Yellen: “It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage”

This is a quote from a speech Federal Reserve Board Vice Chair Janet Yellen gave yesterday at the Annual Meeting of the National Association for Business Economics in Denver, Colorado (emphasis added):

I noted previously–and it is now commonly accepted–that monetary policy can affect systemic risk through a number of channels.15 First, monetary policy has a direct effect on asset prices for the obvious reason that interest rates represent the opportunity costs of holding assets. Indeed, an important element of the monetary transmission mechanism works through the asset price channel. In theory, an increase in asset prices induced by a decline in interest rates should not cause asset prices to keep escalating in bubble-like fashion. But if bubbles do develop, perhaps because of an onset of excessive optimism, and especially if the bubble is financed by debt, the result may be a buildup of systemic risk. Second, recent research has identified possible linkages between monetary policy and leverage among financial intermediaries.16 It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking in the financial system.

This is significant because it demonstrates that some Fed officials recognize that easy money does have an effect on risk appetite in the financial sector. This is one reason financial assets have soared in the United States while the real economy has not.  Nevertheless, Dr. Yellen still favours quantitative easing as a policy measure despite evidence that it has negligible direct influence on the real economy.

Of late, we have been hearing a lot about how easy money in the U.S. and Europe is finding its way into emerging markets, creating problems.  For example, U.S.-based investors, starved for yield, have gone in search in places like Brazil. Emerging markets are therefore worried that their economies will overheat. Brazil and Korea were the first notable EM countries to have taken measured steps to prevent the deleterious effects of hot money flows and  the overheating they cause.

Now, add Thailand to the mix.

Thailand is introducing a tax on foreign holdings of bonds aimed at curbing capital inflows which have propelled the baht to a 13-year high against the dollar.

The Thai cabinet on Tuesday imposed a 15 per cent witholding tax on capital gains and interest payments for government and state-owned company bonds. The measure – which follows moves by Brazil and other Asian emerging economies to stem capital inflows – takes effect from Wednesday.

The Thai move to tackle “hot money” inflows and a rising currency comes as China and the US are locked in a bitter international debate over currency policy. While the US accuses China of undervaluing the renminbi, China blames loose US monetary policy for driving money into emerging markets that threatens to destabilise those economies.

While Brazil, South Korea and Indonesia have taken less drastic measures to control inflows, Thailand on Tuesday sent a clear signal that it was willing to take controversial measures to curb “hot money”.

Should we consider this emerging market retaliation in an escalating currency war or a one-off measure of policy prudence?


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