Recent commentary has described Federal Reserve Chair Janet Yellen’s Jackson Hole, Wyo. speech, where she vigorously supports Dodd-Frank regulations, as highly political and atypical for a Fed chair.
It is. But it is a remarkable break from tradition for another reason: It reads like a premature victory lap for Fed regulation. Her confidence in the Fed’s regulatory prowess will surely look misplaced when the next crisis reveals that financial stability is just another central planner pipe dream.
Usually, Federal Reserve chairs stick to their knitting. They discuss economic conditions and how they relate to monetary policy. Mostly, they discuss where the economy has been in the recent past and offer vague assurances that Fed policies will appropriately adapt as conditions develop. Funny thing about the Fed — they always seem to be waiting for new data to tell them where the economy is headed.
{mosads}The truth is, the Fed’s crystal ball produces pretty accurate predictions of where the economy was six-to-nine months ago. It takes the Fed that long to get a firm grip on the economy’s trajectory. But the Fed is not at fault — economic forecasting is perilous, and I doubt that any forecaster does consistently better.
Still, for decades, the Fed has poured resources into developing its economic forecasting capabilities, and yet it still cannot predict or prevent economic recessions. What would make a Fed chair think it will be more successful at predicting and preventing a financial crisis?
Chair Yellen bases her optimism on the myriad of new powers and regulations that have been put in place since the financial crisis. Surely, the Fed’s new Dodd-Frank powers and thousands of pages of new regulations and guidance written by the Fed and other banking regulators will deliver us from evil speculators and protect us from irrational exuberance.
With the Fed, the Financial Stability Oversight Council and the Office of Financial Research (OFR) constantly on watch for financial system excesses, what could go wrong? Plenty, I think.
Let’s start with the housing market, the root-cause of the last financial crisis. In her Jackson Hole speech, Chair Yellen recounted that housing problems were on the radar at the Fed’s Jackson Hole meeting in 2007. Unfortunately, Fed officials did not appreciate the magnitude of the problem.
Neither Dodd-Frank, nor any other legislation passed since the financial crisis, has reformed the government institutions and mortgage policies that seeded the last financial crisis. Chair Yellen’s defiance of the administration’s plan to rollback some Dodd-Frank regulations is striking given that she fails to even mention the need to reform government-sponsored enterprises (GSEs) and housing policies.
Government housing and mortgage policy reforms are long overdue. The longer we delay reform, the larger the distortion in housing and mortgage markets. The odds are increasing that the next financial crisis will again be triggered by falling house prices and overextended mortgagors.
My American Enterprise Institute (AEI) colleague and housing-risk savant, Ed Pinto, has been tracking the housing and mortgage markets for decades.
His analysis suggests that government programs, such as the Fed’s financial crisis policies of near-zero interest rates and quantitative easing (QE) asset purchases and the low down payments and lax debt-to-income ratios allowed on mortgages guaranteed by the Federal Housing Administration, Fannie Mae and Freddie Mac, have already propelled housing markets deep into boom territory. It is hard to recall any government policy-driven boom that has ended in a “soft landing.”
Many in the mortgage business discreetly share Ed’s concerns. They ask: How are companies growing their mortgage originations when all the good borrowers are gone — when there is more competition — when interest rates rise? The answer is, they get creative and take more risk.
But there is no hint of these concerns in Chair Yellen’s speech. Just the opposite. She suggests that post-crisis regulations may have gone too far, disadvantaging homebuyers “with less than perfect credit histories.”
If housing bubbles are not on the Fed’s radar, what about the other government financial stability sentinels? A quick search of the OFR’s most recent “Financial Stability Report” does not mention residential housing and mortgage markets as key financial risks. This is consistent with street scuttlebutt that the agency’s management tries to steer clear of politically-charged issues.
In her zeal to defend the Fed’s Dodd-Frank powers, Chair Yellen’s speech ignores several other financial stability risks of the Fed’s own making. Years of near-zero interest rates and Fed QE operations are responsible for pumping up stock and long-term bond prices — just as the Fed intended.
But bloated security prices are constraining the Fed’s ability to sell its Treasury and GSE security holdings and “normalize” Fed operations. What Fed chair would sell trillions of dollars of securities and risk tanking the markets? Instead, the Fed will allow its portfolio to self-liquidate, letting it amortizes slowly over time.
Investors understand the Fed’s predicament and rationally expect the Fed to backtrack and repurchase securities if the market sells off. In other words, the Fed’s Greenspan-Bernanke-Yellen put is alive and well and still supporting inflated security prices. While this does produce financial stability — at least temporarily —history shows that financial stability generated by implicit government guarantees will not last long term.
Many post-crisis regulatory reforms will cushion the shock to the financial system when previously unforeseen risks materialize. Higher bank capital requirements are one example. But the benefits Chair Yellen ascribes to many Dodd-Frank reforms are only hypothetical at this point. The financial stability benefits of Orderly Liquidation Authority and livings wills thus far only exist in the minds of regulators — they are untried and unproven in practice, and there is much that could go wrong.
When it comes to central banking, credibility is key. When investors lack confidence in the Fed’s understanding of and response to unfolding economic conditions, investors panic and bad things happen. Central bankers typically husband their credibility by making only guarded statements, never saying or promising too much or offering more information than needed. Chair Yellen’s speech ignored this tradition.
Paul Kupiec is a resident scholar at the American Enterprise Institute. He has served as the director of the Center for Financial Research at the Federal Deposit Insurance Corporation and chairman of the Research Task Force of the Basel Committee on Banking Supervision.
The views expressed by contributors are their own and not the views of The Hill.