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     Nov 18, '13


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CREDIT BUBBLE BULLETIN
Hearing Janet Yellen
Commentary and weekly watch by Doug Noland

Senator Robert Menendez: "Some commentators have suggested that in addition to managing inflation and promoting full employment, the Fed should also monitor and attempt to fight asset bubbles. Do you think it is a feasible job and something that the Fed should be doing? And if so, how would you go about it?"

Janet Yellen: "Well, Senator, I think it's important for the Fed, as hard as it is, to attempt to detect asset bubbles when they are forming. We devote a good deal of time and attention to monitoring asset prices in different sectors, whether it's house prices or equity prices and farmland prices, to try to see if there is evidence of price misalignments that are developing. By in large, I would say that I don't see evidence at this point in major sectors



of asset price misalignments, at least of the level that would threaten financial stability. But if we were to detect such misalignments or other threats to financial stability, in my view I would like as a first line of defense - we have a variety of supervisory tools, micro - and macro - prudential, that we can use to attempt to limit the behavior that is giving rise to those asset price misalignments. I would not rule out using monetary policy as a tool to address asset price misalignments, but because it's a blunt tool and because Congress has asked us to use those tools to achieve the goals of maximum employment and price stability - which are very important goals in their own right - I would like to see monetary policy first and foremost directed toward achieving those goals Congress has given us and to use other tools in the first instance to try to address potential financial stability threats. But an environment of low interest rates can induce risky behavior. And I would not rule out monetary policy conceivably having to play a role."

Senator Richard Shelby: "What have you learned since you were president of the [Federal Reserve Bank of] San Francisco ... You were there during the housing bubble and the debacle. As a regulator, I hope that you and others have learned a lot, not just the Federal Reserve, but others, that you can't let a bubble continue, to continue to grow."

Yellen: "Senator, I think in the aftermath of the crisis, all of us have spent a great deal of time attempting to draw the appropriate lessons. There have been many of them. The Federal Reserve is very focused on broad financial stability, mandates both in terms of our monitoring of the economy, attempting to understand the threats that exist broadly in the financial system and to improve our supervision, especially of the largest institutions, to make sure that we are identifying those threats that can be risks to the economy."

Senator Sherrod Brown: "Do you agree with what I assume you're hearing from bankers too and from others ... do you agree with chairman Bernanke and Mr Dudley that a system where 'too big to fail' institutions have, in Dudley's words, an apparent lack of respect for law, regulation and the public trust? Do you agree we haven't solved the problem? And what do you do as Fed chair to address 'too big to fail'?"

Yellen: "Senator, I would agree that addressing 'too big to fail' has to be among the most important goals of the post - crisis period. That must be the goal that we try to achieve. 'Too big to fail' is damaging. It creates moral hazard. It corrodes market discipline. It creates a threat to financial stability and it does unfairly, in my view, advantage large banking firms over small ones. My assessment would be that we are making progress, that Dodd - Frank put into place an agenda that, as we complete it, should make a very meaningful difference in terms of 'too big to fail.' We've raised capital standards. We will raise capital standards further for the largest institutions that pose the greatest risk by proposing so - called SIFI capital surcharges. We have on the drawing boards the possibility of requiring that the largest banking organizations hold additional unsecured debt at the holding company level to make sure that they are capable of resolution."

Senator Dean Heller: "A quick question about quantitative easing: Do you see it causing an equity bubble in today's stock market?"

Yellen: "I mean, stock prices have risen pretty robustly. But I think that if you look at traditional valuation measures, the kind of things that we monitor, akin to price - equity ratios, you would not see stock prices in territory that suggests bubble - like conditions. When we look at a measure of what's called the equity risk premium, which is the differential between the expected return on stocks and safe assets like bonds, that premium is not - is somewhat elevated historically, which again suggests valuations that are not in bubble territory."

Senator Robert Corker: "We talked a little bit about the Fed in the early summer began to talk about moderating the pace at which it was going to be making purchases. And the market had a pretty stringent reaction. It was like ... the Federal Reserve appeared as if it had touched a hot stove and that this policy was going to greatly affect, if you will, the wealth effect that you were trying to create ... And so the Fed jumped back. And it seemed to me - and I think you discussed this a little bit in the office - that the Fed had become a prisoner to its own policy. That to really try to step away from QE3 was really going to shatter possibly the markets and therefore take away from the wealth effect. And I wonder if you could talk a little bit about some of the discussions that were taking place during that time."

