The US Federal Reserve won’t try and head off rises in asset prices (which some might argue are bubbles) by using monetary policy (which means interest rate rises) is a development that every investor should be aware of.
In other worlds, the world’s most important central bank has rejected the idea that regulators such as it should ‘lean‘ into perceived bubbles in financial markets to prick them early and avoid a repetition of something developing into a new version of the GFC.
In that the Fed joins the Reserve Bank of Australia in being reluctant to use monetary policy to halt or prick asset bubbles – on Thursday RBA governor, Glenn Stevens ruled out using interest rate rises to cool the housing market, especially in Sydney.
There’s this feeling among major central banks that using the blunt instrument that interest rates are could damage the wider economy, halt growth and push up unemployment as well as slowing the property sector.
The Fed wants investors and other market participants to understand that the weight will be taken by what’s called macroprudential (and for that matter, some micro prudential) methods to control any bubbles spotted early (such as the current buoyant level of house prices in many countries).
But at the same time the Fed policy, enunciated on Wednesday night in the US by chair, Janet Yellen, places a great deal of pressure on the banking system and its strengths (i.e. capital levels and buffers for those deemed too big to fail).
She and the Fed want investors of all sizes to be more aware of what is happening in the various markets rather than depending on central banks to protect their backs.
It is a form of caveat emptor for those in the markets – investors should be more aware of conditions in the markets they are operating in than whether regulators and central banks will step in.
And banks and their shareholder and investors generally will have to wear the cost as far as possible for any assets ‘popped‘.
Ms Yellen’s speech is her first major expression of Fed policy since she took the top job earlier this year. In it she makes clear the Fed will not try and use monetary policy – such as interest rate rises – to try and head off asset bubbles and collapses.
She argues (and it’s here where investors had better understand her comments) that the Fed is more interested in terms of the resilience of financial system rather than cracking bubbles. There’s the strong view that using monetary policy (interest rate rises) to try and control bubbles and other overheating in the markets, could have an adverse impact on the wider economy, damaging employment levels and growth.
It is a defence of the Fed’s current very loose monetary policy and its intention of keeping it relaxed for some time to come – she argues that that is more important for the Fed’s twin mandates – employment growth and price stability – than trying to prick asset bubbles.
Ms Yellen suggested in her speech in New York to an IMF conference that the central bank is more interested in having a resilient financial system that can cope when asset bubbles burst than it is in popping them through rate rises.
Based on her comments, it means there is little chance of interest rate increases being used to head off stock or bond markets. That in turn suggests investors will be allowed to inflate and collapse asset values of differing types as long as the underlying financial system is strong enough to withstand any shocks. And investors will have to bear the cost, not central banks or the wider economy.
“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,” said Ms Yellen.
“Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical,” said Ms Yellen.
"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," Ms Yellen said.
She said that monetary policy is too blunt a tool to tackle financial risks unless they become extreme, because there would be a cost in terms of higher unemployment and below target inflation.
That is similar to past comments from Reserve Bank Governor, Glenn Stevens and other senior officials from our central bank about asset bubbles and how to control them. The potential costs to the wider economy from using interest rates to pop a bubble might be far more than the savings made from correcting the asset price inflation.
“The potential cost, in terms of diminished macroeconomic performance, is likely to be too great to give financial stability risks a central role in monetary policy decisions, at least most of the time,” Ms Yellen told the conference.
“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," Ms Yellen said.
Some would argue that the Aussie dollar is a sort of bubble on that basis where the search for yield among big global investors has kept the currency’s value much higher than the fundamentals demand.
Not everyone will agree with her comments and the approach of the Fed.
Last weekend, for example, the Bank of International Settlements (the so-called central banks central bank) argued that interest rates should rise sooner than expected in many developed economies to head off rising financial speculation and bubbles.
But the IMF would be a supporter – it wants central bank to maintain loose monetary policies for as long as possible to help economies repair themselves after the GFC, improve the health of their banks and to boost demand and employment.
And like Australia, the Fed chair made it clear the central bank will focus on tough regulation of banks, which is likely to be bad for bank profitability (As the big banks in Australia, led by the Commonwealth Bank, have been moaning about).
Ms Yellen also made clear the Fed could act against financial excesses, in particular by varying the requirements of its stress tests, which require banks to show they have enough capital to deal with a range of possible shocks.
“The stress tests include a scenario design process in which the macroeconomic stresses in the scenario become more severe during buoyant economic expansions,” she said. That is also a policy route open to the RBA and its fellow regulator, APRA in Australia.
