By Jonathan Spicer and Jason Lange
NEW YORK Feb 28 Turbulence on Wall Street will
likely return when the Federal Reserve decides to hike interest
rates, top U.S. economists said in a paper that warned the Fed's
huge stimulus program could have harmful consequences.
The paper, released on Friday, focused on a financial market
selloff in mid-2013 after Fed officials said they planned to
trim monthly bond-buying.
The authors found mutual fund investors participated heavily
in the selloff even though their market bets weren't made with a
lot of borrowed money.
This is important because policymakers sometimes weigh the
chances of a financial crash by looking at the size of leveraged
bets, which can be prone to swift reversals. The research
highlights a perhaps under-appreciated risk for the Fed's plans
to wind down its easy-money stimulus.
"Whenever the decision to tighten policy is made, then the
instability seen in summer of 2013 is likely to reappear," wrote
JPMorgan chief U.S. economist Michael Feroli, University of
Chicago professor Anil Kashyap and two other well-respected
Several Fed officials were present at the high-profile
economics conference where the paper was presented, and two said
the paper raised real concerns.
That said, the ideas highlighted by the paper already play
into the Fed's current monitoring of financial risks, said
Minneapolis Fed President Narayana Kocherlakota.
Kocherlakota, who is a voting member on the Fed's
rate-setting policy committee this year, has argued forcefully
for monetary stimulus and said the U.S. economy remains so weak
that the Fed still has another "two to three years" to mull
financial stability risks.
"We don't need this theory to be able to make decisions in
March of 2014," Kocherlakota said during a discussion of the
'NOT A FREE LUNCH'
The Fed in January started winding down five years of
ultra-accommodative policies meant to fight the 2007-09
recession and foster a stronger recovery. That means an eventual
end to trillions of dollars in bond buying and a policy of
keeping overnight interest rates at zero.
The risk that all this easy money may have inflated asset
price bubbles has stoked debate within the Fed over whether
policymakers should stand ready to raise rates earlier than
planned to snuff out those risks.
Fed Chair Janet Yellen, however, has said her inclination is
that financial stability risks can be addressed primarily
through regulatory tools.
In the paper, also co-authored by professors Hyun Song Shin
of Princeton University and Kermit Schoenholtz of New York
University, the economists concluded that the current policy
stimulus "is not a free lunch" and can bring about disruptions
when that accommodation is lifted.
"Perhaps the domestic macroeconomic fallout from exit will
be as gentle as was the impact from the 2013 'taper tantrum,'"
they wrote. "However, such a benign outcome is not guaranteed."
Fed Governor Jeremy Stein, who also spoke at the conference,
agreed that the behavior of asset managers needs careful
watching. He flagged the rapid growth fixed-income funds and
similar investment funds.
"It would be a mistake to be complacent about this
phenomenon simply because such funds are unlevered," Stein said.
Daniel Tarullo, a Fed governor and its top bank regulator,
said on Tuesday the central bank should not rule out using
monetary policy to combat asset price bubbles that potentially
threaten financial stability.
The economists argued in their paper that the Fed's two key
stimulus efforts, monthly bond buying and a pledge to keep
interest rates low for a long time, "can build future hazards by
encouraging certain types of risk-taking that are not easily
reversed in a controlled manner."
The paper also underlines a concern that Tarullo and Stein
have raised in the past: that regulatory tools may not be enough
to stamp out risks in harder-to-detect corners of financial
The usual tools of monitoring banks - bank capital ratios
and liquidity requirements, among other regulations - fail to
address instabilities that mutual fund investors, for example,
can cause when they rush for the exits, the economists wrote.
The 55-page paper examined bond flows from mutual funds, and
noted that investors do not want to be the last out of a trade.
It finds that banks need not take action to spark market
tantrums, suggesting that too-big-to-fail banks should not be
the sole focus of regulators looking to stabilize markets.
The "absence of leverage may not be sufficient to ensure
that monetary policy can disregard concerns for financial
stability," the paper said.