 "Fears of renewed instability as Fed ends stimulus")
After a nearly uninterrupted five-year rally in stocks and bonds, some investors seem to be getting nervous. On July 31, the Dow Jones industrial average dropped 317 points, wiping out the year's gains. Last week, junk bond funds experienced record withdrawals and junk bond interest rates spiked.
Such gyrations may be healthy, a reminder that there are risks and that markets go down as well as up. But they could also be the harbinger of something more worrisome, which would be renewed financial instability as the Federal Reserve brings to an end its extraordinary easy money policy. The Federal Reserve has said it expects to raise interest rates in 2015 for the first time since the financial crisis.
"There's no real precedent for ending anything of this magnitude," said Jeremy Stein, who left the Fed's Board of Governors at the end of May to return to Harvard's economics department, where I caught up with him last month on the day of the Dow's big drop. As the Fed feels its way, he said, investors may have to prepare for greater volatility.
While at the Fed, Stein was viewed as the chief advocate for financial stability on the seven-member board, where he pondered the possible unintended consequences of the Fed's stimulus policies.
Stein said his differences with his fellow board members, and especially the chairwoman, Janet Yellen, had been exaggerated and were more a matter of nuance. "I certainly felt we were courting some risks" with the Fed's last round of quantitative easing, he acknowledged. "But then again, given the level of the unemployment rate at the time, some risk-taking was warranted."
In April, in his last speech as a Fed board member, Stein warned that monetary policy should be "less aggressive" when credit risk premiums were extremely low, as they were then, and they've gotten even lower since.
"To be clear, we are not necessarily talking about once-in-a-generation financial crises here, with major financial institutions teetering on the brink of failure," he said in a speech to the International Monetary Fund. "Nevertheless, the evidence suggests that even more modest capital market disruptions may have consequences that are large enough to warrant consideration when formulating monetary policy."
Stein's concerns have been gaining traction. They're expected to be a major topic at next week's annual gathering of Fed officials, policy makers and economists at Jackson Hole, Wyo. This week, former Treasury Secretary Robert Rubin and Martin Feldstein, a former chairman of the Council of Economic Advisers and a Harvard professor, sounded similar themes in an op-ed article in The Wall Street Journal, warning that the Fed-induced low rates "have led to reaching for yield in many ways and in very large magnitudes." They added, "The risk of excesses and the consequent instability have increased substantially."
Stein's analysis has also influenced Yellen, although she puts a higher priority than he does on full employment. Yellen devoted an entire speech to the subject of financial stability last month at the IMF, where she said the Fed had devoted "substantially increased resources" to monitoring stability and acknowledged that the Fed's low-interest rate policy had spurred "households and businesses to take on the risk of potentially productive investments." But, she went on, "Such risk-taking can go too far, thereby contributing to fragility in the financial system."
She even explored a previously taboo subject, which is whether the Fed contributed to the post-2000 housing bubble by keeping rates too low. While conceding the low rates may have been a factor, she warned that raising rates was "a very blunt tool" that would probably have had worse consequences than rising housing prices. While she said she saw no need now for tighter monetary policy than the Fed had charted, she did identify "pockets" of excess and added, "some investors may underappreciate the potential for losses and volatility going forward."
While some critics took Ms. Yellen to the woodshed for purporting to identify bubbles, comparing her comments to then Fed chairman Alan Greenspan's ill-timed reference in 1996 to the stock market's "irrational exuberance," Mr. Stein called Ms. Yellen's speech "admirable." The Fed chairwoman "was being forthright," he said. "She's struggling with this issue in an honest way, which is progress. I don't think anyone has yet figured out the right answer about how to deal with this."
Ms. Yellen is hardly alone in worrying that some asset prices are at unsustainable levels, especially in parts of the bond market. The activist investor Carl Icahn weighed in this week on Tumblr, saying, "Yellen's comments suggest, and I agree, that we are in an asset bubble." It's dubious that Ms. Yellen would go that far, but persistently high prices, especially in the bond market, have puzzled many economists.
