Friday, January 24, 2014

Fed Officials on Risk of Bubble in Emerging Economies
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.

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