The Fed: Blowing Off Bubbles

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)