credit growth remains moderate, while leverage in the financial system, on balance, is much reduced. Reliance on short-term wholesale funding is also significantly lower than immediately before the crisis, although important structural vulnerabilities remain in short-term funding markets.

Taking all of these factors into consideration, I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns. That said, I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macroprudential approach. For example, corporate bond spreads, as well as indicators of expected volatility in some asset markets, have fallen to low levels, suggesting that some investors may underappreciate the potential for losses and volatility going forward. In addition, terms and conditions in the leveraged-loan market, which provides credit to lower-rated companies, have eased significantly, reportedly as a result of a “reach for yield” in the face of persistently low interest rates. The Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation issued guidance regarding leveraged lending practices in early 2013 and followed up on this guidance late last year. To date, we do not see a systemic threat from leveraged lending, since broad measures of credit outstanding do not suggest that nonfinancial borrowers, in the aggregate, are taking on excessive debt and the improved capital and liquidity positions at lending institutions should ensure resilience against potential losses due to their exposures. But we are mindful of the possibility that credit provision could accelerate, borrower losses could rise unexpectedly sharply, and that leverage and liquidity in the financial system could deteriorate. It is therefore important that we monitor the degree to which the macroprudential steps we have taken have built sufficient resilience, and that we consider the deployment of other tools, including adjustments to the stance of monetary policy, as conditions change in potentially unexpected ways.

Next article01 29 2016 | by Victor Xing | Central Banks

Will the Japanese yen see further depreciation?