Some people wonder why the Federal Reserve is in such a hurry to raise interest rates, pointing out that growth in the world’s first economy is hesitant at best. Inflation, of course, is an issue — even the stripped-down official version of inflation, “core” as they like to call it, is rising.
But another, more worrying reason seems to be behind it: the Fed’s prolonged policy of asset purchases and zero interest rates has increased the risks in the financial system, rather than reducing them. This despite the plethora of regulatory measures designed to deal with reckless behaviour by borrowers and banks.
A working paper published recently by the International Monetary Fund suggests that an extended period of quantitative easing does indeed increase the vulnerability of the financial system. The Fed’s policy in particular, since the dollar is the world’s reserve currency, has an impact on the vulnerability of financial systems across the world.
The paper’s authors — Stephen Cecchetti, Tommaso Mancini-Griffoli and Machiko Narita — analysed data for 994 publicly listed financial institutions in 22 countries over the past 15 years to gauge the impact of prolonged monetary easing on risk-taking behaviour.
They looked at leverage and noticed that, after one and two years of prolonged policy easing, the level of leverage for banks and other financial industry firms had consistently risen above the benchmark. Leverage was calculated as an assets-to-equity ratio using the median percent changes and median levels in each industry.
The leverage benchmark for banks was 10.5; after two consecutive years of monetary policy easing, it had risen to 12.5. For insurance companies, the increase in leverage was also notable: from 6.5 to 7.4.
“Bank and nonbank leverage, as well as other measures of financial firms’ vulnerability, increase the longer the period of monetary policy easing both in an institution’s home country and in the U.S.”, the paper’s authors write.
Their analysis shows that “risk-taking by banks and nonbanks responds in the same direction to monetary policy,” contrary to previous research that seemed to indicate that credit extension responds inversely to monetary policy.
For the first time, a measure of the Fed’s influence on other economies is produced, and it is startling: the paper finds that prolonged monetary easing in the US increases the vulnerability of financial sector firms abroad by approximately as much as domestic easing.
The IMF working paper confirms, with rigorous analysis, the unease that many have expressed regarding the Fed’s monetary easing measures: far from reducing moral hazard, money printing encourages it. The Fed is probably finally realising that the risks of quantitative easing have exceeded its benefits.