Fed Governor Brainard Warns of Financial Imbalances

The Federal Reserve will likely continue gradual interest rate increases but will speed up the pace if there will be sign of a buildup in financial imbalances, according to central bank Governor Lael Brainard’s speech.

Speaking in Detroit, the Fed official echoed recent notes from Chairman Jerome Powell that even if the current gradualist approach is appropriate, officials are on the lookout for an acceleration in inflation or distortions in financial markets that would trigger more aggressive action.

“While the information available to us today suggests that a gradual path is appropriate, we would not hesitate to act decisively if circumstances were to change,” said Brainard. “If, for example, underlying inflation were to move abruptly and unexpectedly higher, it might be appropriate to depart from the gradual path.”

The remarks reiterated Powell’s speech at the Fed’s annual retreat in Jackson Hole, Wyoming. He said that the policymaking Federal Open Market Committee would take a “whatever it takes” approach to policy “should inflation expectations drift materially up or down or should crisis again threaten.”

Brainard stated that the progress of the economy, with GDP hovering above trend, unemployment  low, and inflation stable and near the Fed’s 2 percent goal, represent optimism. On the other hand, she also said that various parts of the financial markets are showing excess.

She again reiterated Powell’s comments in saying that  overheating sometimes pops up in markets before more conventional inflation measures.

“The past few times unemployment dropped to levels as low as those projected over the next year, signs of overheating showed up in financial sector imbalances rather than in accelerating inflation,” she said. “The Federal Reserve’s assessment suggests that financial vulnerabilities are building, which might be expected after a long period of economic expansion and very low interest rates.

In particular, she said that corporate debt is rising and is vulnerable to downgrades if conditions should change. She also noted that leveraged lending is on the rise as underwriting standards ease. She then added that the stock market valuations are “elevated.”

Brainard spoke ahead of the FOMC’s September 25-26 meeting. In that meeting, the committee is widely expected to raise its benchmark funds rate a quarter of a point. Markets anticipate another hike in December.

However economists are concerned that the Fed might invert the yield curve by pushing short-term yields above longer-dated government debt. Such kind of inversion has been a solid signal that a recession is on the way in the next year or two.

Brainard, however, acknowledged that the central bank’s short-term “neutral” funds target, which is a level that supports trend growth with full employment and 2 percent inflation, could top the longer-term target. An inverted yield curve is only one of the signs that Fed will heed when the making policies, she added.

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