Bernanke: Fed Keeps Eye on Financial Stability Amid Concerns About Low Rates

WASHINGTON — Federal Reserve Board Chairman Ben Bernanke said Friday the central bank is continuing to take precautionary steps to ensure that prolonged low long-term interest rates will have minimal impact on financial stability.

In his speech before the Federal Reserve Bank of San Francisco, Bernanke addressed broad concerns that have been raised by critics on the timing and pace of increases in long-term interest rates and the implications it could have on financial stability.

For some, Bernanke said simply, the risk is that rates will continue to remain low, while others fear how quickly they could rise. The concern is that an environment where low returns persist could provide incentives for investors to engage in an unsafe "reach for yield" either through excessive use of leverage or through other forms of risk-taking.

Conversely, he said, there is also the risk policymakers face when longer-term rates are lifted sharply and quickly, causing capital losses on holders of fixed-income instruments, including financial institutions.

"Of course, the two risks may very well be mutually reinforcing: Taking on duration risk is one way investors may reach for yield, and the losses resulting from a sharp rise in longer-term rates will be greater if investors have done so," said Bernanke.

While some argue that the right response to avoid such risks is to tighten monetary policy by raising long-term interest rates, Bernanke said such an approach would be "quite costly" and might be "counterproductive" in trying to foster financial stability.

"Long-term interest rates in the major industrial countries are low for good reason: Inflation is low and stable and, given expectations of weak growth, expected real short rates are low," said Bernanke.

"Premature rate increases would carry a high risk of short-circuiting the recovery, possibly leading — ironically enough — to an even longer period of low long-term rates."

The Fed, Bernanke said, has been using three strategies for addressing financial stability concerns as it pursues its current monetary policy strategy — an endeavor the central bank "takes very seriously."

Firstly, the Board has increased its macroprudential oversight over the largest, most complex financial institutions, and now takes special care to look for potential systemic vulnerabilities like buildup of leverage and interest rate risk.

"Throughout the Federal Reserve System, work in these areas is conducted by experts in banking, financial markets, monetary policy, and other disciplines, and at the Federal Reserve Board we have established our Office for Financial Stability Policy and Research to help coordinate this work," said Bernanke. Those findings, he said, are presented to the Fed's board and the Federal Open Market Committee to use in its monetary policy decision making.

Banking regulators, he said, are also looking at the shadow banking sector and how it potentially interacts with regulated institutions. Regulators look for factors that could leave the system vulnerable to an adverse "fire sale" dynamic, which is "when declining asset values could force leveraged investors to sell assets, depressing prices further," he said.

Secondly, the Fed uses regulatory and supervisory tools to ensure that U.S. banks are "sufficiently resilient to weather losses and periods of market turmoil arising from any source." Rules under Basel III and Dodd-Frank have helped to "substantially" increase the amount of capital and liquidity the largest banks hold. Stress testing the largest banks has also helped regulators determine if firms have enough capital to survive an economic downturn.

Lastly, he said, the Fed's approach to communicating and implementing monetary policy provides the Fed with new tools to reduce the risk of a sharp hike in interest rates.

"By providing greater clarity concerning the likely course of the federal funds rate, FOMC communication should both make policy more effective and reduce the risk that market misperceptions of the Committee's intentions would lead to unnecessary interest rate volatility," said Bernanke.

Bernanke said the Fed will continue to evaluate these issues carefully on a routine basis.

"We will be alert for any developments that pose risks to the achievement of the Federal Reserve's mandated objectives of price stability and maximum employment; and we will, of course, remain prepared to use all of our tools as needed to address any such developments," said Bernanke.

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