Wednesday, January 8, 2014

FOMC Minutes Discuss Financial Risk
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.”

No comments:

Post a Comment

Note: Only a member of this blog may post a comment.