Bernanke: Early Tightening Could Be Costly, Counterproductive

While "excessive risk-taking" in a low interest rate environment must be monitored, "prematurely" raising rates to counter financial market risks could be "quite costly" and "counterproductive, Federal Reserve Chairman Ben Bernanke said Friday night.

There are, however, other ways that the Fed can use its monetary tools to promote financial stability in conjunction with its supervisory efforts, Bernanke said.

To counter "excessively sharp adjustments" in long-term interest rates in the years ahead, he said the Fed could adjust the timing and pace of its asset sales. And he said the Fed's clearer "forward guidance" about the economic conditions which would lead it to raise short-term rates should exert a calming effect on markets.

Bernanke, in remarks prepared for delivery at a San Francisco Federal Reserve Bank conference, said long-term rates are currently very low throughout the industrialized world because for common reasons, chiefly slow economic growth and low inflation. But he said that as the economy recovers, long-term rates will "rise gradually toward more normal levels over the next several years."

As the transition to higher rates occurs, he identified two sets of risks to financial stability: first, that of undue speculation while rates are still very low and second, the risk of sharp rises in market rates once the economy gains momentum.

Fed Governor Jeremy Stein, among others, has focused on the former risk recently, citing rising prices (and falling yields) in the junk bond market. Stein said the Fed needs to keep "an open mind" about using monetary policy and not just supervision and regulation to curb risks and prevent asset bubbles.

Bernanke, who has tended to hold with the more traditional Fed view that monetary policy is too "blunt" an instrument to address specific financial imbalances, appeared to meet Stein halfway in his comments.

Echoing comments he made earlier in the week when testifying on the Fed's semi-annual Monetary Policy Report to Congress, he acknowledged that "in an environment of persistently low returns, incentives may grow for some investors to engage in an unsafe 'reach for yield' either through excessive use of leverage or through other forms of risk-taking."

But he forcefully opposed using Fed rate hikes to counter such activity, saying that "at least in economic circumstances of the sort that prevail today, such an approach could be quite costly and might well be counterproductive from the standpoint of promoting financial stability."

"Long-term interest rates in the major industrial countries are low for good reason," he continued. "Inflation is low and stable and, given expectations of weak growth, expected real short rates are low."

"Premature rate increases would carry a high risk of short-circuiting the recovery, possibly leading - ironically enough - to an even longer period of low long-term rates," he added.

Bernanke made clear that the Fed's preferred approach to controlling financial risk is "macro-prudential oversight," which he noted has been greatly increased since the financial crisis. This involves monitoring different financial sectors, and especially the largest financial firms, for signs of vulnerability.

Secondly, the Fed and its fellow supervisors are increasing capital and liquidity requirements and performing bank stress tests, including ones designed to measure the impact of higher rates.

While suggesting that these are the Fed's main line of defense, Bernanke did assign a role to monetary policy.

"Our approach to communicating and implementing monetary policy provides the Federal Reserve with new tools that could potentially be used to mitigate the risk of sharp increases in interest rates," he said.

Unlike 1994, when long-term rates shot up dramatically because markets weren't fully prepared for Fed tightening, Bernanke noted that the Fed has now provided a set of economic thresholds - 6.5% unemployment and 2.5% inflation - for considering hikes in the federal funds rate. And he noted the Fed's rate-setting Federal Open Market Committee has said it will keep rates very low "for a considerable time" after it stops buying bonds.

"By providing greater clarity concerning the likely course of the federal funds rate, FOMC communication should both make policy more effective and reduce the risk that market misperceptions of the Committee's intentions would lead to unnecessary interest rate volatility," he said.

"In addition, the Federal Reserve could, if necessary, use its balance sheet tools to mitigate the risk of a sharp rise in rates," Bernanke went on. "For example, the Committee has indicated its intention to sell its agency securities gradually once conditions warrant."

"The Committee also noted, however, that the pace of sales could be adjusted up or down in response to material changes in either the economic outlook or financial conditions," he said. "In particular, adjustments to the pace or timing of asset sales could be used, under some circumstances, to dampen excessively sharp adjustments in longer-term interest rates."

The Fed chief said he and his fellow policymakers have been running a very easy money policy "to prompt a return to the productive risk-taking that is essential to robust growth and to getting the unemployed back to work."

In so doing, he said, "we must be mindful of the possibility that sustained periods of low interest rates and highly accommodative policy could lead to excessive risk-taking in some financial markets."

However, he added, "we must also be aware of constraints posed by the present state of the economy. In light of the moderate pace of the recovery and the continued high level of economic slack, dialing back accommodation with the goal of deterring excessive risk-taking in some areas poses its own risks to growth, price stability, and, ultimately, financial stability."

Although the Fed has been criticized by some Fed officials and others for holding rates too low for too long, Bernanke said rates are low throughout the industrialized world because "market participants anticipate persistently slow growth and, consequently, low real returns to investment."

Low long-term rates reflect not only low inflation expectations, but also falling real interest rates and a lower term premium - all reflecting economic weakness, he said.

"This weakness, all else being equal, dictates that monetary policy must remain accommodative if it is to support the recovery and reduce disinflationary risks," he said. "At the present time the major industrial economies apparently cannot sustain significantly higher real rates of return."

So Bernanke said the Fed and other major central banks "have little choice but to take actions that keep nominal long-term rates relatively low," so long as they meet their price stability mandates.

Another factor keeping U.S. rates low, he noted, is that "the global economic and financial stresses of recent years - triggered first by the financial crisis, and then by the problems in the euro area - appear to have significantly elevated the safe-haven demand for Treasury securities at times, pushing down Treasury yields and implying a lower, or even a negative, term premium."

But this is due to change at some point, he said, citing forecasts showing the 10-year Treasury note yield at 3% by the end of 2014 and up 200 to 300 basis points by 2017.

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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