To get a sense of some of the effects of excess liquidity, you need look no further than Neil Irwins front-page, above-the-fold article in the July 8 issue of the New York Times, titled From Stocks to Farmland, Alls Booming, or Bubbling. Welcome to the Everything Bubble, it reads...

I spoke of this early in January, referencing various indicia of the effects on financial markets of the intoxicating brew we (at the Fed) have been pouring. In another speech, in March, I said that market distortions and acting on bad incentives are becoming more pervasive and noted that we must monitor these indicators very carefully so as to ensure that the ghost of irrational exuberance does not haunt us again. Then again in April, in a speech in Hong Kong, I listed the following as possible signs of exuberance getting wilder still:

-The price-to-earnings, or P/E, ratio for stocks was among the highest decile of reported values since 1881;
-The market capitalization of U.S. stocks as a fraction of our economic output was at its highest since the record set in 2000;
-Margin debt was setting historic highs;
-Junk-bond yields were nearing record lows, and the spread between them and investment-grade yields, which were also near record low nominal levels, were ultra-narrow;
-Covenant-lite lending was enjoying a dramatic renaissance;
-The price of collectibles, always a sign of too much money chasing too few good investments, was arching skyward.

I concluded then that the former funds manager in me sees these as yellow lights. The central banker in me is reminded of the mandate to safeguard financial stability.

Since then, the valuation of a broad swath of financial assets has become even richer, or perhaps more accurately stated, more careless. It is worrisome, for example, that covenant-lite lending has continued its meteoric revival and has even surpassed its 2007 highs.

[O]ne has to consider the root cause of the Everything Boom. I believe the root cause is the hyper-accommodative monetary policy of the Federal Reserve and other central banks.

At some point you cross the line from reviving markets to becoming the bellows fanning the flames of the Booming and Bubbling that Neil Irwin writes about. I believe we have crossed that line. I believe we need an adjustment to the stance of monetary policy.

Let me be quick to add that one negative, collateral impact of engaging in reverse repos is that during a period of heightened financial risk, investors might flee to the reverse repo market. This would provide a safe asset for investors, but might also encourage runs from higher-risk, short-term private debt instruments. This would have the potential to create significant private sector financing disruptions during times of stress. Presumably, capping the size of the reverse repo facility could help limit the impact.

In addition to our monetary policy responsibilities, the Federal Reserve works to promote financial stability, focusing on identifying and monitoring vulnerabilities in the financial system and taking actions to reduce them. In this regard, the committee recognizes that an extended period of low interest rates has the potential induce investors to reach for yield by taking on increased leverage, duration risk, or credit risk. Some reach for yield behavior may be evident, for example, in the lower-rated corporate debt markets where issuance of syndicated leverage loans and high-yield bonds has continued to expand briskly, spreads have continued to narrow, and underwriting standards have loosened further. While some financial intermediaries have increased their exposure to duration and credit risk recently, these increases appear modest to date, particularly at the largest banks and life insurers. More generally, valuations for the equity market as a whole and other broad categories of assets, such as residential real estate, remain within historical norms. In addition, bank holding companies have improved their liquidity positions and raised capital ratios to levels significantly higher than prior to the financial crisis. For the financial sector more broadly, leverage remains subdued and measures of short-term funding continue to be far below levels seen before the financial crisis. ... So, we can't detect within any certainty whether or not there's an asset bubble. But we can look at a variety of different valuation metrics akin to price-earnings ratios and the stock market; a variety of ways of measuring those. And we can look to see how valuations in that sense moved out of historically normal ranges. And I would say for the equity market as a whole, the answer is that valuations are in historically normal ranges. Now, interest rates, long-term interest rates are low and that is one of the factors that feeds into equity market valuations. So, there is that linkage. So, there are pockets where we could potentially see misvaluations in smaller-cap stocks, but overall those broad metrics don't suggest that we are in obviously bubble territory. But, you know, we don't have targets for equity prices and can't -- can't detect if we're in a bubble with -- with certainty.

“I don’t want to do it all at once, but I think we should begin to taper very soon and hopefully end it by the end of this year,” Plosser said today in an interview in Jackson Hole, Wyoming. “That would be a healthy thing for the economy. We can do it gradually.”

Fed Chairman Ben S. Bernanke said last month the Fed is on track to begin reducing its bond buying later this year and halt the program by around mid-2014 if the economy performs in line with central bank forecasts. Plosser, who doesn’t vote on monetary policy this year, has repeatedly spoken out against additional easing by the Fed.

“I’d like for us to start in September” to taper the purchases, Plosser said in the Bloomberg Television interview with Michael McKee to air July 15. “We don’t want to create another housing boom,” and “we have to be careful of the unintended consequences of our policies.”

[T]here were large growths in gross inflows of financial flows from Europe to the United States, which again were a demand for safe assets, if you will, which at the time, there being an insufficiency of safe assets. In the view of many people, the — Wall Street was in some sense trying to construct safe assets through securitization and tranching. And we know that that didn’t work out so well.

I think that — you know, there are some issues with safe assets in that, besides collateral, you know, we have potentially increased liquidity requirements, increased margin requirements. And that may create some pressure on supply of safe assets, at the same time that, you know, we’re having sovereign debt issues in some parts of the world, which reduces the supply of safe assets. So I think that’s an interesting, important question, and one that we have discussed at the Federal Reserve.

I would say, however, that I do not think that our asset purchase programs are having a significant affect on that supply-demand balance.

And the reason is the very simple point that when we buy assets — and our total purchases, by the way, are a pretty small share of the global amount of safe assets — but anyway, when we buy safe assets, we of course pay for them with bank reserves, which is another safe asset, and one that’s even more liquid.

