MNI INTERVIEW: Fed May Be Fueling Risk Rally: Ex Fed Liang

By Jean Yung

     WASHINGTON (MNI) - The Federal Reserve may be inadvertently incentivizing

risk-taking with its efforts to dampen repo market volatility, the former

director of its financial stability division told MNI, saying that the question

of whether recent Treasury bill purchases are fueling a rise in stocks and other

assets merits further study.

     That the market moves have come at a time of accommodative monetary policy,

already-stretched valuations and looser credit conditions could undermine

financial stability more broadly, Nellie Liang added in an interview.

     "There are two facts: Asset prices are higher, and the Fed is buying

short-term treasuries. The question is whether one is causing the other," Liang

said. "You can't establish causality with one event," but, "it raises a lot of

questions about how QE works."

     "I'm sure they're debating it, it's a puzzle," she said.

     Policymakers and investors appear split on whether Fed balance sheet growth

since October could be characterized as quantitative easing. Fed Chair Jay

Powell insists it is a technical adjustment rather than monetary stimulus, while

Dallas Fed President Rob Kaplan said the bill purchases were a "derivative of

QE." President Donald Trump's top economic adviser Larry Kudlow this month also

called it stealth QE.

     --FINANCIAL STABILITY

     Since September, when overnight funding markets spiked unexpectedly, the

Fed has poured hundreds of billions of dollars of temporary liquidity into the

repo market. In October it began USD60 billion in Treasury bill purchases per

month, pumping the balance sheet up to USD4.1 trillion from a low of USD3.8

trillion. The S&P 500 has risen more than 10% since October.

     Liang, who was nominated by President Donald Trump to the Fed Board of

Governors but later withdrew herself from consideration, said it "wouldn't take

much" to get to a state of higher-than-moderate financial stability risk given

the run-up in asset prices.

     The more asset prices rise, the bigger the fall if it happens, she said.

The Fed has also flagged imbalances in the corporate debt market as raising the

concern that deteriorating credit quality could lead to sharp increases in risk

spreads.

     On the whole the financial system is much more resilient after the

financial crisis, with banks amply supplied with capital and liquidity. The

largest firms are in pretty good shape to weather stress. But, she said: "It's a

trickier time right now, and you want to be careful."

     "That's one of the difficulties facing the Fed, when it takes actions to

reduce risk, people think there's less risk in the system, and that gives them

incentives to take on more risk," she said, noting that U.S. asset prices are

overvalued relative to historical trends and profit expectations.

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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