BOSTON – The Federal Reserve should continue buying long-term bonds to support economic growth until the outlook for U.S. employment gets considerably better, Fed Board Governor Jeremy Stein said on Friday.
Stein, who joined the U.S. central bank in May, defended the Fed's unconventional monetary policies on a panel with Minneapolis Fed President Narayana Kocherlakota, who focused his comments on regulating big U.S. banks, arguing that the perceived risk of a failure has receded in recent years.
The Fed has kept short term rates almost at zero for four years and has bought some $2.5 trillion in bonds to drive down longer-term borrowing costs and boost the recovery from recession.
Stein argued that these policies have not only brought down rates on long-term government bonds, but also have made it cheaper for corporations to borrow in capital markets.
"While this is not entirely uncontroversial, my own reading of the evidence is that there has also been substantial pass-through to corporate bond rates," Stein, who was a Harvard finance professor before joining the Fed, said at a conference hosted by the Boston Fed bank.
He estimated an additional $500 billion on Treasury purchases would lower long-term bond rates in the government and corporate markets by around 0.15-0.20 percentage point.
The effectiveness of the "pass-through" of the Fed's aggressive policies have been a hot topic since the central bank launched a third quantitative easing program in September, dubbed QE3, to buy $40 billion in mortgage bonds per month. Policymakers could decide to ramp that up when they meet in Washington on Dec. 11-12.
While some have bemoaned the very incremental reduction in rates on home loans since QE3, others such as Stein and Kocherlakota, argue that every bit of support from the Fed helps in spurring economic growth and lowering the 7.9 percent unemployment rate.
Stein expressed frustration with the "constraint" lenders are showing in, for example, issuing mortgage loans.
He admitted that the impact of purchasing assets tends to diminish over time because, in a weak economic environment, companies opt to lower their funding costs by refinancing rather than make new investments.
Still, Stein argued the Fed's strategy of buying mortgage-backed securities was particularly effective in helping the housing finance sector.
"I suspect that mortgage purchases may confer more macroeconomic stimulus dollar-for-dollar than Treasury purchases," Stein said.
The U.S. economy expanded 2.7 percent in the third quarter, but growth is expected to be significantly slower for the last three months of the year. Consumer spending posted its first drop in five months during October, according to a report on Friday.
TOO BIG TO FAIL
Turning to the Fed's other key function, financial regulation, Kocherlakota highlighted that studies using measures of market risk, including credit default swaps, show "that the size of the too-big-to-fail problem has fallen over the past couple of years but remains large."
While the perceived risk of a big U.S. bank failure has receded, more study is needed to understand whether the improvement is due to government policies or simply an improved economic outlook.
For any given financial institution "it could be that creditors believe that there is little likelihood of that financial institution becoming distressed" perhaps because new rules require banks to put up more capital, Kocherlakota said.
It could also be that creditors believe a government bailout is unlikely, suggesting that other policies - such as the requirement banks devise blueprints for a wind-down should they become insolvent - are working.
But metrics could be improving "simply because creditors' assessments of future macroeconomic conditions improve," he said.
Teasing apart the reasons for the improvement in the too-big-to-fail problem is key to understanding whether approaches like those enshrined in the 2010 Dodd-Frank financial reform act are having the intended effect, Kocherlakota said.
The wide-ranging law, written in response to the 2007-2009 financial crisis, aims to reduce the likelihood of banks failing and to lessen the cost to society if they do.
Kocherlakota has urged the Fed to adopt guideposts for policy in terms of unemployment and inflation, and on Friday reiterated his view that without such metrics "it is challenging to know whether monetary policy is overly accommodative or not."
The same point can be made for the too-big-to-fail bank problem, which Congress has set out to resolve.
"The public can only hold Congress and its (delegates) responsible for achieving this mandate if there are quantitative measures of the size of the too-big-to-fail problem," he added. (Additional writing and reporting by Pedro Nicolaci da Costa and Ann Saphir. Editing by Andre Grenon)