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Overview: Excess reserves, speculation, and financial instability

Phalguni Soni

Fisher on the rate rise, financial excess, and political pliancy (Part 2 of 8)

(Continued from Part 1)

Dallas Fed’s Richard Fisher speaks on financial instability risks

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 expressed concerns on “financial excess” and the risks to the economy by keeping monetary policy “too loose too long.” In this section we’ll discuss some of these risks to financial stability.


Impact of excess liquidity in the financial system

The Fed’s accommodative monetary policy has resulted in excess liquidity in financial markets. The Fed’s monthly bond buying program (or QE3) has injected liquidity in financial markets and created excess reserves in the banking system. Instead of the additional liquidity being lent by banks to create investment and jobs, it has resulted in excess reserves at the 12 Federal Reserve Banks to ~$2.5 trillion.

“As evidenced by the buildup in excess bank reserves, the money we have printed has not been as properly circulated as we had hoped. Too much of it has gone toward corrupting or, more appropriately stated, corrosive speculation,” explained Richard Fisher.

Mr. Fisher spoke of bubbles in asset classes, and that “market distortions and acting on bad incentives are becoming more pervasive.” He noted that “we must monitor these indicators very carefully so as to ensure that the ghost of ‘irrational exuberance’ doesn’t haunt us again.”

Unfavorable fallouts from loose monetary policy

In an earlier speech in April ,  in Hong Kong, Richard Fisher discussed some of the unfavorable fallouts resulting from the accommodative monetary policy stance adopted by the Fed, including:

  • At ~26, the inflation-adjusted Shiller price-earnings (or PE) ratio was in the highest range of reported values since 1981.
  • Fisher had also said the market cap of the U.S. stock market as a percentage of the country’s economic output has more than doubled, to 145%, over the last five years, which is also the highest level recorded since the March, 2000.
  • Margin debt has been setting historic highs for several months. According to data released by the New York Stock Exchange (or NYSE), margin debt stood at ~$466 billion in March.
  • An increasing trend of covenant-lite loans due to money center banks advancing sums on imprudent terms.
  • Declining junk-bond yields are nearing historic lows at less than 5.5%.

Since then, these valuations have grown even richer. For example, the S&P 500 Index (VOO), touched numerous record highs in June and July. It touched 1985.44 on July 3, on the better-than-expected non-farm payroll additions in June.

High-yield debt (JNK) yields also touched record lows at 5.18% on June 20, lower than the 5.5% mentioned in Fisher’s speech in April.

Investor impact

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

Macroprudential tools for SIFIs

The use of macroprudential tools to deal with risks to financial stability are very much in vogue currently. In the following section, we’ll discuss why Richard Fisher thinks these tools are inadequate to deal with the risks arising from systematically important financial institutions (or SIFIs).

Continue to Part 3

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