Quick post here. In a post last week, I mentioned a speech Fed Governor Lael Brainard made on financial stability. And the key takeaway from that speech for me was that the Fed doesn’t see rate policy as the correct conduit to maintain financial stability. Not once did Brainard talk about raising interest rates to ensure the integrity of the payments system. But she did talk about capital buffers. And I think that’s significant.
Remember dual-barrelled tightening?
If you think back to when the Fed first announced its quantitative tightening program in June 2017, it was Jerome Powell who introduced the program. At the time, there was angst around double-barrelled tightening. Reducing the Fed’s balance sheet at the same time the Fed was increasing the federal funds rate would mean an additional channel of tightening. And the Treasury yield curve had flattened to the point where St. Louis Fed President James Bullard was voicing concern.
So, later in the month, Fed President Charles Harker, who is generally considered hawkish, telegraphed a pause in rate policy while quantitative tightening got off the ground. He said:
“It is prudent for us to pause on the next rate increase; at some point, and I would assume it is this year, cease reinvestment; and see how the markets react. We can take our time to do this. We don’t have to be in a rush.”
And the Fed put rate increases on hold until December.
When Powell became Fed Chairman, policy took a more hawkish tilt and double-barrelled tightening became policy. Now, quantitative tightening has proceeded without any major calamity. So, hawks and doves alike are comfortable with rolling off the balance sheet while simultaneously increasing rates.
Next come financial stability concerns
This is where financial stability comes into play. Here’s what Brainard said.
The objective of financial stability policy is to lessen the likelihood and severity of a financial crisis. Guided by that objective, our financial stability work rests on four interdependent pillars: systematic analysis of financial vulnerabilities; standard prudential policies that safeguard the safety and soundness of individual banking organizations; additional policies, which I will refer to as “macroprudential,” that build resilience in the large, interconnected institutions at the core of the system; and countercyclical policies that increase resilience as risks build up cyclically. This work also recognizes the important connections to our monetary policy objectives.
Translation: financial stability is integrally tied to the Fed’s dual mandate. But we use macroprudential policies to address it, not rate policy.
And then we are on to countercyclical capital buffers
Look at what she said specifically about countercyclical buffers for bank capital:
Countercyclical capital requirements can lean against a dangerous increase in financial vulnerabilities at a time when the degree of monetary tightening that would be needed to achieve the same goal would be inconsistent with the Federal Reserve’s dual mandate of full employment and price stability. The reverse is also true. The countercyclical capital buffer (CCyB) is designed to increase the resilience of large banking organizations when there is an elevated risk of above-normal losses, which often follow periods of rapid asset price appreciation or credit growth that are not well supported by underlying economic fundamentals. The CCyB is an additional margin of capital that the nation’s largest banks can be asked to build to augment resilience at times of rising cyclical pressures and to release as the economy weakens in order to allow banks to lend more when it is most needed.
Translation: given our concern about elevated asset prices, we are likely to require increased capital buffers in the future. The key to if and when is in how large mitigating factors are in keeping financial stability concerns at bay.
What does it mean that the low level of Treasury yields is a mitigating factor?
Notice, though, that Brainard doesn’t completely rule out rate policy as a tool for addressing financial stability. She asks what the Fed should do if financial stability concerns require a “degree of monetary tightening that would be… inconsistent with the Federal Reserve’s dual mandate”.
That’s something to remember if economic growth increases. It says the Fed could accelerate its tightening.
Now, earlier in her speech, Brainard specifically said:
In the assessment of elevated asset valuations, the relatively low level of Treasury yields is a mitigating factor
I think the big question is whether Brainard is saying higher yields mean more systemic risk from financial asset valuation. That’s the interpretation I take. I see her saying that asset prices are too high but the low level of yields makes us less concerned about those high prices. The upshot is that, were yields to rise, the Fed should be more concerned about the financial stability implications of elevated asset prices. And that means high capital buffer requirements.
In effect, Brainard has announced countercyclical capital buffers as the Fed’s third tightening channel.
We need to listen to see exactly how the Fed plans on using this tool. This tightening channel will have particular impact on banks and bank stocks. But capital buffers will also impact credit more broadly.
Source: An Update on the Federal Reserve’s Financial Stability Agenda, Lael Brainard, Federal Reserve