For the Fed, a Recipe for Crisis Without Leverage

When the Federal Reserve first talked about tapering last summer, investors responded like startled animals. Interest rates jumped; stocks dropped. It took months for the Fed to calm the waters by convincing investors that it had not changed its plan for short-term interest rates. It just wanted to stop buying bonds.

A new paper suggests that history is going to repeat itself.

The paper argues that forward guidance - the Fed’s efforts to explain its plans for short-term interest rates - is building instability into markets that is likely to be unleashed again whenever the Fed does hint at raising rates.

“Our analysis does suggest that unconventional monetary policies (including QE and forward guidance) can build future hazards by encouraging certain types of risk-taking that are not easily reversed in a controlled manner,” write the authors, the economists Michael Feroli of JPMorgan Chase; Anil Kashyap of the University of Chicago; Kermit Schoenholtz of New York University; and Hyun Song Shin of Princeton.

The paper was presented Friday in New York at the U.S. Monetary Policy Forum, convened by the Booth School of Business of the University of Chicago.

The Fed’s huge stimulus campaign, and recent experience, has focused a great deal of scrutiny on the stability of financial markets. Fed officials say they are watching closely - much more closely than they did before the crisis - but that they don’t see evidence that their policies are causing significant problems.

“At this stage broadly I don’t see concerns,” Janet L. Yellen, the Fed’s chairwoman, told a Senate committee Thursday, although she added that she did see “pockets” of concern, including underwriting standards for leveraged loans.

Ms. Yellen’s comments underscored that the Fed, in looking for new problems, has been particularly focused on the use of leverage, or borrowed money, which was a major factor in the financial instability during the Great Recession.

Leverage, in the standard view, is the yeast of financial instability.

The authors of the new paper fret that the Fed is fighting the last war.

“The absence of leverage may not be sufficient to ensure that monetary policy can disregard concerns for financial stability,” the paper says. “It does not follow that future bouts of financial instability will operate only through the same mechanism that was present in 2008 and 2009.”

The focus of the paper, which also discusses the prospective effects of an exodus from emerging market bond funds, is a sketch model of how the Fed’s actions may produce instability without a buildup in leverage:

Investors move in herds. Even without significant leverage, those movements can build sharply and recede sharply. Monetary policy is a significant influence on those movements. As a result, changes in monetary policy can produce volatility.

The practical implication is that the Fed, when it begins to retreat, could find that financial conditions tighten much more quickly than it considers desirable. Moreover, the authors argue those changes could affect the broader economy, even without traditional mechanisms like bank failures, by raising interest rates.

“Stimulus now is not a free lunch,” the paper says. “It comes with a potential for macroeconomic disruptions when the policy is lifted. Perhaps the domestic macroeconomic fallout from exit will be as gentle as was the impact from the 2013 ‘taper tantrum.’ However, such a benign outcome is not guaranteed.”