Must-know: Future impacts of financial stability measures

By

Updated

Dr. Narayana Kocherlakota talks about real interest rates in Boston 

Minneapolis Fed president and chief executive officer (or CEO) Dr. Narayana Kocherlakota, spoke on the subject of low real interest rates at the Ninth Annual Finance Conference, held at Boston College in Boston, Massachusetts on June 5, 2014. Real rates of interest are the reported rates of interest, net of inflation.

In his speech, Dr. Kocherlakota mentioned that real rates of interest had fallen sharply below 2007 levels, and five-year Treasury Inflation Protected Securities (or TIPS) yields were currently in negative territory. In the last section, we discussed Dr. Kocherlakota’s views of how the Fed must weigh the benefits of financial markets stability which may result through monetary tightening versus the adverse impact of higher real rates of interest on employment and prices. In this section, we’ll discuss his views on why financial stability concerns are likely to play a key role in framing future monetary policy. We’ll also discuss their implications on bond (BND) and stock (OEF) markets.

Part 5

Article continues below advertisement

Eventually, Dr. Kocherlakota believes that the Fed would achieve its goals of ensuring mandate consistent levels of full employment and inflation in the economy. At that juncture, he still expects the real rates of interest to be low. This would mean that risks to financial stability would still exist in the system when the Fed’s targets are achieved. At that point, these risks would dominate the Fed’s monetary policy decisions.

How do financial stability risks impact investors?

Some excesses of instability in financial markets include:

  • Spreads between high-yield (JNK) and investment grade debt (LQD) at historical lows
  • Taking advantage of low interest rates to invest in in stock markets (OEF) using leverage, thus contributing to stock market bubbles
  • Over-optimism on the synergies resulting from M&A transactions as companies scramble to take advantage of record low real interest rates
  • Bank runs during the 2008 financial crisis (for example—the run on Wachovia in September, 2008, which resulted in a hasty acquisition of Wachovia by Wells Fargo (WFC) in October, 2008)

What resources is the Fed using to monitor these risks?

The Fed currently uses considerable staff resources in monitoring financial markets for risks arising from financial instability. One of the ways in which the Minneapolis Fed is involved in financial markets surveillance, is through monitoring “the risk-neutral probability distributions of future asset values.” This helps the Fed gain information on these risks on an ongoing basis.
However, as Dr. Kocherlakota said, “There is more to be learned. We need to understand better, in light of the current state of supervision and regulation, which residual financial system risks have the potential to translate into macroeconomic risks. And we need to understand better to what extent monetary policy tightening can in fact temper those residual financial system risks.”

To read about Philadelphia Fed president and CEO, Dr. Charles Plosser’s views on financial stability, please read the Market Realist series, Charles Plosser’s 3 must-know ideas for financial stability.

Advertisement

More From Market Realist