Thursday, February 21, 2013

The Fed Minutes and QE3

Those who follow financial news are aware that the release of the minutes of the Fed January meeting contributed to a decline in the stock market yesterday (Feb 20).  Basically, the minutes revealed that there was significant debate over the costs and benefits of QE3 and raised questions as to how much longer the Fed will engage in quantitative easing (click here for an earlier post describing QE3; earlier posts have also addressed the arguments for and against QE3).  In a speech earlier this month, Jeremy Stein, one of the newest members of the Board of Governors gave a speech, "Overheating in Credit Markets: Origins, Measurement, and Policy Responses," which provided useful insight into the thinking of some members of the Fed as well as ways to assess whether credit markets are functioning properly (i.e., if credit is too easy, whether credit is being misallocated - too much credit going to higher-risk borrowers, etc.).  Stein's speech is insightful, but one needs a solid understanding of finance and economics to follow it.  Here are some highlights.  Junk bond (bonds issued by high-risk corporations) issuance is at a record high as shown below:

The above chart shows that both banks (blue) and non-bank institutions (red) issued record amounts of leveraged loans at the end of 2012 and high-yield corporate bond issuance also hit a record high (top chart).   Meanwhile, credit spreads on high-yield (junk) bonds have declined significantly (see below), but are not out of line with historical averages (note: this is the difference between the interest rate on an average high-yield bond and a comparable US Treasury bond and measures the perceived risk of holding high-yield bonds):

Though the credit spread is not out of line with its historical average, it must be noted that interest rates on high-yield bonds are at record lows.  How does that work?  The credit spread of 400 basis points (i.e., 4%) indicates that interest rates on high-yield bonds are 4 percentage points above US Treasuries.  But interest rates on US Treasuries are still near record lows reached earlier in 2012.  When one adds 4% to a near record-low Treasury interest rate, the result is a record low junk bond rate.

Stein's conclusion is that there are preliminary indications of credit markets may be overheated, but not necessarily posing a significant problem yet (some other indicators are mixed).  He does raise the concern that if the trends continue, there may be a credit bubble that could have a harmful impact on the economy.

OK, what's going on?  QE1 (Fall 2008) was designed to avoid a financial collapse/depression.  QE2 (2010) was smaller and designed out of fear of possible deflation (market-based estimates of future inflation were declining significantly).  QE3 (Fall 2012) is intended to be an economic stimulus, particularly to reduce long-term unemployment which, if left unchecked, may lead to some of the currently unemployed to become unemployable, resulting in a "permanent" increase in unemployment.  Pushing interest rates lower should help interest-sensitive parts of the economy (for example, housing and autos) thus restoring stronger economic growth.  Given that housing and autos are now the strongest sectors of the economy, it seems to be working.  So what's the problem?

As we saw in the mid-2000s, if credit is too cheap, riskier borrowers may obtain credit to which they shouldn't have access, setting the stage for problems down the road as risky borrowers default, etc.  In the short run, it's helpful for more companies and individuals to get credit, but risky lending is harmful over time (recall the housing bubble and its aftermath).  Doesn't the Fed realize this?  Of course.  Those supporting continued quantitative easing perceive that lending is too risk-averse and thus should become a little riskier.  Also, the benefits of short-run stimulus offset the possible problems down the road (and it could be reversed in time to avoid some of the future problems).  Stein's speech points out that credit may already be too easy (or soon will be) and that the potential costs are rising.  In addition, reversing policy to avoid the future problems is easier said than done,

What's the key takeaway?  Conducting monetary policy is very difficult, particularly in the aftermath of a financial crisis.  Though the Fed may want to implement loose policy (policy that makes credit easier to obtain) in order to offset lending policies that are perceived to be too risk averse and to provide an overall boost to the economy, it must consider the underlying details.  Policy that results in too many risky borrowers obtaining credit can result in worse problems down the road.