UPDATE 1-Fed's Stein says low rates create risks, watching corporates

Thu Feb 7, 2013 10:10am EST

By Pedro Nicolaci da Costa

WASHINGTON Feb 7 (Reuters) - An extended period of low interest rates could create risks to financial stability, and policymakers should keep an eye on junk bond and leveraged loan markets for signs of excess risk-taking, a top Federal Reserve official said on Thursday.

Jeremy Stein, a member of the U.S. central bank's powerful board of governors, said the current evidence is inconclusive.

"In terms of the variables that could be informative about the extent of market overheating, the picture is mixed," Stein said in prepared remarks at a conference sponsored by the St. Louis Federal Reserve Bank.

Stein's remarks come at a time when some analysts, including top Fed officials, have raised concerns about the potentially destabilizing effects of the central bank's unconventional monetary policies, in particular its asset purchase program.

In December the Fed reinforced its third round of quantitative easing, replacing a more modest earlier program that did not add to its balance sheet with a more aggressive buying of Treasuries, maintaining a pace of $85 billion in purchases first established in September.

With U.S. stocks rallying sharply in January and corporate bond issuance breaking records, some worry the Fed's low rates policy might encourage investors to take on excess risk. Stein argued policymakers should remain attuned to these risks, and not shy away from using monetary policy to mitigate them - a break with past convention, which has tended to favor regulatory tools to deal with asset price inflation.

"If the underlying economic environment creates a strong incentive for financial institutions to, say, take on more credit risk in a reach for yield, it is unlikely that regulatory tools can completely contain this behavior," Stein said.

"Waiting for decisive proof of market overheating may amount to an implicit policy of inaction on this dimension."