Brainard: Fed rate policy is not for financial stability
Federal Reserve governor Lael Brainard gave a speech on financial stability yesterday afternoon. The big takeaway for me was that she did not mention rate policy as an element of the Fed’s core financial stability regulatory function. From a market perspective, the corollary is that the “Powell Put” is not very strong. The Fed will not stop its rate hike train just because markets fall. Caveat Emptor!
Brainard: financial sector vulnerabilities are moderate
When looking at the overall picture today, Lael Brainard assessed the systemic risks as middle of the road. And she believes much of this owes to safeguards that US regulators put in place after the financial crisis. This long paragraph encapsulates her view. I have broken it up into three:
Although asset valuations are elevated, vulnerabilities due to debt owed outside the financial sector appear to be moderate–in the middle of their historical range. This reflects elevated leverage in the nonfinancial business sector and a moderate pace of borrowing in the household sector. In the nonfinancial business sector, the debt-to-earnings ratio has increased to near the upper end of its historical distribution, and net leverage at speculative-grade firms remains especially elevated.
Overall, however, the ratio of nonfinancial-sector borrowing to gross domestic product has been below an estimate of its trend for several years as a result of the deleveraging of the household sector following the crisis. While the sustained period of post-crisis household deleveraging appears to have come to an end and savings rates have recently moved down, overall borrowing has been at a moderate pace and, on net, concentrated among borrowers with high credit scores.
Even though the balance sheet of the household sector as a whole appears relatively strong, recent years have seen a rapid rise in student debt as well as rising default rates for borrowers with subprime credit scores on auto loans and, more recently, credit card balances.
The risk buried in Brainard’s moderate financial stability assessment
The first thing to note is that she believes that valuations across markets are broadly “elevated relative to historical norms”. And from a financial stability standpoint, that is not good.
At the same time, banks are better capitalized due to post-crisis regulatory action. And households are less leveraged than before the crisis. The areas of worry she mentions there are student debt and subprime auto and subprime credit cards.
But low interest rates are what she calls a “mitigating factor”. So it’s a push. The key — and she says this directly — is inflation. To the degree that inflation increases, forcing the Fed’s hand, overvalued markets will become a source of concern regarding financial instability. And that will force the Fed to take macroprudential steps like mandating increased countercyclical buffers at financial institutions.
The takeaway, then, is this:
- If inflation remains muted, the Fed will maintain a gradual rate increase path.
- However, if inflation rises more than anticipated, the Fed will become extremely concerned and further accelerate its timetable.
- If the Fed accelerates its timetable, that will be negative for asset markets.
- And given the present overvaluation of virtually all asset markets, this is a financial stability concern.
- From a market perspective, fear a big downturn in stocks then.
- Moreover, the Fed will then force banks to increase capital buffers. And that will hurt bank earnings and valuations.
Aggressive late-cycle fiscal policy is a wildcard
Brainard had this to say about fiscal policy more specifically:
As I have noted elsewhere, the recently enacted fiscal stimulus should boost the economy at a time when it is close to full employment and growing above trend. It is hard to know with precision how the economy is likely to respond. If unemployment continues to decline at the rate of the past year, it could reach levels not seen in several decades. Historically, such episodes tended to see a risk of accelerating inflation in earlier decades or a risk of financial imbalances in more recent decades. It is important to be attentive to the emergence of any imbalances, because we do not have much experience with pro-cyclical fiscal stimulus at a time when resource constraints are tightening and growth is above trend.
The clear implication is a reiteration of her inflation remarks. The Fed will accelerate its rate hike path and increase capital buffers if inflation rises. In this case she points specifically to late-cycle fiscal stimulus as the potential cause.
Brainard did not address trade policy specifically here. But to the degree, a trade war increases inflation at a time when headline unemployment is low, expect the Fed to accelerate its timetable for tightening.
Interest income versus credit stress as conduits of policy
When I mention interest rate hikes as “tightening”, I am always referring to credit stress, and not the interest income channel. We should expect interest income to rise with interest rates. And that’s positive for the private sector. But financial institutions have not passed interest rate increases through to savers to expect much impact there yet.
Now, the way we traditionally think of interest rate policy is through a borrower’s prism. And although there is no empirical evidence that higher interest rates alter investment decisions, they can cause marginal debtors stress. Look at Tesla, for example:
Tesla bonds keep falling. pic.twitter.com/sdcZaGDRWc
— Lisa Abramowicz (@lisaabramowicz1) April 2, 2018
This is typical late cycle risk-off sentiment. Tesla is a market darling. And investors have given it the benefit of the doubt for years.
— Mark B. Spiegel (@markbspiegel) April 3, 2018
The fact that its bonds are showing signs of credit stress speaks to how rising rates are restrictive for marginal debtors late in the business cycle.
Brainard: Rate policy is not where the Fed acts on financial stability concerns
Nowhere in Lael Brainard’s speech does she mention interest rate increases as a way to address financial stability. She does begin her speech saying, “The Federal Reserve’s work on financial stability is integral to our dual-mandate objectives of price stability and full employment.” However, she does not then go on to say that the Fed needs to increase or decrease rates to address financial stability issues.
Instead she says:
The primary focus of financial stability policy is tail risk (outcomes that are unlikely but severely damaging) as opposed to the modal outlook (the most likely path of the economy). The objective of financial stability policy is to lessen the likelihood and severity of a financial crisis.
And that means macroprudential policy: regulation, stress tests, countercyclical capital buffers and so on. And all of this is about credit. It’s about insuring the safety and soundness of the financial system, the credit system. For example, she mentioned cryptocurrencies as an area of concern. But she dismisses cryptocurrencies as a systemic risk specifically because there is marginal credit risk.
One area that the Federal Reserve is monitoring is the extreme volatility evidenced by some cryptocurrencies… it is hard to see evidence of substantial leverage used in the purchase of the cryptocurrencies, or a material degree of use in payments, although our assessment of these markets is limited by their opacity. Nonetheless, we will continue to study them.
So forget about the Powell Put
So, if financial stability risks are moderate and rate policy is not about those risks anyway, what does that mean for rates? To me, it means that Fed rate decisions have nearly nothing to do with asset markets. It’s all about the real economy. Boston Fed President Eric Rosengren has even said increased asset market volatility is a good sign. It shows the markets’ “realization that financial markets need to factor in the risk that wages and prices could grow too quickly”.
Translation: Forget about the Powell Put. If markets fall out of bed, the Fed won’t be put off. Only to the degree that what happens in asset markets spills over into the real economy does it matter for interest rate policy.
The Brainard speech reinforces my view that the Fed will continue to talk about three rate hikes in its forward guidance. But the Fed will also stress economic tailwinds and inflation concerns, as Brainard did yesterday. That makes four rate hikes in 2018 a distinct possibility. The big unmentioned wildcard is a trade war. That could have significant real economy effects. And I have yet to hear the Fed take a view on how this subject affects rate policy.
Source: Speech by Governor Brainard on an update on the Federal Reserve’s financial stability agenda – Federal Reserve Board