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Must-know: Will financial instability concerns impact rates?

Phalguni Soni

Fisher on the rate rise, financial excess, and political pliancy (Part 4 of 8)

(Continued from Part 3)

Dallas Fed’s Richard Fisher discusses financial instability

Dallas Fed Chief, Richard Fisher spoke at the Annenberg School for Communication and Journalism, at the University of Southern California on Wednesday, July 16, about the inherent risks in the Fed’s current accommodative monetary policy. In his speech titled “Monetary Policy and the Maginot Line,” he discussed why adjusting the Fed’s monetary policy stance may be more appropriate to deal with systemic risks to financial stability.

Keeping the Fed’s congress-mandated targets on the top of the agenda

While an accommodative monetary policy was necessary to revive the economy during the financial crisis and Great Recession, Richard Fisher believes that the Fed’s mandates of full employment and price stability are goals that should be kept in sight, rather than engineering “puts” for financial market participants. He said that the Fed had now crossed the point where further accommodation was only leading to bubbles in asset markets. He explained that an adjustment to the Fed’s stance was needed to address these risks.

Janet Yellen’s take on macroprudential supervision and financial instability risks

Richard Fisher also cited Fed Chair, Janet Yellen speaking on the issue in a speech to the International Monetary Fund (or IMF) on July 2.

“I’m also mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk, and of the limits of macroprudential measures to address these and other financial stability concerns. Accordingly, there may be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risks to financial stability,” said Yellen.

Key differences between Yellen’s and Fisher’s stance on the use of macroprudential tools

While Yellen spoke about addressing these risks primarily through macroprudential tools, she wasn’t broadly in favor of using monetary policy to curb these risks as “efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment.”

Fisher believes that macroprudential tools would be ineffective to curb financial instability risks because depository institutions comprise only ~20% of the credit markets. Also, financial market operators would always find loopholes to get around them.

On the Fed’s interest rate mandate

The Fed hadn’t been able to promote moderate long-term interest rates—a goal that was required under the Federal Reserve Act of 1977, which states that “The Board of Governors of the Federal Reserve System and the FOMC shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

The near-zero cost of funds and the “rain of money” made possible by quantitative easing (or QE), has benefited credit, equity, and other trading markets. However, Fisher believes that some people are willing to accept these excesses as a consequence of low interest rates because they think that the Fed hasn’t closed in on its twin mandate of ensuring full employment and price stability.

Investor impact

Market participants closely watch the Fed’s actions and the views of Fed officials and policymakers. The monetary policy decisions at Federal Open Market Committee (or FOMC) meetings have bearing on both fixed income and stock (IVV) markets. Fixed income markets including Treasuries (TLH), high yield and investment-grade debt, and municipal debt (PZA) and mortgage-backed securities, among others, are particularly sensitive due to the implications of monetary policy on interest rates.

Monetary tightening would also affect real estate investment trusts (or REITs) which typically rely on leverage, like Annaly (NLY) and American Capital Agency (AGNC).

In the next section, we’ll discuss why Richard Fisher believes that the Fed is closer to its goals that many believe.

Continue to Part 5

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