US Federal Reserve Governor Jeremy Stein said monetary policy should be less accommodative when bond markets are overheated even if it raises the risk of higher unemployment.
The remarks suggest financial stability should receive strong consideration as the Fed pursues its two mandates — stable prices and maximum employment — because financial crises can do so much damage to jobs and growth.
“All else being equal, monetary policy should be less accommodative — by which I mean that it should be willing to tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level — when estimates of risk premiums in the bond market are abnormally low,” Stein said.
He did not comment on the current stance of policy.
The Fed governor took office on May 30, 2012, and has been one of the Fed Board’s intellectual leaders on the relationship between monetary policy and financial stability.
Stein previously was an economics professor at Harvard University in Cambridge, Massachusetts.
In February last year, Stein said that there may be times when central bankers should raise interest rates in response to rising financial risk because, unlike supervision and regulation, higher borrowing costs get “in all of the cracks,” or markets the Fed may not regulate.
Stein said pursuing lower levels of unemployment with low interest rates may also entail costs if they raise financial instability that could affect jobs and growth at later time if yields shoot back up.
“There is a cost to be weighed alongside the benefit” of an accommodative policy, Stein said on Friday at a forum on monetary policy at Georgetown University in Washington.
Financial stability matters “insofar as it affects the degree of risk around the employment leg of the Federal Reserve’s mandate,” he said.
Fed officials have raised financial-stability concerns at their meetings in recent months, minutes show, as they continue to hold the benchmark lending rate near zero for a sixth consecutive year.
The central bank is also keeping yields low on longer-term US Treasury securities and mortgage-backed securities through a direct-purchase program which it slowed to a US$55 billion monthly pace at its meeting last week.
Those purchases have pushed total assets on the Fed’s balance sheet up to a record US$4.22 trillion.
As one measure of financial overheating, Stein pointed to risk premiums on longer-term debt, or the component of the bond’s yield that compensates investors for owning a longer-term security as opposed to a short-term security.
He said that in the spring of last year in the US when yields on US 10-year notes were about 1.6 percent, estimates of the term premium were about minus-0.8 percentage point.
“Applied to this period, my approach would suggest a lesser willingness to use large-scale asset purchases to push yields down even further,” he said.
US 10-year yields rose sharply from the lows of May last year when then-Fed chairman Ben Bernanke told the Joint Economic Committee of the US Congress that month that the Fed would consider reducing monetary accommodation in steps as the labor market improved.
Stein said the “dark side” of collapsed risk premiums occurs if they return to normal abruptly in a way that causes “larger economic effects than the initial compression.”