I support a gradual adjustment of short-term interest rates toward a more normal level, but I view the current level as too low for today’s economic conditions. The economy is at or near full employment and inflation is close to the FOMC’s target of 2 percent, yet short-term interest rates remain near historic lows. Just as raising rates too quickly can slow the economy and push inflation to undesirably low levels, keeping rates too low can also create risks. Interest-sensitive sectors can take on too much debt in response to low rates and grow quickly, then unwind in ways that are disruptive. We witnessed this during both the housing crisis and the current adjustments in the energy sector. Because monetary policy has a powerful effect on financial conditions, it can give rise to imbalances or capital misallocation that negatively affects longer-run growth. Accordingly, I favor taking additional steps in the normalization process.

While I view the gradual approach as appropriate, postponing the removal of accommodation when the economy is near full employment and inflation is rising toward the 2 percent target could promote alternative risks that would decrease the likelihood of achieving our longer-run objectives. In the long run, a failure to keep interest rate policy in line with improving fundamentals can distort the allocation of capital toward less fruitful—or perhaps excessively risky—endeavors. Within the last two decades we have faced episodes of accelerating equity prices, housing prices and, most recently, commodity prices. Currently, commercial real estate markets, where prices have continued to drift higher, bear watching. When these types of imbalances tip, the entire economy can face the consequences of their fallout, with some sectors and populations more impacted than others. My concern for some time has been that extending monetary policy too far beyond its scope of capability risks undesirable financial, economic and
political distortions.

In the current environment, waiting to make additional adjustments to monetarypolicy may seem costless in the face of benign inflation pressures. Some argue that we have the ability to make more rapid adjustments later if inflation moves higher than currently projected. From a technical standpoint, it is true that the Fed has the ability to steer short-term rates and could raise them quickly if needed. But such actions are likely to be costly, inducing financial market volatility and slowing economic activity. Historically, rapid increases in interest rates end poorly, resulting in economic recessions.

“We remain concerned about the potential for the CRE market to overheat and hurt banks again,” Lockhart said, referring to commercial real estate. Bank regulatory agencies issued a statement in December that calls for ”sensible risk management practices regarding” real estate, he said.

The recent sell-off in global equity markets, along with increases in risk spreads in corporate bond markets, may have made [the risk of asset-price bubbles] less of a concern over the medium term.

If asset prices across the economy -- that is, taking all financial markets into account -- are thought to be excessively high, raising the interest rate may be the appropriate step.

I don’t see anything I would call a bubble. People use that word, obviously, as something that’s going down real soon. So far, things seem pretty manageable, so I don’t see something that’s so out of whack.

I am starting to see signs of imbalances emerge in the form of high asset prices, especially in real estate, and that trips the alert system. One lesson I have taken from past episodes is that, once the imbalances have grown large, the options to deal with them are limited. I think back to the mid-2000s, when we faced the question of whether the Fed should raise rates and risk pricking the bubble or let things run full steam ahead and deal with the consequences later. What stayed with me were not the relative merits of either case, but the fact that by then, with the housing boom in full swing, it was already too late to avoid bad outcomes. Stopping the fallout would’ve required acting much earlier, when the problems were still manageable. I’m not assigning blame by any means, and economic hindsight is always 20/20. But I am conscious that today, the house price-to-rent ratio is where it was in 2003, and house prices are rapidly rising. I don’t think we’re at a tipping point yet—but I am looking at the path we’re on and looking out for potential potholes.

St. Louis Federal Reserve Bank President James Bullard warned Tuesday that low interest rates may be feeding a new asset price bubble.

Bullard said he is open to weighing evidence that conditions are different than in the late 1990s when the stock market went through a high-tech "dot.com bubble," but said it appears to him that stock valuations, particularly in the tech-heavy Nasdaq Composite index are high.

Bullard cited a number of what he considers danger signs of a possible stock bubble and asked "do low interest rates feed this process?"

"The net wealth to disposable income ratio has returned to a high level," he observed in remarks prepared for delivery to an Emerging Venture Leaders Summit. "It has been high and volatile since the mid-1990s."

He also said the Nasdaq is "near a high in real terms" and "the price-earnings ratio is relatively high but still below the 1990s peak."

"Can the U.S. escape the boom-bust cycle this time?"

