The Federal Reserve will likely have to continue with its bond buying efforts into the second half of this year but needs to watch out for the possible formation of asset price bubbles, a key central bank official said Tuesday.

"It's something we have to watch out for, particularly for reasons of financial stability," Federal Reserve Bank of Atlanta President Dennis Lockhart told journalists after giving a speech in the Spanish capital.

Mr. Lockhart, who isn't a member of Federal Open Market Committee this year, said there are currently no signs that asset price bubbles are forming. He said that some have pointed to the recent rise of the value of farm land and stock markets as evidence that these assets are no longer rationally valued. "I don't think you can make that claim," he said. "But I think the recent history of our housing bubble suggests we have to be vigilant about that."

As reported by Dow Jones News

Let me suggest three factors that can contribute to {credit market} overheating. The first is financial innovation. While financial innovation has provided important benefits to society, the institutions perspective warns of a dark side, which is that innovation can create new ways for agents to write puts that are not captured by existing rules…

The second closely related factor on my list is changes in regulation. New regulation will tend to spur further innovation, as market participants attempt to minimize the private costs created by new rules. And it may also open up new loopholes, some of which may be exploited by variants on already existing instruments.

The third factor that can lead to overheating is a change in the economic environment that alters the risk-taking incentives of agents making credit decisions. For example, a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to "reach for yield."

It is sometimes argued that … policymakers should follow what might be called a decoupling approach. That is, monetary policy should restrict its attention to the dual mandate goals of price stability and maximum employment, while the full battery of supervisory and regulatory tools should be used to safeguard financial stability. There are several arguments in favor of this approach. First, monetary policy can be a blunt tool for dealing with financial stability concerns…

A related concern is that monetary policy already has its hands full with the dual mandate, and that if it is also made partially responsible for financial stability, it will have more objectives than instruments at its disposal and won't do as well with any of its tasks…

Nevertheless, as we move forward, I believe it will be important to keep an open mind and avoid adhering to the decoupling philosophy too rigidly. In spite of the caveats I just described, I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability. Let me offer three observations in support of this perspective. First, despite much recent progress, supervisory and regulatory tools remain imperfect in their ability to promptly address many sorts of financial stability concerns...

Second, while monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation--namely that it gets in all of the cracks. The one thing that a commercial bank, a broker-dealer, an offshore hedge fund, and a special purpose ABCP vehicle have in common is that they all face the same set of market interest rates. To the extent that market rates exert an influence on risk appetite, or on the incentives to engage in maturity transformation, changes in rates may reach into corners of the market that supervision and regulation cannot.

Third, in response to concerns about numbers of instruments, we have seen in recent years that the monetary policy toolkit consists of more than just a single instrument…

One of the most difficult jobs that central banks face is in dealing with episodes of credit market overheating that pose a potential threat to financial stability. We ought to be open-minded in thinking about how to best use the full array of instruments at our disposal. Indeed, in some cases, it may be that the only way to achieve a meaningfully macroprudential approach to financial stability is by allowing for some greater overlap in the goals of monetary policy and regulation.

So, you're not going to identify every possible {bubble} for sure, but you can - you can do your best and you can try to make sure the system is strong. And when you identify problems you can use - I think the first line of defense needs to be regulatory and supervisory authorities …

The Federal Reserve was created about 100 years ago now in 1913. It was the - it was the law. Not a new monetary policy, but rather to address financial panics. And that's what we did in 2008 and 2009. And it's a difficult task. But I think going forward the Fed needs to think about financial stability and monetary economic stability as being in some sense the two key pillars of what the central bank tries to do. And so we will obviously be working very hard on our financial stability. We'll be using our regulatory supervisory powers. We'll be trying to strengthen the financial system. And if necessary, we'll adjust monetary policy as well. But I don't think that's the first line of defense.

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.

[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.

Fisher said he is "beginning to see signs of speculative excess" in the U.S., evidenced in the "fresh flow of money" into the stock market, a surge in so-called covenant-lite loans and the re-leveraging by private equity firms.   "There’s lots of liquidity sloshing around the U.S. financial system," Fisher said. "We are seeing signs of all the intoxication that typically takes place when we have the ambrosia of cheap and readily available capital."