So I don’t think that our asset purchases are significantly affecting the net supply of safe assets. But it — but it is an issue, and one that we’ve looked as we’ve thought about, for example, margining and liquidity policy.

But I do believe that big money does organize itself somewhat like feral hogs. If they detect a weakness or a bad scent, they’ll go after it.

...

My personal feeling is that you don’t walk up to a lion and flinch.

A long period of unusually low interest rates is changing investors’ behavior and is reshaping the products and the asset mix of financial institutions. Investors of all profiles are driven to reach for yield, which can create financial distortions if risk is masked or imperfectly measured, and can encourage risks to concentrate in unexpected corners of the economy and financial system. Companies and financial institutions, such as insurance companies and pension funds, and individual savers who traditionally invest in long-term safe assets, are facing challenges earning reasonable returns, and so they may reach for yield by taking on more risk and reallocating resources to earn higher returns. The push toward increased risk-taking is the intention of such policy, but the longer-term consequences are not well understood.

Of course, identifying financial imbalances, asset bubbles or looming crises is inherently difficult, as policymakers were painfully reminded during the financial crisis in 2008. Public transcripts of the FOMC’s discussions from as early as 2006 show participants were clearly focused on issues in the housing market and yet did not fully appreciate the risk to the economy from the financial sector’s exposure to risky mortgages.

Accordingly, I approach policy decisions with a healthy dose of humility when considering the long-run effects of monetary policy. We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances. Prices of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels. A sharp correction in asset prices could be destabilizing and cause employment to swing away from its full-employment level and inflation to decline to uncomfortably low levels.

Simply stated, financial stability is an essential component in achieving our longer-run goals for employment and stable growth in the economy and warrants our most serious attention.

This afternoon, I will aim to make three basic points: First, despite serious reforms to strengthen our financial system, significant risk remains that another asset bubble could develop. Moreover, the financial system and the economy are still vulnerable to such an event. Second, financial stability should not be thought of as a distinct goal from macroeconomic stability and, therefore, inherently separate from traditional monetary policy. Instead, risks to financial stability are first and foremost risks to future economic activity and inflation. Third, the framework used to analyze the relationship between monetary policy, financial instability, and the macroeconomy needs to be revamped. That framework must take more fully into account the life cycles of asset, credit, and leverage bubbles, and it should consider the role monetary policy plays in feeding or restraining these bubbles.

“I know that some people are concerned that exuberance is coming back a little too quickly in certain market segments,” though supervisors have a “stronger eye” on some prices, Evans said in response to audience questions.

“I’m hard pressed to second guess the market pricing mechanism” for such assets, he said.

[E]ven if there were stronger evidence of [an asset] bubble, I’m not convinced that leaning against it is good policy. Even if the Fed could accurately detect a bubble in real time, and even if we decided that a bubble-pricking exercise would be warranted, monetary policy is too blunt an instrument for this task... Our attempts to counter a hypothetical future bubble would end up weakening our efforts to achieve the stabilization benefits embodied in the dual mandate.

During the mid-2000s, many forms of collateral around the world were either implicitly or explicitly backed by U.S. residential land. As I’ve described, beginning in mid-2007, it became clear that this asset had more risk than financial markets had originally appreciated. It was not clear, though, how much more risk was involved. As a result, financial markets became increasingly uncertain about how to evaluate assets backed by U.S. land. That uncertainty translated into uncertainty about the ultimate solvency of institutions holding those assets—and the ultimate solvency of any of those institutions’ creditors. Spreads in credit markets between Treasury returns and other bond returns began to widen—at first slightly and then alarmingly.

I will try to define some of the important characteristics of asset price bubbles. I will argue that bubbles do exist and that bubbles typically occur after an innovation that has created uncertainty about fundamental valuations. This has two important implications. First, a bubble is difficult to discern and, second, each bubble has unique characteristics. This implies that a rules-based approach to bubbles is likely to be ineffective and that tackling bubbles to diminish their potential to destabilize the financial system requires judgment.

That said, there is some evidence that a tighter monetary policy will reduce desired leverage in the financial system by flattening the yield curve and reducing the profitability of maturity transformation activities.¹² To the extent this is true, that may imply a somewhat more favorable trade-off in “leaning against” a bubble. More research is needed on this subject. For now at least, monetary policy appears to be inferior to macroprudential tools that seek either to limit the size of prospective bubbles or to strengthen the financial system so that it is more resilient when asset prices fall sharply.

Asked about record gold prices and the decline of the dollar, Plosser said "I think we don't want to entirely dismiss that... I do think from a policy standpoint that we need to be cognizant of what these asset markets are doing and.. better understand how they may or may not be giving us clues about what the future may hold."

(I)n principle, mortgage securitizations make good economic sense: By providing access to the broad capital market, securitization allows loan originators to access a wider source of funding than they can obtain directly. In addition, securitization can limit an originator's exposure to prepayment risks associated with interest rate movements, to geographic concentrations of loans, and to credit and funding risks associated with holding mortgages all the way to maturity. Effectively, securitization can significantly lower the cost of extending home loans, and some of those cost savings can be passed along to homeowners in the form of lower mortgage rates.

The paucity and inaccessibility of data about the underlying home loans was, in my opinion, one of the reasons that private-label MBS was able to expand so rapidly in 2005 and 2006 despite a deterioration in underwriting and prospective credit performance. That is not to say that better data would necessarily have led investors to completely sidestep the private-label MBS that have caused them so much difficulty. But I do think it was a significant hindrance that the information needed to infer, in real time, the extent to which subprime and alt-A mortgage underwriting was sliding simply did not exist in a form that allowed the widespread scrutiny or objective analyses needed to bring these risks more clearly into focus.

Thus, I believe that markets for private-label MBS are unlikely to recover unless comprehensive and standardized data for home mortgage pools are made widely available to market participants.