The message to emerging economies in today’s FOMC statement was: “Vaya con Dios.” Of course, that phrase did not appear in the statement. Rather, it was implied when the recent crisis among several emerging economies wasn’t mentioned at all. In other words: “We wish you well, but your problems aren’t our problem. So there’s no reason to suggest that your crisis is having any impact on US monetary policy.”

Indeed, Fed officials seem quite sanguine that the crisis among some of the emerging economies won’t have any significant impact on the US economy. On the contrary, the FOMC statement noted: “The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee sees the risks to the outlook for the economy and the labor market as having become more nearly balanced.” The exact same comments appeared in the previous statement following the 12/18 meeting of the FOMC. I agree with the Fed's assessment.

As was widely expected, the FOMC voted to taper QE by another $10 billion to $65 billion per month. There were no dissenters. So the committee unanimously voted to reject the recent advice of IMF officials and economists to temper their tapering for the sake of the emerging economies.

How will the Fed respond to last week’s global financial turmoil? The FOMC meets this week on Tuesday and Wednesday. It is widely expected that the committee will continue to taper QE. They started to do so after the previous meeting on December 18, when the FOMC statement noted that “the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.” Bond purchases were reduced from $85 billion per month to $75 billion per month.

According to a 1/20 WSJ article by Jon Hilsenrath, despite December’s weak employment report, the Fed is on track to taper QE to $65 billion at the FOMC meeting this week. In his Barron’s column this week, Randy Forsyth explains why he thinks the Fed will do so, notwithstanding last week’s global financial instability:

Speculation in the markets Friday suggested that the FOMC wouldn't taper in view of the market turmoil. That seems highly unlikely on two counts: First, the FOMC only made the first, small reduction in its so-called quantitative easing…at its December meeting. The S&P 500 is down all of 3.3% from its record hit in mid-January. That's a reason to change course so soon? To do so would suggest panic. Moreover, the Treasury market already has eased in reaction to the turmoil. The benchmark 10-year note's yield is down about 30 basis points…to 2.72% since the turn of the year--when the universal forecast was that yields had nowhere to go but up.

I tend to agree with Randy. Last week’s turmoil might make Fed officials realize that their ultra-easy monetary policy has inflated yet another speculative bubble, this time in emerging markets. Taking the air out of it might be wiser than continuing to inflate it.

If this bubble is about to burst, then once again Fed officials didn’t see it coming. They’ve been aware of the possibility, but minimized its likelihood. Obviously, they once again failed to learn from history, which shows that excessively easy credit conditions tend to inflate speculative bubbles that inevitably burst. Let’s review what Fed officials said (or did not say) on this subject:

(1) FRB Governor Jeremy Stein. In a speech on February 7, 2013, Governor Jeremy Stein discussed several areas in which a noticeable increase in risk-taking behavior had emerged. He did not mention emerging economies. Rather, he focused on risks in the corporate bond market, but was reassuringly unconcerned about the potential adverse consequences for the financial system.

(2) FRB Vice Chair Janet Yellen. On April 16, 2013, Fed Vice Chair Janet Yellen spoke at a conference on monetary policy sponsored by the IMF. In her remarks, she briefly speculated about speculation, but concluded that there is nothing to worry about: “I don’t see pervasive evidence of rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would threaten financial stability. But there are signs that some parties are reaching for yield, and the Federal Reserve continues to carefully monitor this situation.”

(3) Fed Chairman Ben Bernanke. In his press conference on September 18, 2013, Fed Chairman Ben Bernanke was asked for his reaction to charges coming out of emerging economies that the Fed’s policies have been causing them financial distress. His initial response was that “we’re watching that very carefully.” Then, he went on to defend the Fed’s policies as good for everyone:

The main point, I guess, I would end with, though, is that what we’re trying to do with our monetary policy here is, I think, my colleagues in the emerging markets recognize, is trying to create a stronger US economy. And a stronger US economy is one of the most important things that could happen to help the economies of emerging markets.

(Based on an excerpt from YRI Morning Briefing)

Could it be that the Fed’s ultra-easy monetary policy has already inflated yet another speculative bubble that is about to burst, or at least lose lots of air very quickly? If so, the obvious candidate is emerging economies, which borrowed lots of money (often in dollars) in recent years. They were able easily to attract foreign buyers, who were “reaching for yield” because interest rates were so low in the bond markets of the US, Europe, and Japan. The capital inflows boosted their currencies. That may have started to reverse during the spring and summer of 2013, when Fed officials began to talk about tapering QE, which boosted bond yields in the US and around the world, especially in the emerging economies.

