Fed Official Sees Tension in Some Credit Markets

The official, Fed Governor Jeremy Stein, highlighted a surge in junk bond issues, the popularity of certain kinds of real estate investment trusts and shifts in bank balance sheets as areas the central bank is watching closely, although he downplayed any immediate threat to the financial system or the economy.

“We are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit,” Mr. Stein said in a St. Louis speech. He added, however, “it need not follow that this risk-taking has ominous systemic implications.”

Mr. Stein gave no indication that the Fed is contemplating any change in its aggressive efforts to hold down interest rates. Rather, he described the overheating as a trend that might require a response if it intensified over the next 18 months. But the speech nonetheless underscored that the Fed increasingly regards bubbles, rather than inflation, as the most likely negative consequence of its efforts to reduce unemployment by stimulating growth.

It also showed that theoretical concerns are becoming more tangible.

Critics of the Fed’s policies have pointed to the high-profile junk bond market as evidence that low interest rates are encouraging excessive speculation. Investors are eagerly providing money to companies and countries with low credit ratings – and they are demanding relatively low interest rates in return. Junk bond issuance in the United States set a new annual record last year – by the end of October.

Mr. Stein noted dryly that this may not “bode well” for investors in those bonds, but the Fed is not charged with preventing them from losing money. It is charged with maintaining the function of the financial system and preventing the consequences from dragging on the broader economy.

In the wake of the financial crisis, regulators have focused increasingly on where investors get their money, reasoning that short-term funding is particularly vulnerable to panic. And Mr. Stein said that here, too, there was evidence that short-term funding was growing in importance.

He described similar evidence of growing risks in other corners of the financial market, and emphasized that the Fed was also concerned about other kinds of financial speculation that it did not see.

“Overheating in the junk bond market might not be a major systemic concern in and of itself, but it might indicate that similar overheating forces were at play in other parts of credit markets, out of our range of vision,” he said.

Central bankers historically have been skeptical that asset bubbles can be identified or prevented from popping. Moreover, they tend to regard financial regulation as the appropriate means to prevent excessive speculation and not changes in monetary policy, which affect the entire economy. In other words, when mortgage-lending standards loosen, regulators should tighten those standards rather than raising interest rates on all kinds of loans.

But the crisis has forced central bankers to reconsider both the importance of financial stability and the role of monetary policy.

Mr. Stein said Thursday that central bankers should keep an “open mind.”

Regulators, he noted, can address only problems that they can see. Monetary policy, by contrast, can reduce risk-taking across the economy.

“It gets in all of the cracks,” Mr. Stein said. “Changes in rates may reach into corners of the market that supervision and regulation cannot.”

He said that the Fed also could use its vast investment portfolio to address some kinds of risk-taking because the Fed can reduce the profitability of a given investment by shifting the composition of its holdings.

And he closed on a cautionary note.

“Decisions will inevitably have to be made in an environment of significant uncertainty,” he said. “Waiting for decisive proof of market overheating may amount to an implicit policy of inaction on this dimension.”

Article source: http://www.nytimes.com/2013/02/08/business/fed-official-sees-tension-in-some-credit-markets.html?partner=rss&emc=rss