Ben Bernanke: "Financial Instability" Is A "Credible" Risk Of QE (Brookings Institution Interview)

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In an interview with the Brookings Institution on January 17, 2014 (watch below), Federal Reserve Chairman Ben Bernanke said "financial instability" was a "credible" risk of QE. Here's what he said (emphasis added):

The main risk that my colleagues have pointed to is various aspects of financial stability or potential for financial instability. There is always some concerns that, really for any kind of easy monetary policy, that after a period of time there may be some reaching for yield or some misevaluation of assets. And given what happened, of course, just five years ago we're extraordinarily sensitive to that risk.

Now, of course, that's really for different kinds of monetary policy, QE in addition works on term premiums to a significant extent, and we simply have less knowledge information about how term premiums are determined, and therefore there's a little bit of additional concern, volatility associated with the management of QE.

So there are certainly some risks there, our strategy though has been to -- not to distort monetary policy in order to address those risks directly. Indeed, insufficient monetary policy accommodation if it leads to a weaker economy and bad credit outcomes, etcetera is also a financial stability risk.

So our basic approach has been, at least for the first, second, and third lines of defense, to rely on supervision, regulation, monitoring macro prudential policies, and that whole set of tools that we have and our developing to try to avoid potential  problems.

We also look very carefully at the implications of any potential kind of financial imbalance. For example, is that asset class heavily levered? Is it supported heavily by leverage which would in turn mean that a sharp drop in that valuation would lead to other types of problems? Those are the kinds of things we look at, and we've greatly increased our ability to monitor and analyze those types of situations.

So our goal is to address financial instability concerns primarily, at least in the first instance, through supervision, regulation, and other microeconomic types of tools. But it is something that I think of the various costs that have been ascribe to QE, I think it's the only one that I find personally credible, frankly. And it's the one that we have spent the most time thinking about, and trying to make sure that we can address it as best we can.

MR. AHAMED: Sort of bottom line for the moment you're not worried about too much froth in financial markets?

MR. BERNANKE: Well, it's always, of course, bad luck to make any forecast about any particular market, but the markets currently seem to be broadly within, you know, the metrics of market valuation seem to be broadly within historical ranges. The financial system is strong. Key financial institutions are well capitalized, so we're watching this very vigilantly.

We've developed a tremendous additional capacity for doing that. But at this point, you know, we don't think that, and I think I can speak for my colleagues in this, we don't think that financial stability concerns should, at this point, detract from the need for monetary policy accommodation which we are continuing to provide.
(transcript source)

Meaning the Federal Reserve will keep injecting money (QE) into the system if/when algorithmic and HFT trading robots decide to short stocks and drive prices down every day with all the liquidity. (The market overdoses on QE like the Wolf of Wall Street did in the 1990s). I think the Federal Reserve clearly mismanaged rates when Alan Greenspan lowered the federal funds rate to a record low of 1% in 2003-4, which severely mispriced asset prices and the financial system. So when the Fed started to tighten monetary policy between 2004-2006 and unwind the distortions (which were also fueled by systemic control fraud and the trade deficit with China), the asset and credit markets came crashing down (post: "Beware of the Fed's Next "Conundrum"; Revisiting Alan Greenspan's 2005 Interest Rate Conundrum"). The Fed even mismanaged rates and its balance sheet in 2007-2008, which is a topic for another post. So I'm glad Bernanke realizes that QE poses a credible threat to market stability.

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