Thursday, January 13, 2011

Janet Yellen and the Fed's New Approach to Asset Bubbly

     I love Janet Yellen because she is an academic and a Hyman P. Minsky follower on the Federal Reserves Board of Governors.  In a recent speech titled "The Federal Reserve's Asset Purchase Program", Yellen breaks down the Fed's decision to engage in a second round of asset purchases while offering the best research available.  She delves into the beverage curve- which is the relationship between unemployment and job vacancies- to talk about both structural and cyclical factors affecting unemployment.  Additionally, she details the Fed's new attempts at monitoring quantitative easing effects on credit flows and asset bubbles.  This is a revolutionary and remarkable change in procedure at the Fed because before this crises the Fed would have completely denied looking at asset price movements and credit in making its decisions.  This signals a significant shift in the attitude and mindset that recognizes that markets are not always efficient or rational, especially when it comes to asset prices.  In evaluating the dangers of the Fed's latest round of quantitative easing, Yellen mentioned the following asset price and credit indicators:

With respect to the stock market:
"In the stock market, for example, price-to-earnings ratios, by some measures, remain below their averages over the past several decades, and other valuation measures also indicate that equity prices are not significantly out of alignment with past norms."
Then looking at the Price-to-rent ratio for the housing market:
"In the real estate market, price-to-rent ratios for both residential and commercial real estate are now within a reasonable range of their long-run averages, in contrast to the severe misalignment that occurred prior to the crisis. Again, there is little sign here of imbalances relative to fundamentals, at least if history is used as a guide."
In the Bond market we have seen the obvious bubble created by the fed when it intervenes into the market and buys up treasuries:
"In fixed-income markets, narrow risk spreads and risk premiums could be signs of excessive risk-taking by investors, and indeed spreads on corporate bonds have dropped dramatically since the financial crisis, as the economic outlook has improved and investor sentiment has picked up. Risk premiums on nonfinancial corporate bonds, as measured by forward spreads far in the future, are relatively low compared with historical norms, although other indicators for this market do not point to overvaluation." 
Yellen even mentions identifying financial imbalances by focusing more directly on measuring credit flows and exposure to credit risk! In this area the risks are mute:
"Thus, there is little evidence that financial institutions are significantly expanding the level of credit and liquidity provided to households and businesses on net. Indeed, given the current very low level of interest rates and the continuation of the economic recovery, credit flows remain stubbornly sluggish."
The Fed even created a new survey called the Senior Credit Officer Opinion Survey on Dealer Financing Terms to monitor leverage:
"To monitor leverage provided by dealers to financial market participants, last June the Federal Reserve launched the Senior Credit Officer Opinion Survey on Dealer Financing Terms. This survey provides information on credit terms and availability of various forms of dealer-intermediated financing, including funding for securities positions and over-the-counter derivatives. The survey results suggest that over the past several months there has been some easing of terms applicable to financing for a range of counterparty types and many types of collateral, as well as an increase in demand from clients to fund most types of securities. These results indicate that the availability and use of leverage by nonbank financial institutions increased somewhat last year."
The Fed is on track to be extremely successful in the long-run.  Although, the additional asset purchases are a dangerous move given that the Fed has created and set in motion a bond bubble.  The asset purchases explicitly say to the financial markets that the Fed will not be afraid to use this tool in the future, which may in itself create a moral hazard for the bond market.  The thing that I love best about Janet Yellen's speech must be the explicit statement about using adaptive regulation to target financial imbalances versus using the extremely blunt federal funds rate.  Janet wants to work closely with other regulators to monitor systemic risk and nip asset inflation in the bud.  I wrote about this a while back (June 21,2010 to be exact)  thus making me especially delighted that someone on the board has formed the same views (albeit independently):
"We are working with other regulators to make the financial system more robust and are attentive in our supervision to developments that may affect systemic risk. If evidence of financial imbalances were to develop, I believe that supervision and regulation should provide the first line of defense so that monetary policy can concentrate on its longstanding goals of price stability and maximum employment. That said, we cannot categorically rule out using monetary policy to address financial imbalances, given the damage that they can cause."

1 comment:

  1. The fed is the primary cause of income inequility INFLATION EQUALS INEQUALITY.