Fed's Stein: No Bank Bubble in Fed Bond Buying

NEW YORK ( TheStreet) - Federal Reserve governor Jeremy C. Stein said Friday the central bank's bond buying and zero interest rate policy hasn't created an unhealthy amount of risk taking in the financial system. Tradeoffs between financial stability and the Fed's work to spur asset prices still favor an accommodative stance, Stein said.

Stein also said Chairman Ben Bernanke's discussion of the economic data the Fed will consider as it eventually slows and ends a $85 billion a month bond buying program was a decision to give specificity to markets beyond previous guidance of "substantial progress" in the U.S. economic recovery.

Speaking at the Council of Foreign Relations, Stein noted that despite a significant rise in bond yields since Bernanke's June 19 comments, there has been no change to the Fed's bond buying. He did acknowledge there may have been a change in market expectations and a possible of re-jiggering of discount rates used by investors on Wall Street.

While Stein's comments put to rest speculation the Fed's recent change in communication may have been an attempt to quell asset bubbles, they are notable as a vote of confidence in the current health of the financial sector and the nation's largest banks.

"Although asset purchases also bring with them various costs and risks--and I have been particularly concerned about risks relating to financial stability--thus far I would judge that they have passed the cost-benefit test," Stein said Friday.

When asked whether the Fed's change in communication intended to curb aggressive behavior on Wall Street, particularly in credit markets, Stein said "it was not about trying to manipulate volatility."

Amid a recent surge in the 10-year Treasury yield, some banking analysts had question whether the Fed was trying to let out some air from booming credit markets.

"Many investors seem to believe that if the Fed starts tapering, then it must be a sign of a strong economy. But, what if the Fed believes it needs to start tapering because it is concerned about the potential for asset bubbles? " Christopher Mutascio, a large cap bank analyst at Keefe Bruyette & Woods wrote, in a June client note.

Governor Stein would likely be the Fed official driving such decisions, given his focus on the interplay between loose monetary policy and often opaque credit markets.

In February, the Fed governor raised the prospect the central bank's bond buying and low interest rate policies could create a a credit market overheating, which might undermine the stability of the U.S. financial system. He argued the Fed's regulatory authority might be insufficient in preventing firms from reaching too far for yield and that the central bank's regulatory powers might not impact all markets given a dramatic expansion of its policy toolkit since the financial crisis.

Monetary policy, on the other hand, might be more effective.

"I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability," Stein said in February.

The Fed has made "meaningful progress" in repairing the U.S. financial system, Stein said Friday, and highlighted an imminent finalization of Basel III capital rules, the central bank's stress testing and progress made on a so-called 'resolution authority' to wind down failing large banks. The Fed governor, however, indicated further work may need to be done to end a perception of 'too big to fail.'

"I would not characterize this as job done," Stein said. "I think there is potentially a further road to go on large institutions."

Although Stein rejected the notion the Fed's change in communication was intended to cool overheated credit markets, his belief that the central bank's bond buying hasn't been undermined expresses confidence in the standing of the nation's largest banks.

Even if the Fed hadn't meant for a June rise in interest rates to impact large banks, many investors see the market move as beneficial to firms such as Wells Fargo ( WFC), JPMorgan ( JPM), Citigroup ( C) and Bank of America ( BAC).

For example, a rise in mortgage rates spurring losses on banks' available for sale (AFS) portfolios might push them to slow their securities buying and increase their lending, Fitch Ratings financial institutions managing director Joo-Yung Lee said at a Tuesday conference.

Rising mortgage yields and short term rates kept low by weak commodity prices would be "nirvana for banks," Bill Smead, chief investment officer of Smead Capital said in a Thursday interview. Smead owns shares in Wells Fargo, Bank of America and JPMorgan.

On Friday, Stein said the Fed's more clear discussion of the data it will consider in policy changes still give the central bank ample flexibility. Even if unemployment falls below 7%, Stein said weak inflation could give the Fed an ability to maintain its easing program if it believes the economy has not recovered.

Policy flexibility also extend's to the Fed's role in curbing financial system asset bubbles. Financial stability is part of the Fed's "dual mandate" of fostering acceptable unemployment and inflation, Stein said on Friday.

-- Written by Antoine Gara in New York.

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