Janet Yellen probably will confront a test during her tenure as Federal Reserve chairman that both of her predecessors flunked: defusing asset bubbles without doing damage to the economy.
The central bank’s easy money policies already have led to pockets of frothiness in corporate debt and emerging markets. The danger is that unwinding such speculative excesses will end up shaking the financial system and hurting growth.
Yellen is “going to be trying to do something that no one has ever done,” said Stephen Cecchetti, former economic adviser for the Bank for International Settlements, the Basel, Switzerland-based central bank for monetary authorities. She needs “to ensure that accommodative monetary policy doesn’t create significant financial stability risks,” he said in an interview.
Investors got a taste of the hazards in recent days when news of a slowdown in China’s economy, coupled with expectations of reduced stimulus from the Fed, helped trigger a rout in emerging markets that had been pumped up by easy money imported from the U.S. Emerging-market stocks dropped yesterday by the most in five months, dragging U.S. shares with them. The MSCI Emerging Markets Index has lost 7.1 percent this year.
Reducing Purchases
The turbulence in the financial markets probably won’t deter the Fed from deciding this week to reduce its monthly bond purchases by another $10 billion, according to economists at Goldman Sachs Group Inc., JPMorgan Chase & Co. and Credit Suisse in New York. It is currently buying $75 billion per month.
While the Standard & Poor’s 500 index has fallen in recent days, it’s only 3.6 percent off its record high set on Jan. 15. “It would be very abnormal if we didn’t have consolidating moves in the assets that have gone up so much,” Lloyd Blankfein, chief executive officer of Goldman Sachs, told Bloomberg Television on Jan. 24.
Yellen faces two challenges in dealing with bubbles: she has to identify and deflate them before they get too big and dangerous; and she has to manage monetary policy without causing them to burst in a way that causes havoc in financial markets and undercuts the expansion.
The trouble is that the tools she has for the first task, such as raising capital standards for banks or requiring homebuyers to put down more of their own money, are largely untested in the U.S. They are potentially cumbersome to put in place with multiple regulatory bodies involved and could prove politically unpopular.
Bernanke, Greenspan