Federal Reserve Governor Jeremy Stein said diminishing returns from Fed purchases of Treasury securities indicate the central bank should instead buy mortgage-backed debt.
“MBS purchases may offer a better cost-benefit profile than Treasury purchases in the current environment,” Stein said today in a speech at the Brookings Institution in Washington. Because corporate borrowers can already secure inexpensive credit, “it is natural to focus on a sector that is more sensitive to financing costs,” he said. “The housing market would seem to fit this bill.”
Stein used the remarks, his first monetary policy speech since joining the central bank in May, to defend the Fed’s decision last month to begin purchasing $40 billion of mortgage- backed securities each month until the labor market improves. Still, he presented a detailed outline of the costs and risks from the central bank’s bond purchasing programs, including a concern the Fed may trigger financial instability.
“Our recently announced policy of MBS purchases, coupled with the change in our forward guidance, are strong positive steps,” Stein said. At the same time, the Fed’s asset purchase programs “are a different animal, and it is important for us to try to better understand these differences.”
A strategy by the central bank of deliberately seeking higher inflation in order to spur economic growth probably wouldn’t work, Stein said.
“It would be a mistake to seek higher inflation,” Stein said in response to audience questions. Such a strategy would take the Fed away from one leg of its dual congressional mandate to maintain stable prices and ensure full employment, he said. Also, consumers and businesses may not react to higher inflation the way that they do in economic models, he said.
The possibility that Fed policies are causing banks, insurance companies and pension funds to take on more risk as they reach for higher yield “should be taken very seriously,” he said.
“A short summary would be that there is some qualitative evidence of reaching-for-yield behavior in certain segments of the market, but that we are not seeing anything quantitatively alarming at this point,” Stein said. “The worry is that one often sees only the tip of the iceberg in these kinds of situations, so one needs to be cautious in interpreting the data.”
The Fed should be ready to “intervene” with supervisory and regulatory tools, Stein said, dismissing arguments the central bank should raise rates to ensure financial stability.
“The potential damage that could be caused by choking off the recovery is too great,” he said, noting that long-term asset purchases can benefit financial stability by encouraging companies to issue long-term debt to replace short-term debt.
Quantitative easing programs pose another risk of possible disruption to “various aspects of market functioning, including bid-ask spreads and market depth,” Stein said.
“It would indeed be a concern if large Fed ownership of some segments of the Treasury or MBS market were to cause market liquidity to deteriorate significantly,” Stein said. “We have seen little evidence of such problems so far, and we continue to closely monitor market conditions.”
The central bank has undertaken three rounds of large scale asset purchases, or quantitative easing. In the first round, beginning in late 2008, the Fed began buying $1.25 trillion of mortgage bonds, $300 billion of Treasuries and $175 billion of Federal agency debt.
In the second round from November 2010 to June 2011 the Fed purchased $600 billion of Treasury securities. In the current round, the central bank is purchasing $40 billion of mortgage bonds.
U.S. stocks advanced, sending the Standard & Poor’s 500 Index higher for the first time in five days, as American jobless claims slid to a four-year low. The S&P 500 added 0.4 percent to 1,438.57 at 11:48 a.m. in New York.
An unresolved question for the Fed is what to do once its current Operation Twist program expires in December. In Operation Twist, the Fed is swapping about $45 billion a month of short-term Treasuries for longer-term government debt.
Stein, 51, a former Harvard University professor, was nominated by President Barack Obama in December to a term at the Fed lasting through January of 2018. Stein and Jerome Powell, an attorney and private equity investor, were confirmed by the U.S. Senate on May 17.
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