Why Jeremy Stein calls for a more realistic approach to Fed policy



Downsides to using Stein’s capital markets–centric approach

Jeremy C. Stein, Governor of the Federal Reserve System, spoke on monetary policy at the International Research Forum in Washington, DC, on March 21. Stein pointed out that using increases in excess bond premiums’ to predict future economic activity might not always reflect a causal link. Perhaps there are economic slowdowns that are caused entirely by non-financial factors, and, when investors see one on the horizon, they get wary, causing the EBP (the excess bond premium) to rise. If so, it would be wrong to conclude that easy monetary policy has any causal effect on the probability of a future slowdown.

SPY and Unemployment rate


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Stein believes that measures of bond market risk premiums—for example, estimates of the expected excess returns on long-term Treasury securities relative to Treasury bills and on credit-risky bonds relative to Treasury securities—may turn out to be useful inputs into monetary policy. These variables can serve as simple proxies for a particular sort of financial market vulnerability that may not supervision and regulation may not easily address.

The iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD), with investments in the corporate bonds of Apple Inc. (AAPL) and Goldman Sachs (GS), is a popular ETF in the corporate bond category. Treasuries, on the other hand, are well represented by ETFs such as the iShares Barclays 1-3 Year Treasury Bond Fund (SHY) and the iShares Barclays 20 Year Treasury Bond Fund (TLT).

Stein stressed the importance of time variation in risk premiums (or expected returns) on a wide range of assets. He concluded by restating his belief that for our macro models to be more useful as a guide to policy, they need to build on a more empirically realistic foundation with respect to the behavior of interest rates and credit spreads.

To learn more about how monetary policy affects your ETF investment, see the Market Realist series The Dallas Fed’s Richard Fisher shares key forward guidance.


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