One of the main arguments for the Federal Reserve to raise interest rates and deflate financial bubbles lost some of its strength Monday with the release of government research that found that the December rate increase didn’t ease pressure for investors to take excessive risks.
The Office of Financial Research, an agency within the Treasury Department charged with identifying potential threats to the financial system, on Monday flagged the low long-term interest rate environment as an area of concern. Facing low returns on bonds, investors are forced to seek profits, or “reach for yield” by betting on riskier assets, the report warned.
That dynamic wasn’t changed by the Fed’s historic decision in December to raise its short-term interest rate, the first time it raised its target since it set it to near zero in late 2008.
Instead, agency Director Richard Berner spelled out Monday, markets have assumed that the Fed will avoid raising rates further because of bad economic news, especially the June 23 United Kingdom referendum on leaving the European Union. In the wake of the vote to leave, interest rates on long-term U.S. Treasury bonds fell to historically low levels, well below the December rate hike.
“There’s been a lot of talk of additional stimulus” in the U.S. and in other countries, Berner told reporters Monday. “Markets have largely recovered on the back of those discussions.”
The market rally following the financial turmoil that immediately followed Brexit vote “largely reflects the anticipation of slower growth and the policy response to it,” Berner said, referring to investors’ expectations that the Fed would hold off on interest rate hikes in response to bad news.
Fed officials have long debated whether raising rates to stave off bubbles would be advisable.
Some Fed officials, such as Federal Reserve Bank of San Francisco President John Williams, have cited the need to cool off financial markets as a reason to raise rates earlier, rather than later, with Williams specifically pointing to real estate prices as a sign of speculation running high.
Other Fed members, however, have argued that rate hikes themselves could put pressure on banks and markets.
Daniel Tarullo, the Federal Reserve governor who leads efforts related to financial regulation, said in a July interview with the Wall Street Journal, that “if markets do regard economic prospects as only modest or moderate going forward, then raising short-term rates is almost surely going to flatten the yield curve.”
n other words, the Fed would force up short-term rates without long-term rates rising correspondingly, which would hurt bank profit margins. That possibility “generally speaking is not good for financial intermediation, and in some sense could exacerbate financial stability concerns,” Tarullo said.
The Board of Governors, in its monetary policy report, hasn’t reported any major signs of bubbles. In testimony before the Senate last month, Chairwoman Janet Yellen said that she didn’t see signs of “extreme threats to financial stability at this time. This is something we monitor very closely. But it is something that can happen in a low-interest rate environment.”