If this bubble is about to burst, then once again Fed officials didn’t see it coming. They’ve been aware of the possibility, but minimized its likelihood. Obviously, they once again are failing to learn from history, which shows that easy credit conditions always lead to speculative bubbles that inevitably burst. Let’s review what Fed officials said (or did not say) on this subject:

1) FRB Vice Chair Janet Yellen. On April 16, 2013, Fed Vice Chair Janet Yellen spoke at a conference on monetary policy sponsored by the IMF. In her remarks, she briefly speculated about speculation, but concluded that there is nothing to worry about:

Some have asked whether the extraordinary accommodation being provided in response to the financial crisis may itself tend to generate new financial stability risks. This is a very important question. To put it in context, let’s remember that the Federal Reserve’s policies are intended to promote a return to prudent risk-taking, reflecting a normalization of credit markets that is essential to a healthy economy. Obviously, risk-taking can go too far. Low interest rates may induce investors to take on too much leverage and reach too aggressively for yield. I don’t see pervasive evidence of rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would threaten financial stability. But there are signs that some parties are reaching for yield, and the Federal Reserve continues to carefully monitor this situation.

On March 4, in a speech titled, “Challenges Confronting Monetary Policy,” Yellen said that the Fed is watching out for risks in the financial system and that so far there is nothing to worry about:

At this stage, there are some signs that investors are reaching for yield, but I do not now see pervasive evidence of trends such as rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would clearly threaten financial stability. That said, such trends need to be carefully monitored and addressed, and the Federal Reserve has invested considerable resources to establish new surveillance programs to assess risks in the financial system. In the aftermath of the crisis, regulators here and around the world are also implementing. a broad range of reforms to mitigate systemic risk. With respect to the large financial institutions that it supervises, the Federal Reserve is using a variety of supervisory tools to assess their exposure to, and proper management of, interest rate risk.

On January 4, 2013, Yellen spoke at a joint lunch of the American Economic Association / American Finance Association in San Diego. The word “risk” appears 82 times in her speech titled, “Interconnectedness and Systemic Risk: Lessons from the Financial Crisis and Policy Implications.” Her presentation was a general overview, without getting into any specifics. The risk of a bubble in emerging economies was not mentioned.

2) FRB Governor Jeremy Stein. In her March 4 speech, Yellen noted in a footnote that her colleague, Governor Jeremy Stein, had given a speech on February 7, 2013 in which he “discussed several areas in which a noticeable increase in risk-taking behavior has emerged.” He did not mention emerging economies. Rather, he focused on risks in the corporate bond market, but was reassuringly unconcerned about the potential adverse consequences for the financial system:

Putting it all together, my reading of the evidence is that we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit. However, even if this conjecture is correct, and even if it does not bode well for the expected returns to junk bond and leveraged-loan investors, it need not follow that this risk-taking has ominous systemic implications. That is, even if at some point junk bond investors suffer losses, without spillovers to other parts of the system, these losses may be confined and therefore less of a policy concern.

3) Fed Chairman Ben Bernanke. In his press conference on September 18, 2013, Fed Chairman Ben Bernanke was asked for his reaction to charges coming out of emerging economies that the Fed’s policies have been causing them financial distress. His initial response was that “we’re watching that very carefully.” Then, he went on to defend the Fed’s policies as good for everyone:

The main point, I guess, I would end with, though, is that what we’re trying to do with our monetary policy here is, I think, my colleagues in the emerging markets recognize, is trying to create a stronger U.S. economy. And a stronger U.S. economy is one of the most important things that could happen to help the economies of emerging markets. And, again, I think my colleagues in many of the emerging markets appreciate that--notwithstanding some of the effects that they may have felt--that efforts to strengthen the U.S. economy and other advanced economies in Europe and elsewhere ultimately redounds to the benefit of the global economy, including emerging markets as well.

How will the Fed react to today’s weak payroll employment report? When the FOMC meets on January 28-29, odds are that the committee will vote to maintain the current pace of bond purchases at $75 billion, which was lowered from $85 billion at the previous meeting on December 17-18. They might have considered tapering some more if the report had been as strong as suggested by December’s ADP private payrolls survey. Now that’s less likely.

