The Fed, Credit Bubbles, and Exit

Jeremy Stein’s speech  today–“Overheating in Credit Markets:  Origins, Measurement, and Policy Responses”–provides valuable insight on the issue of credit bubbles that could result as a consequence of current Federal Reserve policy.  As such, it speaks to the upcoming debate over the Fed’s exit strategy.  It’s a must read.

Stein’s review of credit markets suggest “we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit.”  Even so, that by itself is not a reason for policy to react–in Stein’s view, its when bad credit decisions are combined with excessive maturity transformation that troubles occur.

One important contribution of the paper is the tour he takes through credit markets, trying to measure reach-for-yield and maturity extension behavior.  This includes major markets (e.g., high-yield corporate bonds and syndicated-leverage loans), the instruments that fund them (including money market/collateral markets) and other indicators of maturity transformation.  The evidence is mixed, but my read is that, if trends continue, eventually these patterns will become a source of concern.  At a minimum, it points to indicators  that should be followed and that are likely to make their way into Fed discussions.

Finally, Stein reviews the debate over whether monetary policy, rather than supervisory/regulatory policy, should be used to deflate bubbles.  His conclusion is that while monetary policy may not be the best tool for the job, it has the important advantage of broad market effect, “reaching into corners” that supervision and regulation cannot. That could be true even if the dual mandate pointed towards a continuation of current accommodative policies.  When you have multiple instruments, you can pursue multiple objectives.  That’s a powerful statement.