Yellen: "Well, Senator, I don't think that the Fed ever can be or should be a prisoner of the markets ... "

Senator Robert Corker: "But to a degree in this case, it did affect the Fed, did it not?"

Yellen: "Well, we do have to take account of what is happening in the markets, what impact market conditions are likely to have on spending and the economic outlook. So it is the case, and we highlighted this in our statement, when we saw a big jump in rates - a jump that was greater than we would have anticipated from the statements that we made in May and June - and particularly saw mortgage interest rates rise in the space of a few months by over a hundred basis points, we had to ask ourselves whether or not that tightening of conditions in a sector where we were seeing a recovery and a recovery that could really - recovery in housing that could drive a broader recovery in the economy - we did have to ask ourselves whether or not that could potentially threaten what we were trying to achieve. But overall, we are not a prisoner of the markets. I continue to feel that we're seeing an improvement in the labor market, which was the goal of the program. And we will continue to evaluate incoming data and to make decisions on the program in that light going forward."

Corker: "Thank you. I'd [say] just a little bit of a prisoner, maybe not fully, I understand ... My last question is you talked a little bit about monitoring sort of the financial markets and know that it is, again, monetary policy is a blunt instrument. I know that you've been credited, with back in 2005, signaling that the housing market was bubbling, if you will, in that part of the country. I guess my question is: do you believe that under your leadership the Fed would have the courage to, when it saw asset bubbles, even though you only have blunt instruments, and I realize that, would it have the courage to actually prick those bubbles and ensure that we didn't create another crisis?

Yellen: "Senator, no one who lived through that financial crisis would ever want to risk another one that could subject the economy to what we're painfully going through and recovering from. And we have a variety of different tools that we could use if we saw something like that occur. They include tools of supervision and monetary policy is a possibility."

Corker: "And you would have the courage to do that?"

Yellen: "I believe that I would, and I believe that this is a most important lesson learned from the financial crisis, Senator."

The Wall Street Journal went with the headline "Yellen Stands by Fed Strategy." From Bloomberg: "Yellen Signals She'll Continue QE Undeterred by Bubble Risk." New York Times: "Message From Yellen is Full Speed Ahead on the Stimulus." Forbes: "Janet Yellen: No Equity Bubble, No Real Estate Bubble, And No QE Taper Yet." My personal favorite came via the Financial Times: "Federal Reserve Continues to Support Market 'Melt up.'"

When Dr Bernanke was designated head of the Federal Reserve back in 2006, I assumed that the credit bubble had become so obviously problematic that the powers that be sought the individual with the strongest academic credentials to ready a massive experimental post - bubble reflation operation. These days, I'll presuppose they see no alternative than to press forcefully ahead with monetary inflation. Ms. Yellen is the loyal soldier, with a similar academic mindset to Bernanke. Importantly, she's fully wedded to the QE program and has the best academic credentials to support the guise of a jobless rate target. Like Bernanke, she's amiable and seemingly earnest. Difficult to see her as a strong leader, at least outside the ardent dovish contingent. They'll be no tough love for the markets. No new direction for a Fed sprinting blindly ahead in a perilously flawed policy course.

Members of the Senate Banking Committee were ready to raise the key issues of "asset bubbles" and "too big to fail." Fitting of her reputation, Dr Yellen arrived well - prepared. She easily handled issues already vetted in private meetings.

The 2008 fiasco forced the Fed to jettison the Greenspan/Bernanke doctrine that insisted asset bubbles were only recognizable in hindsight. Yellen: "I think it's important for the Fed, as hard as it is, to attempt to detect asset bubbles when they are forming. We devote a good deal of time and attention to monitoring asset prices in different sectors, whether it's house prices or equity prices and farmland prices, to try to see if there is evidence of price misalignments that are developing ... "

