Thursday, July 17, 2014

Yellen: Fashion Statement
Bubbles are in fashion. On Tuesday, when she testified before the Senate Banking Committee, Fed Chair Janet Yellen wore a stylish outfit with a jacket that was grayish looking with lots of white circles. That was a fitting choice since they looked like bubbles, which was a topic covered during her semi-annual congressional testimony on monetary policy. Let’s review the testimony:

(1) Prepared remarks. In her prepared remarks, Yellen said that the FOMC “recognizes that low interest rates may provide incentives for some investors to ‘reach for yield,’ and those actions could increase vulnerabilities in the financial system to adverse events.” She pinpointed the junk bond market, where “valuations appear stretched and issuance has been brisk.” The Fed is also monitoring the leveraged loan market and working on supervising it effectively. On the other hand, she doesn’t see much irrational exuberance in the prices of real estate, equities, and corporate bonds. While they “have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms.”

(2) The report. The Fed’s latest Monetary Policy Report accompanied Yellen’s testimony. The word “stretched” is in fashion. It appeared twice in the report to describe valuations in some asset markets, “particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”

The report also downplayed any irrational exuberance in the rest of the equity market: “However, valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities.”

What about other asset classes? “Beyond equities, risk spreads for corporate bonds have narrowed and yields have reached all-time lows. Issuance of speculative-grade corporate bonds and leveraged loans has been very robust, and underwriting standards have loosened.”

(3) Q&A. During the Q&A session, Senator Tom Coburn (R-OK) framed his question as follows: “Rather than preventing asset bubbles from happening, we're now taking the approach that they're going to happen and we're going to deal with them. It just seems to me now that we're kind of locked in this zero interest rate phenomenon, and one of the consequences of that is reaching for yield, and now we're going to try to attenuate the response to the zero interest rate rather than change the policy so we don't have the bubbles in the first place.”

Yellen responded by expressing confidence in the Fed’s macroprudential tools: “They diminish the odds that bubbles will develop.” However, she did concede, “So I think there are some risks in a low interest rate environment. I've indicated that, and we're aware of them. But I think the improvements we've put in place in terms of regulation both diminishes the odds that risk will develop and, if there is an asset bubble and it bursts, it will--it will, and we're not going to be able to catch every asset bubble or everything that develops.” Her comment raises an interesting question: Might there be too many bubbles to catch?

There was no discussion in either the testimony or the report, nor during the Q&A, of what might happen when the Fed finally starts raising rates. Last year’s “taper tantrum” triggered a mini crisis in emerging market currencies, debt, and stocks. When the Fed starts hiking rates, that could happen again. Another worrisome development under this scenario would be massive withdrawals from corporate bond mutual funds, which have become a large “shadow bank.” That would be particularly troublesome since the corporate bond market has become increasingly illiquid since the Great Financial Crisis.

The biggest bubble of them all, of course, is in government debt around the world. All the more reason why the Fed and other central banks might be very hesitant to raise interest rates. They’ve been getting away with their NZIRPs (near-zero interest rate policies) because CPI inflation rates have remained surprisingly low. That might actually be attributable to ultra-easy money, which has financed too much excess capacity, particularly in China. However, there has certainly been lots of asset inflation (a.k.a. bubbles), and probably more to come.

In her prepared remarks, Yellen was a two-handed economist about the outlook for interest rates. If the labor market continues to improve faster than expected, “then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned.” On the other hand, if economic activity is disappointing, “then the future path of interest rates likely would be more accommodative than currently anticipated.”

During the Q&A, she clearly favored erring on the ultra-easy side of the street. “The Federal Reserve does need to be quite cautious with respect to monetary policy.” She warned about the “false dawns” that tricked Fed officials in recent years. Later, Yellen told lawmakers that “accommodative policy” would be necessary until the economic headwinds that have slowed the recovery are “completely gone.” She didn't explain how she will determine that to be the case.
(Based on an excerpt from YRI Morning Briefing)

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