.....

"No further accommodation is needed after June," including by tapering the central bank’s purchases, the regional bank chief, who votes on monetary policy this year, said in a speech today in Frankfurt. "Doing so would only prolong the injustice that we have inflicted" on savers through inflation, he said.

As reported by Bloomberg News

Moreover, although we do need to remain ever-watchful for signs that low interest rates could foster a buildup of financial excesses or bubbles that might pose a medium-term risk to both full employment and price stability, risk premia on U.S. financial assets do not appear unduly compressed at this juncture.

STEVE LIESMAN: There's a lot of talk about the distortions that out there that Fed policy is really punishing savers. Do you agree with that and is it something that you think is useful or warranted for the overall health of the economy?

CHARLES PLOSSER: Well, I think the judgment has been-- and the reason policy has been what it is is that judgment has been that for the sake of the economy as a whole that we're willing to tolerate if you will, that. But it's certainly true that low interest rates of close to zero are punishing savers, there's no question to that. But that-- the idea policy of that is to sort of get people to quit saving and start spending. So that's kind of one of the objectives.

But it is, the people who are on fixed incomes-- I think there are some real risks that-- if they can't get a return on their savings they start liquidating their assets, liquidating their wealth in order to live. Well, that means that in future generations who would have inherited some of that wealth from their parents let's say, aren't going to get it, it's going to be gone.

STEVE LIESMAN: I've also had portfolio managers complain to me about the Federal Reserves saying, "You're forcing me into a risk profile I do not want to be in." How do you respond to that?

CHARLES PLOSSER: Well, I think there's some cases where that's probably true. I've talked to money managers and financial managers and private equity people in the financial markets. And a lot of them do share the view that somehow in the stretch for yield many people are taking unwise risks. Now, of course the Fed has made it very clear that at times we're trying to force people to take some more risk, but we can't control how that happens.

And so by trying to push people into riskier assets as we're trying to do with Operation Twist or with an Asset Purchase Programs, we don't know the full consequence with that. And we could, could-- I don't want to say we are, we could be breeding some problems for us down the road if we don't exit in the right time. And then we go past the exit and we have another credit bubble of some kind.

"Bubble, Bubble, Toil and Trouble: A Dangerous Brew for Monetary Policy"

 ...

Sound policymaking requires us to understand the limits of what we know. I doubt we could find enough agreement among policymakers or economists about the interpretation of asset-price movements to allow for stable, rule-based policymaking. In the absence of such a clearly stated rule, we risk uncertainty about central bank policy itself as well as its effect on the economy... Humility in policymaking requires that we respect the limits of our knowledge and not overreach, particularly when it involves over-riding market signals with policy actions.

Another challenge in addressing asset-price bubbles in practice is that contrary to many economic models, in reality there are many assets, not just one. And these assets have different characteristics. For example, equities are very different from homes. Misalignments or bubble-like behavior may appear in one asset class and not in others. But monetary policy is a blunt instrument. How would monetary policy go about pricking a bubble in technology stocks in 1998 and 1999 without wreaking havoc on investments underlying other asset classes?

...

Indeed, I believe that we are discussing the question of asset prices and monetary policy today, at least in part, because Fed policy during mid-2000s “went off track.” John Taylor has argued forcefully that the Fed kept interest rates too low for too long from 2003 to 2005. As an erstwhile member of the Shadow Open Market Committee, I stood in this very room in 2003 and 2004, expressing concerns that the fears of deflation were excessive and that policy was probably too accommodative. The error may not have been that policymakers failed to pay attention to the fast upward rise in asset prices, but that they deviated from a systematic approach to setting nominal interests.

It concerns me that liquidity is omnipresent on bank and corporate balance sheets, and yet it is not being used to hire American workers.

