Fed Officials Want to Tackle "Reaching for Yield"

Cleveland Fed President Sandra Pianalto gave a speech on February 15 called "Providing Balance while Managing Uncertainty." She says that the Federal Reserve "has been aggressive and creative in its response to a very challenging economic environment, and our actions have been beneficial for the economy." Nonetheless, her outlook is not among the most optimistic. She predicts that the unemployment rate will be 7.5% at the end of this year, and around 7% at the end of 2014. According to the Fed's threshold rule, the Fed won't raise the funds rate until unemployment falls below 6.5% or inflation rises above 2.5%. By Pianalto's estimation, that won't be happening until 2015 at the earliest.

Pianalto's counterpart at the St. Louis Fed, James Bullard, expounded upon the threshold rule in a speech the day prior to Pianalto's speech. Both Bullard and Pianalto address the Fed's balance sheet policy, QE3.  While Bullard describes the asset purchase program as "potent," Pianalto fears that it will have both "diminishing benefits" and increasing costs:

Over time, the benefits of our asset purchases may be diminishing. For example, given how low interest rates currently are, it is possible that future asset purchases will not ease financial conditions by as much as they have in the past. And it is also possible that easier financial conditions, to the extent they do occur, may not provide the same boost to the economy as they have in the past. In addition to the possibility that our policies may have diminishing benefits, they also may have some risks associated with them.

The first such risk that she notes is the following:

First, financial stability could be harmed if financial institutions take on excessive credit risk by “reaching for yield” —that is, buying riskier assets, or taking on too much leverage—in order to boost their profitability in this low-interest rate environment. 

This is reminiscent of John Taylor in an Op-Ed in the Wall Street Journal called "Fed Policy is a Drag on the Economy." Taylor writes that

The Fed’s current zero interest-rate policy also creates incentives for otherwise risk-averse investors—retirees, pension funds—to take on questionable investments as they search for higher yields in an attempt to bolster their minuscule interest income.

Miles Kimball challenged the logic of this "reaching for yield" concern in two posts. Karl Smith weighed in on Forbes, and I did too on this blog. Kimball argues,

The often-repeated claim that low interest rates lead to speculation cries out for formal modeling. I don’t see how such a model can work without some combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance and irrationality...

I have no problem believing that, indeed, investor ignorance and irrationality and schemes that prey on that ignorance and irrationality do indeed cause people to take on more risk as a result of low interest rates than they otherwise would. This is a genuine cost to the Fed stimulating the economy with low interest rates. But— especially once we figure out the details—it has much bigger implications for financial regulation than for monetary policy...Regulation has serious costs, but so does tight monetary policy in the current environment.

Interestingly, Kimball's point about the appropriate domains of financial regulation versus monetary policy brings up yet another February Fed speech, this one by Governor Jeremy Stein of St. Louis. Stein argues that the Fed should take on what has typically been the role of financial regulators in alleviating "overheating" in credit markets. No surprise, he cites as one cause of overheating the fact that "a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to `reach for yield.'"

Stein alludes to the same sort of model that Kimball has in mind. Stein admits both irrationality ("changes in the pricing of credit over time reflect fluctuations in the preferences and beliefs of end investors such as households, where these beliefs may or may not be entirely rational") and fraudulent schemes ("At any point, the agents try to maximize their own compensation, given the rules of the game. Sometimes they discover vulnerabilities in these rules, which they then exploit in a way that is not optimal from the perspective of their own organizations or society.")

Their models for the causes of reaching for yield are roughly the same, but their policy prescriptions are polar opposites. Kimball says that tighter monetary policy is the worst solution to reaching for yield, and improved financial regulation is the better option. Stein says that monetary policy has benefits over financial regulation. Pianalto apparently comes down on the side of Stein, tentatively suggesting that tighter monetary policy may be necessary to reduce the threat of financial instability caused in part by reaching for yield. She says that "we could aim for a smaller sized balance sheet than would otherwise occur if we were to maintain the current pace of asset purchases through the end of this year, as some financial market participants are expecting."