At the previous meeting, there seemed to be a difference of opinion between the members of the FOMC and the Fed’s staff on the outlook for the economy. The former were more optimistic than the latter. Indeed, according to the minutes of that meeting, the staff viewed the risks to the forecast for real GDP growth “as tilted to the downside, reflecting concerns that the extent of supply-side damage to the economy since the recession could prove greater than assumed; that the tightening in mortgage rates since last spring could exert greater restraint on the housing recovery than had been projected; that economic and financial stresses in emerging market economies and the euro area could intensify; and that, with the target federal funds rate already near its lower bound, the U.S. economy was not well positioned to weather future adverse shocks.” Recent better-than-expected economic indicators suggested that the staff was too pessimistic, but the payroll report is more consistent with their view.

The minutes also noted that further reductions in bond purchases “would be undertaken in measured steps.” That was widely viewed as implying that the Fed might taper QE by $10 billion per meeting if the economic data remained strong. In his WSJ article on the Fed’s likely reaction to the employment data, Jon Hilsenrath concluded: “Friday’s report should put to rest for the time being any notion that the Fed will reduce the bond-buying program more quickly than planned.”

The FOMC is composed of the seven members of the Board of Governors and five Reserve Bank presidents. The president of the Federal Reserve Bank of New York serves on a continuous basis; the presidents of the other Reserve Banks serve one-year terms on a rotating basis. This year, the voting presidents will be Sandra Pianalto (Cleveland), Charles Plosser (Philadelphia), Richard Fisher (Dallas), and Narayana Kocherlakota (Minneapolis). On Friday, President Barack Obama nominated Stanley Fischer as the Fed’s next vice chairman and Lael Brainard as a governor. He also nominated Governor Jerome Powell to another term.

My assessment is that not much will change under incoming Fed Chair Janet Yellen. The doves will continue to determine the course of monetary policy. However, tapering should continue, with the termination of QE likely by the end of the year. Stanley Fischer is likely to be a more pragmatic and less liberal vice chair than was Ms. Yellen. He has expressed some skepticism about providing forward guidance. However, he is likely to be a team player.

The question is whether QE5--i.e., the tapering of QE4--will cause another significant correction or even kill the bull if tapering leads to the termination of quantitative easing. Yesterday’s minor 0.4% drop in the S&P 500 suggests that stock investors might be ready to tolerate more tapering, which was implied in the minutes released yesterday of the December 17-18 FOMC meeting. Consider the following:

(1) More discussion of financial risks. The latest minutes accentuated the risks of financial instability caused by ultra-easy monetary policy much more so than any previous ones since the start of the bull market. Previous ones, especially those that discussed and justified the implementation of the various QE policies, stressed the importance of doing so to restore financial stability. The pendulum is starting to swing the other way.

The minutes noted: “In their discussion of potential risks, several participants commented on the rise in forward price-to-earnings ratios for some small-cap stocks, the increased level of equity repurchases, or the rise in margin credit. One pointed to the increase in issuance of leveraged loans this year and the apparent decline in the average quality of such loans.”

(2) Financial instability and QE. Perhaps the oddest part of the minutes was a discussion of a survey conducted by the Fed’s staff “over the intermeeting period regarding participants’ views of the marginal costs and marginal efficacy of asset purchases.” I don’t recall anything like this before. Aren’t they all supposed to be sharing their views during the actual meetings?

In any event, once again, the risks of financial instability were raised in this discussion of the survey: “Participants were most concerned about the marginal cost of additional asset purchases arising from risks to financial stability, pointing out that a highly accommodative stance of monetary policy could provide an incentive for excessive risk-taking in the financial sector. It was noted that the risks to financial stability could be somewhat larger in the case of asset purchases than in the case of interest rate policy because purchases work in part by affecting term premiums and policymakers have less experience with term premium effects than with more conventional interest rate policy.”

(3) Diminishing returns. The survey also found that participants are mostly curbing their enthusiasm for QE: “A majority of participants judged that the marginal efficacy of purchases was likely declining as purchases continue, although some noted the difficulty inherent in making such an assessment.”

