Record low interest rates are causing markets from farmland to junk bonds to become overheated, causing concern at the Fed that risks will be sharply increased when its bond-buying program is over.
One reason the Fed has kept interest rates so low was to encourage investors to take more risk.
The strategy has worked; investors have been pouring money into riskier assets ever since the Fed cut its interest rate target close to zero in December 2008.
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Kansas City Fed president Esther George said last week that prices of assets such as bonds, agricultural land, and high-yield and leveraged loans were at historically high levels.
She said the Fed cannot ignore the possibility that incentives caused by low interest rates may lead to future financial imbalances.
Fed Chief Ben Bernanke expressed concern during a January 14 discussion at the University of Michigan’s Gerald R. Ford School of Public Policy in Ann Arbor.
Atlanta Fed president Dennis Lockhart says he sees a legitimate concern in the growth of the Fed’s balance sheet with the additional purchases of mortgage-backed bonds and Treasuries.
He also expressed confidence that at the appropriate time, the Fed can withdraw the stimulus in an orderly way. He admitted that the larger the Fed’s balance sheet, the more the unknown factor.
US economists say there is no way to pull back just a little. The first sign of Fed tightening will cause investors to price in the entire amount of bonds coming back into the market, setting off a hair trigger in the bond markets.
Extreme stimulus measures cause extreme market distortions; the comforting factor
is that the Federal Open Market Committee (FOMC) meetings are seeing increasing debate.