It also concerns me that the most recent Lipper/AMG financial market data show year-to-date flows into virtually all asset classes except money market funds. The flows are strong into every category: high-risk to low-risk bond vehicles, taxable and nontaxable, domestic and external, fixed and floating rate, and, of course, commodities. Margin debt remains shy of 2007 highs but is fast approaching levels that prevailed before the NASDAQ implosion in 2001; in fact, margin-account debit balances as a percentage of the market capitalization of the S&P 500 now exceed the precrash level of 1987 and 2001.

Junk yields are at their lowest levels since October 2007. And the leveraged buyout market is back to paying 2006 levels of EBITDA (earnings before interest, taxes, depreciation and amortization) of 6 to 8.5 times, with the recent announcement of Carlyle Group’s reported 11 times EBITDA purchase of Syniverse Holdings echoing the peak of the precrash craze. As you know, buyout people do not typically acquire companies with a plan to expand the workforce, but instead with an eye to tighten operations, drive productivity, rejigger balance sheets and provide an attractive payback, usually in shorter time than under normal corporate horizons. And the corporations I talk to that are eyeing possible acquisitions with their surplus cash and ready access to the credit markets are not given to thinking of strategic acquisitions as a way to expand payrolls.

In sum, scanning the business landscape and the conditions of the financial markets, I concluded as a golfer that the greens are playing very fast and must be approached with great caution. At a minimum, I concluded, the committee would need to be very careful in how we calibrated our next strokes, lest we overplay it.

I fully understand the theoretical impulse to drive long-term interest rates to lower levels in hopes of stimulating loan demand and challenging the propensity for economic actors to hoard rather than invest. Given that foreign exchange markets react to interest rate differentials between countries, one effect of engineering lower rates would be to devalue the dollar, presumably to create demand for exports. The ultimate objective would be to advance final demand, generate employment for American workers and revive output.

Note that I’m talking about land, not housing. Theoretically, it is hard to motivate the existence of significant overvaluation in housing structures (they’re readily replaceable). Empirically, there is considerably less evidence of overvaluation for structures than for land. Here, I refer to data from the Lincoln Institute of Land Policy that separates the price of housing into the price of structures and the price of land. The data were originally constructed by Davis and Heathcote (2005, 2007), and are derived from the Case-Shiller housing price index. These data indicate that the price of housing structures rose by less than 100% in nominal terms from 1996 to 2006, and has fallen by less than 10% since that date. 

It is also possible to overreact, shutting down a particular financial market practice which in reality does not pose a systemic risk. During the technology boom of the 1990s, many argued that a bubble had formed and that policymakers should address the bubble with appropriate action. Still, I think few would now argue that we would have wished to miss out on the technology boom of the 1990s. Closing off those developments through aggressive policy might have deprived the economy of important advances in productivity.

I think we’re in a liquidity trap where there is excess savings, greater than investment. It would take a lower real interest rates to address that.

But, look, if the right thing to do for the macro economy is to have lower interest rates but that comes with some risk for the financial system, we’ve only got one monetary policy tool and we have to focus on our mandate. But we have other supervisory tools which are supposed to  address emerging risks in financial markets. I think they have to be used.

We will soon give notice to the third anniversary since the onset of the global financial crisis. As we mark this occasion--and continue to witness shocks arising intermittently and unevenly--it might be worth debunking some popular views that have become part of the crisis narrative. In their stead, I will begin with what I believe are some truths, perhaps hiding in plain sight all along.

Subprime mortgages were not at the core of the global crisis; they were only indicative of the dramatic mispricing of virtually every asset everywhere in the world. The crisis was not made in the USA, but first manifested itself here. The volatility in financial markets is not the source of the problem, but a critical signpost. Too-big-to-fail exacerbated the global financial crisis, and remains its troubling legacy. Excessive growth in government spending is not the economy's salvation, but a principal foe. Slowing the creep of protectionism is no small accomplishment, but it is not the equal of meaningful expansion of trade and investment opportunities to enhance global growth. The European sovereign debt crisis is not upsetting the stability in financial markets; it is demonstrating how far we remain from a sustainable equilibrium. Turning private-sector liabilities into public-sector obligations may effectively buy time, but it alone buys neither stability nor prosperity over the horizon.