Is the Fed tightening too slowly?

Matthew C. Klein

We’ll never be sure whether the Federal Reserve’s low short-term interest rates and trillions of dollars of bond purchases have helped more than they hurt. Whatever the historians conclude, the Fed’s monetary policy now looks loose.

If that’s the case, the Fed may be risking an endless cycle of bubbles and busts - a concern for more and more voting members of the Federal Open Market Committee, according to the minutes from their latest meeting.

One reason to be worried that the Fed is still encouraging the sort of risk-taking that got us here in the first place: the hot market for leveraged loans. These are usually made to highly indebted companies in order to pay large dividends to their owners, which are often private-equity firms. As more money flowed into the leveraged-loan market, credit spreads over risk-less investments narrowed and covenants meant to protect lenders withered away.

Regulators became so concerned that they wrote a strongly worded letter to the big banks back in October, but recent news suggests that underwriting has continued apace. In fact, the demand for these risky debts is so strong that corporate borrowers such as Aramark Holdings have been able to refinance their loans into ones with even narrower credit spreads, according to Bloomberg News (only on the terminal, sorry). The result is even less compensation for investors exposed to credit risk and even greater incentive for companies to saddle themselves with debts they may be unable to repay in a less favorable economic environment.

Consumers are also borrowing more. According to the Federal Reserve Bank of New York, Americans took out more consumer debt at the end of 2013 than at any time since the summer of 2007, although the rate of new mortgage originations continued to fall.

Finally, there is the jobs outlook. The New York Fed, which is often the bellwether for the rest of the FOMC, has been arguing that the U.S. job market is tighter than it looks. A recent post makes a convincing argument that the number of people out of work for 26 weeks or less is a better predictor of wage trends than the total number of unemployed. If not for the millions of people who have been jobless for 27 weeks and longer, the U.S. economy would be very close to full employment. The plight of the long-term unemployed is a shameful waste of human potential. But it may not be something that lower borrowing costs can alleviate, especially when weighed against the dangers of prolonged monetary stimulus.

Fed policy makers are aware of these developments, which helps explain why they decided to cut back monthly asset purchases back in December. The resilience of U.S. households and businesses, even in the face of harsh winter weather, suggests that tighter policy might be in order. Would the world end if asset purchases were scaled back at a faster pace, or if short-term rates rose a bit?

By Matthew C. Klein, Writer for Bloomberg View