After a brief spike last year after the Fed announced that it would taper its bond purchases, interest rates have fallen this year - the opposite of what many economists and investors expected. (Bond prices fall as interest rates rise, and vice versa.)
"You can only explain about 20 percent of the variability in asset prices based on fundamentals," Mr. Stein said. "We don't understand the other 80 percent. All the Fed can hope to do is to be slow and deliberate" and communicate its intentions.
The Princeton economist Markus K. Brunnermeier, an expert on asset bubbles and crashes, has identified what he calls "synchronization risk," a phenomenon in which investors ride a wave of price increases even if they realize the assets are overpriced. "It's what economists call a lack of common knowledge," he said. "We may all know an asset price is too high, but we don't know that others know it, too. Timing is everything. The danger is if you move too early and the market doesn't follow up. So everyone waits on the sidelines watching and listening," as long as asset prices keep rising. The danger comes when they all try to get out at the same time.
This seems especially true of many fund managers, who don't want to underperform their rivals and obsessively follow one another's moves. Professor Brunnermeier attributes the sudden spike in interest rates last year partly to a fund stampede once bond prices showed signs of cracking.
"I very much think that stability is a major issue, and the Fed has to take it into account," Professor Brunnermeier said. "Ideally, you want to see markets correct early rather than late in one big crash."
How to achieve that remains elusive. "Speaking only for myself, you don't want to raise rates too aggressively now," Mr. Stein said. "It may be too late for that. Financial markets are fairly fragile." Current official forecasts are for the federal funds rate to rise to 2.5 percent in 2016 from the current rate of 0.25 percent, and Mr. Stein said he was "comfortable" that a rise of that magnitude made sense if the economy stayed on its current course.
Still, he says the Fed should stick to its guns even if markets gyrate. "This is subtle, but I'd try to indicate a little more willingness to stay the course if financial markets fluctuate one way or the other," he said. "Markets seem to sense an element of a Fed put, and that complacency can be a source of risk in itself, so you have to push back on that a bit." (A put is an option that protects investors if prices decline.)
In other words, investors shouldn't expect the Fed to come to the rescue just because stock or bond markets falter. No one wants another crash, but a garden-variety correction may be just what's needed to avoid one in the future.
Such gyrations may be healthy, a reminder that there are risks and that markets go down as well as up. But they could also be the harbinger of something more worrisome, which would be renewed financial instability as the Federal Reserve brings to an end its extraordinary easy money policy. The Federal Reserve has said it expects to raise interest rates in 2015 for the first time since the financial crisis.
"There's no real precedent for ending anything of this magnitude," said Jeremy Stein, who left the Fed's Board of Governors at the end of May to return to Harvard's economics department, where I caught up with him last month on the day of the Dow's big drop. As the Fed feels its way, he said, investors may have to prepare for greater volatility.
While at the Fed, Stein was viewed as the chief advocate for financial stability on the seven-member board, where he pondered the possible unintended consequences of the Fed's stimulus policies.
Stein said his differences with his fellow board members, and especially the chairwoman, Janet Yellen, had been exaggerated and were more a matter of nuance. "I certainly felt we were courting some risks" with the Fed's last round of quantitative easing, he acknowledged. "But then again, given the level of the unemployment rate at the time, some risk-taking was warranted."
In April, in his last speech as a Fed board member, Stein warned that monetary policy should be "less aggressive" when credit risk premiums were extremely low, as they were then, and they've gotten even lower since.
"To be clear, we are not necessarily talking about once-in-a-generation financial crises here, with major financial institutions teetering on the brink of failure," he said in a speech to the International Monetary Fund. "Nevertheless, the evidence suggests that even more modest capital market disruptions may have consequences that are large enough to warrant consideration when formulating monetary policy."
Stein's concerns have been gaining traction. They're expected to be a major topic at next week's annual gathering of Fed officials, policy makers and economists at Jackson Hole, Wyo. This week, former Treasury Secretary Robert Rubin and Martin Feldstein, a former chairman of the Council of Economic Advisers and a Harvard professor, sounded similar themes in an op-ed article in The Wall Street Journal, warning that the Fed-induced low rates "have led to reaching for yield in many ways and in very large magnitudes." They added, "The risk of excesses and the consequent instability have increased substantially."
