This week’s Federal Open Market Committee meeting didn’t have any big surprises, but that also means it has yet to find an answer to analysts who worry that the country is falling into a QE trap where market reactions prevent the Fed from ever really ending accommodative policies. It’s not that the Fed doesn’t realize its attentiveness to market reactions creates moral hazard, but ignoring the market entirely could easily throw the recovery off track. A shift to macro-prudential policy measures (MAP) could be a way to get out of this mess, and John Briggs, Head of Cross Asset Strategy and Head of Asset Backed Product Strategy for RBS, argues that it may already be underway.
Fed’s attention to minor market moves has created moral hazard
“By over-reacting to comparatively minor market moves, be it in equities or in interest rates, the Fed has created an expectation that it will not allow any pain, so investors believe that in the future it will not allow any either,” writes Briggs. “We believe that it is through MAP that the Fed will try to thread this needle.”
Unlike micro-prudential regulations, which seeks to ensure that individual entities are financially secure, MAP explicitly looks at systemic risks. So while a micro-prudential approach might conclude that the financial system is sound because each institution that makes it up seems healthy, a MAP approach might realize that each of those institutions are exposed to a common risk which threatens to undermine the whole. MAP isn’t a brand new concept, but it has a way of gaining credibility following crashes.
Bond fund exit fee proposal shows a shift toward MAP
Briggs points to the March 2013 attempt by the Fed to limit systemic risk by issuing new leveraged lending guidelines. He doesn’t think the effort was particularly successful, but the attempt still shows a MAP way of thinking about risk. The more recent proof was the Fed floating the idea of bond fund exit fees as a way to fight the first mover advantage and avoid a run on bond funds. The idea certainly hasn’t been popular; as Joshua Brown at The Reformed Broker put it, “name one financial crisis that was aided by liquidity constraints. No? Didn’t think so.” Federal Reserve Chair Janet Yellen later said that the fees weren’t going to happen, but Briggs sees it as part of a conceptual shift toward MAP. Hopefully that shift will bring us some more fruitful ideas down the road.