This is a major modification in Fed "lip service" of no consequence. Any concern the markets had that the Fed might actually contemplate a little tough love for overheated securities markets was put to rest with the rapid about face on taper this past summer. It's worth noting that the Fed's balance sheet has expanded $1.0 TN over the past year, or 35.6%. Over this period, the S&P500 has returned 35.8%. The small cap Russell 2000 returned 47.1%; the S&P 400 Mid - Caps 40.7%; and the Nasdaq Composite 42.7%. On the individual stock front, Tesla enjoys a 12 - month gain of 344%, Netflix 333%, Micron Technologies 256%, Zillow 248%, 3D Systems 216%, Best Buy 218%, First Solar 173%, Green Mountain Coffee 156%, Deckers 154%, TripAdvisor 131%, GameStop 121%, Facebook 121% and Chipotle 108% (to name a few). Meanwhile, the IPO market is the hottest since 2000. From my vantage point, the breadth of current speculative excess exceeds even 1999.

At $343 billion, global telecom M&A volume has doubled 2012 to the highest level since 2000 (Dealogic). It will be a record year in junk bond and leveraged loan issuance, not to mention a record year in investment grade bond issuance. National home prices are inflating at double - digit rates, while key housing and real estate markets are indicating all the signs of problematic bubble excess. Meanwhile, "money" flows into global risk markets via huge inflows into mutual funds and hedge funds. If the Fed is serious about efforts to "detect asset bubbles when they are forming," I'd be curious to know what it might take to garner their interest.

The "too big to fail" issue is a similar red herring. I do concur with Dr Yellen's comment: "' ... Too big to fail' has to be among the most important goals of the post - crisis period. That must be the goal that we try to achieve. 'Too big to fail' is damaging. It creates moral hazard. It corrodes market discipline. It creates a threat to financial stability ... " Yet there's a major dilemma: Is the Fed is supposed to impose regulatory discipline on the big banks while it grows it balance sheet by $1 TN in twelve months? Clearly, I take a much different analytical view of the "too big to fail" issue than our academic Fed. Isn't the issue really about government involvement and backstops distorting market perceptions and fostering excessive risk - taking?

The root of the problem is that the regulator needs a regulator. Today's prevailing bubble excesses are clearly not emanating from excess bank lending or, likely, even egregious proprietary trading. Instead, monetary instability is spurred by the Fed's endless zero - rate policy and its ongoing $85bn money printing operation. After the "Greenspan put" and asymmetrical monetary policy ("tighten" gingerly and loosen forcefully to support the markets), the "Bernanke put," and QE1, QE2, and open - ended QE3, the Fed has at this point zero credibility on the issue of "too big to fail." After all, fueling asset inflation has been fundamental to the Fed's monetary experiment. Powerful speculators these days trade/leverage with impunity knowing that the Federal Reserve has indeed become prisoner to a dysfunctional marketplace.

Dr Yellen asserts that the Fed has learned "appropriate lessons." They clearly have not. Indeed, the Fed's role in fomenting highly distorted markets has never been greater. I have argued that critical "too big to fail" market distortions have evolved from the big banks to the entirety of global securities markets. And the Fed is today, along with fellow global central banks, propagating the greatest distortion in the pricing and allocation of finance in history. Regrettably, it has regressed into the "granddaddy of all bubbles." And, at this point, it's delusional to maintain faith in the existence of "a variety of supervisory tools, micro - and macro - prudential, that we can use to attempt to limit the behavior that is giving rise to those asset price misalignments."

It is paramount for a central bank to recognize bubble Dynamics early before they foment major financial excess - before they inflict deep impairment upon economic structures - before they gain powerful constituencies (as monetary inflations invariably do). And I strongly believe this key regulatory role became wholly impractical when market - based credit (as opposed to traditional bank lending) assumed such a prevailing role in credit systems and economies (at home and then abroad).

Indeed, what commenced during the Greenspan era only accelerated throughout Bernanke's chairmanship: Progressively, Federal Reserve policymaking directly targeted the securities markets and asset inflation as its prevailing monetary policy transmission mechanism. And, here we are today, with top Fed officials having stated that the Fed is prepared to "push back" against a "tightening of financial conditions" with even larger quantities of QE. The harsh reality is that bubble markets will eventually burst with a problematic tightening of "financial conditions" commensurate with the excesses of the preceding boom. And there is simply no precedent for a global securities bubble fueled by Trillions of central bank liquidity and bolstered by promises of ongoing liquidity backstops. And the greater the bubble, the tighter the noose becomes around the necks of the markets' central banker hostages.

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