Answering his own question, Bullard said, "My view is that low interest rates tend to feed bubble processes."

Bullard, who will be a voting member of the Fed's policymaking Federal Open Market Committee next year, said "the Fed should hedge against the possibility of a third major macroeconomic bubble in the coming years by shading interest rates somewhat higher than otherwise.

"The benefit would be a longer, more stable economic expansion," he added.

Ms. Yellen said in May that “equity-market valuations at this point generally are quite high.” Mr. Powell on Tuesday said overall equity values are “certainly higher than normal” but that he doesn’t see evidence of “bubblelike conditions” in valuations or a buildup of risk-taking and leverage in financial markets.

Im not that worried today about bubbles, but from here going forwardis the time when we are most vulnerable to the financial bubbles that emerge when easy money policies persist in an economy that has been growing for some time, [Bullard] warned. He noted that even as the Fed edges closer to rate rises it still expect interest rates to stay very low for well into the future. That could be a recipe for financial markets to get into trouble, and he doubts regulatory powers will be enough to reduce the threat, he said.

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.

With respect to bubbles, I've stated my strong preferences to use macroprudential and supervision policies to address areas where we see concerns. And as I mentioned, we're doing that in the case of, for example, leveraged lending. But I would never take off the table totally the idea that monetary policy might be needed to address financial stability concerns. To me, now I don't see financial stability concerns at the level at this point where they need to be a key determinant of monetary policy. And it's not my preference as a first line of defense by any means. But I would never want to take off the table that in some circumstances, particularly if macroprudential tools failed, monetary policy might be called on to play a role. But we're not there.

I would like to see short-term interest rates move higher in response to improving economic conditions shortly after completion of the taper. Many of the rules offering policy guidance on the federal funds rate such as the Taylor rule and its variants are already or close to prescribing a policy rate higher than the current funds rate. Second, the path toward the longer-term neutral funds should be gradual. Given the lengthy period of unconventional policy and low rates, the necessary adjustment by financial markets to less central bank intervention and influence could be volatile. In this environment, the pressure to quickly back away from a rising rate policy will be significant; such pressures will need to be resisted. If not, we risk moving into a confusing stop-and-go policy environment.

In terms of the path after liftoff, the FOMC has signaled that it will take a gradual approach toward the longer-run funds rate... So, the funds rate could reach its longer-run level well after the economic recovery is complete and inflation has returned to the 2 percent goal. These signals suggest to banks that they will continue to contend with a low interest rate environment for a few years, even as economic conditions are likely to improve. I see this as a set of conditions ripe for greater risk-taking as firms reach for yield and the imbalances related to such incentives grow.

Gradualism can promote financial stability, as it reduces the incidence of unexpected shifts in interest rates. Even so, the degree of inertia suggested in the median path of the federal funds rate in the FOMCs Summary of Economic Projections goes beyond what is required to achieve a smooth exit. In my view, it will likely be appropriate to raise the federal funds rate at a somewhat faster pace than the median of committee members projections. Low rates into late 2016 will likely continue to provide incentives for financial markets and investors to reach for yield in an economy operating at full capacity and risks achieving our objectives over the longer run.

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.

A top Federal Reserve official known for his dovish views on policy acknowledged on Friday that monetary policymakers may need to take financial stability risks into account when making policy choices.

But Minneapolis Fed President Narayana Kocherlakota, who has repeatedly called on the U.S. central bank to ease policy further, stopped short of saying that such risks should keep the Fed from doing whatever it can to return the economy more quickly to full employment.

…

Arguably, the "large increase in yields only happened because monetary policy (QE3) had lowered yields so much," Kocherlakota said. The key question, he said, is whether that sudden rise in yields hurt overall economic growth more than the earlier decline in yields had helped. The answer, he said, is far from clear.

"There is considerable need for new theory and empirics," he concluded.

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From Market News International

Minneapolis Federal Reserve Bank President Narayana Kocherlakota said Friday that supervision is the best way for the Fed to tackle threats to financial stability, but said "residual risks" may remain for monetary policy to deal with.

Kocherlakota suggested "a framework to incorporate systemic risk mitigation into monetary policymaking" using a "mean variance framework." But he did not flesh out this suggestion, saying more theoretical work is needed.