In other words, they think it worked, but they aren’t sure it is working as well anymore, and aren’t sure how to know or measure any of that! So maybe phasing it out is a good idea. Not so fast: “Most participants judged the marginal costs of asset purchases as unlikely to be sufficient, relative to their marginal benefits, to justify ending the purchases now or relatively soon.” But they don’t know that for sure.

(4) Complicating the exit strategy. Here’s another good reason to phase out QE, according to the survey discussed in the minutes: “Further, participants noted that ongoing asset purchases could increase the difficulty of managing exit from the current highly accommodative policy stance when the time came. Many participants, however, expressed confidence in the tools at the Federal Reserve's disposal for managing its balance sheet and for normalizing the stance of policy at the appropriate time.”

(5) Capital losses. Another interesting point raised in the survey is that the bigger the Fed’s balance sheet, the greater the losses will be when interest rates move higher. They are already doing so in the bond market. Not to worry: “Participants also expressed some concern that additional asset purchases increase the likelihood that the Federal Reserve might at some point suffer capital losses. But it was pointed out that the Federal Reserve's asset purchases would almost certainly provide significant net income to the Treasury over the life of the program, especially when the effects of the program on the broader economy were taken into account, and that potential reputational risks to the Federal Reserve arising from any future capital losses could be mitigated by communicating that point to the public.”

(Based on an excerpt from YRI Morning Briefing)

The minutes of the FOMC meeting held on December 17 and 18 was released today. Here are some of the key points regarding the risks that QE could increase financial instability:

(1) More discussion of financial risks. The latest minutes accentuated the risks of financial instability caused by ultra-easy monetary policy much more so than any previous ones since the start of the bull market. Previous ones, especially those that discussed and justified the implementation of the various QE policies, stressed the importance of doing so to restore financial stability. The pendulum is starting to swing the other way.

The minutes noted: “In their discussion of potential risks, several participants commented on the rise in forward price-to-earnings ratios for some small-cap stocks, the increased level of equity repurchases, or the rise in margin credit. One pointed to the increase in issuance of leveraged loans this year and the apparent decline in the average quality of such loans.”

(2) Financial instability and QE. Perhaps the oddest part of the minutes was a discussion of a survey conducted by the Fed’s staff “over the intermeeting period regarding participants’ views of the marginal costs and marginal efficacy of asset purchases.” I don’t recall anything like this before. Aren’t they all supposed to be sharing their views during the actual meetings?

In any event, once again, the risks of financial instability were raised in this discussion of the survey: “Participants were most concerned about the marginal cost of additional asset purchases arising from risks to financial stability, pointing out that a highly accommodative stance of monetary policy could provide an incentive for excessive risk-taking in the financial sector. It was noted that the risks to financial stability could be somewhat larger in the case of asset purchases than in the case of interest rate policy because purchases work in part by affecting term premiums and policymakers have less experience with term premium effects than with more conventional interest rate policy.”

(3) Diminishing returns. The survey also found that participants are mostly curbing their enthusiasm for QE: “A majority of participants judged that the marginal efficacy of purchases was likely declining as purchases continue, although some noted the difficulty inherent in making such an assessment.”

In other words, they think it worked, but they aren’t sure it is working as well anymore, and aren’t sure how to know or measure any of that! So maybe phasing it out is a good idea. Not so fast: “Most participants judged the marginal costs of asset purchases as unlikely to be sufficient, relative to their marginal benefits, to justify ending the purchases now or relatively soon.” But they don’t know that for sure.

(4) Complicating the exit strategy. Here’s another good reason to phase out QE, according to the survey discussed in the minutes: “Further, participants noted that ongoing asset purchases could increase the difficulty of managing exit from the current highly accommodative policy stance when the time came. Many participants, however, expressed confidence in the tools at the Federal Reserve's disposal for managing its balance sheet and for normalizing the stance of policy at the appropriate time.”

(5) Capital losses. Another interesting point raised in the survey is that the bigger the Fed’s balance sheet, the greater the losses will be when interest rates move higher. They are already doing so in the bond market. Not to worry: “Participants also expressed some concern that additional asset purchases increase the likelihood that the Federal Reserve might at some point suffer capital losses. But it was pointed out that the Federal Reserve's asset purchases would almost certainly provide significant net income to the Treasury over the life of the program, especially when the effects of the program on the broader economy were taken into account, and that potential reputational risks to the Federal Reserve arising from any future capital losses could be mitigated by communicating that point to the public.”