Stein's analysis has also influenced Yellen, although she puts a higher priority than he does on full employment. Yellen devoted an entire speech to the subject of financial stability last month at the IMF, where she said the Fed had devoted "substantially increased resources" to monitoring stability and acknowledged that the Fed's low-interest rate policy had spurred "households and businesses to take on the risk of potentially productive investments." But, she went on, "Such risk-taking can go too far, thereby contributing to fragility in the financial system."
She even explored a previously taboo subject, which is whether the Fed contributed to the post-2000 housing bubble by keeping rates too low. While conceding the low rates may have been a factor, she warned that raising rates was "a very blunt tool" that would probably have had worse consequences than rising housing prices. While she said she saw no need now for tighter monetary policy than the Fed had charted, she did identify "pockets" of excess and added, "some investors may underappreciate the potential for losses and volatility going forward."
While some critics took Ms. Yellen to the woodshed for purporting to identify bubbles, comparing her comments to then Fed chairman Alan Greenspan's ill-timed reference in 1996 to the stock market's "irrational exuberance," Mr. Stein called Ms. Yellen's speech "admirable." The Fed chairwoman "was being forthright," he said. "She's struggling with this issue in an honest way, which is progress. I don't think anyone has yet figured out the right answer about how to deal with this."
Ms. Yellen is hardly alone in worrying that some asset prices are at unsustainable levels, especially in parts of the bond market. The activist investor Carl Icahn weighed in this week on Tumblr, saying, "Yellen's comments suggest, and I agree, that we are in an asset bubble." It's dubious that Ms. Yellen would go that far, but persistently high prices, especially in the bond market, have puzzled many economists.
After a brief spike last year after the Fed announced that it would taper its bond purchases, interest rates have fallen this year - the opposite of what many economists and investors expected. (Bond prices fall as interest rates rise, and vice versa.)
"You can only explain about 20 percent of the variability in asset prices based on fundamentals," Mr. Stein said. "We don't understand the other 80 percent. All the Fed can hope to do is to be slow and deliberate" and communicate its intentions.
The Princeton economist Markus K. Brunnermeier, an expert on asset bubbles and crashes, has identified what he calls "synchronization risk," a phenomenon in which investors ride a wave of price increases even if they realize the assets are overpriced. "It's what economists call a lack of common knowledge," he said. "We may all know an asset price is too high, but we don't know that others know it, too. Timing is everything. The danger is if you move too early and the market doesn't follow up. So everyone waits on the sidelines watching and listening," as long as asset prices keep rising. The danger comes when they all try to get out at the same time.
This seems especially true of many fund managers, who don't want to underperform their rivals and obsessively follow one another's moves. Professor Brunnermeier attributes the sudden spike in interest rates last year partly to a fund stampede once bond prices showed signs of cracking.
"I very much think that stability is a major issue, and the Fed has to take it into account," Professor Brunnermeier said. "Ideally, you want to see markets correct early rather than late in one big crash."
How to achieve that remains elusive. "Speaking only for myself, you don't want to raise rates too aggressively now," Mr. Stein said. "It may be too late for that. Financial markets are fairly fragile." Current official forecasts are for the federal funds rate to rise to 2.5 percent in 2016 from the current rate of 0.25 percent, and Mr. Stein said he was "comfortable" that a rise of that magnitude made sense if the economy stayed on its current course.
Still, he says the Fed should stick to its guns even if markets gyrate. "This is subtle, but I'd try to indicate a little more willingness to stay the course if financial markets fluctuate one way or the other," he said. "Markets seem to sense an element of a Fed put, and that complacency can be a source of risk in itself, so you have to push back on that a bit." (A put is an option that protects investors if prices decline.)
In other words, investors shouldn't expect the Fed to come to the rescue just because stock or bond markets falter. No one wants another crash, but a garden-variety correction may be just what's needed to avoid one in the future.
©2014 The New York Times News Service