Fed's Mester flags financial stability concerns in central bank accommodation

© Reuters. FILE PHOTO: Cleveland Fed President Loretta Mester takes part in a panel convened to speak about the health of the U.S. economy in New York November 18, 2015. REUTERS/Lucas Jackson

By Howard Schneider

WASHINGTON (Reuters) - Cleveland Federal Reserve bank president Loretta Mester said Tuesday that the extended low interest rates, ongoing bond purchases, and loose-policy promises that central banks have used during the coronavirus crisis could pose financial stability risks over time.

Mester, in advocating central banks adopt "escape clauses" so they can exit from loose policy if financial risks mount, did not say explicitly that she felt the Federal Reserve's current approach was running such risks now or say she was ready to tighten monetary policy.

The Fed's current strategy does say that policy is contingent on officials' "assessments of the balance of risks, including risks to the financial system," a phrase some have interpreted as letting the Fed shape policy as needed around financial stability considerations.

Still, in remarks prepared for delivery to a monetary policy conference organized by Norway's central bank, Mester raised a broad set of recommendations that could be relevant to the Fed's current debate over how much longer to keep in place the emergency policies used to fight the fallout from the coronavirus pandemic.

Those include ongoing asset purchases of $120 billion per month as well as explicit promises about the conditions that must be met before interest rates are raised.

"A central bank’s asset purchases could create vulnerabilities by encouraging investors to be less sensitive to risk or could impact market functioning and thereby the transmission mechanism of monetary policy," Mester said. Promises to keep policy loose, meanwhile, "may mute financial market volatility and spur a buildup of leverage."

"We need to be more explicit in our monetary policy framework that there will be times when macroeconomic and financial stabilities will come into conflict and include consideration of financial stability risks when issuing forward guidance on monetary policy," she said.

Some Fed officials have begun raising concerns that the Fed's ongoing purchases of mortgage-backed securities may be raising the likelihood of a bubble in housing prices.

Along with explicitly accounting for financial stability risks in monetary policy, Mester said bank capital rules may need to be "recalibrated" to match an environment where interest rates remain low and risk appetite is high, and that nonbank financial firms be more closely monitored.