The Fed: Don’t Worry, We’ll Keep An Eye On Things

With stocks already posting double-digit gains for the year and seemingly making new record highs every other day, the Federal Reserve is reminding investors that the fox is keeping a close eye on the hen house.

After more than four years since the beginning of the financial crisis, the side effects still remain. In a recent speech to bankers and regulators, Fed Chairman Ben Bernanke warned that the financial system has improved, but still faces multiple vulnerabilities. Furthermore, the central bank is monitoring asset markets in hopes of preventing the next great bubble.

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“Not surprisingly, we try to identify unusual patterns in valuations, such as historically high or low ratios of prices to earnings in equity markets. We use a variety of models and methods,” explained Bernanke at a banking conference in Chicago.

“In light of the current low interest rate environment, we are watching particularly closely for instances of ‘reaching for yield’ and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals,” he said. “It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices.”

Central banks such as the Federal Reserve have been trying to create a wealth effect by injecting historic amounts of liquidity into the financial system. By punishing savers through low interest rates, more people have been forced into riskier assets such as stocks that offer a higher rate of return. Since June 2007, more than 500 interest rate cuts have occurred around the world.

Individuals are not the only participants reaching for yield. Low rates on government bonds are pushing more central banks into equities. According to a recent annual survey of 60 central bankers conducted by Central Banking Publications and Royal Bank of Scotland, nearly a quarter of reserve managers already own equities or plan to buy them within five years. In total, the 60 central banks polled are responsible for almost $7 trillion in reserves. Earlier this year, the Bank of Japan announced plans to expand its investments in equity exchange-traded funds to 3.5 trillion yen by the end of 2014.

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During the Q&A session of the conference, Bernanke continued to discuss financial bubbles and even mentioned one specific stock. “We do try to identify much moreso than in the past, whether major asset classes are deviating in terms of their price or valuation from historical norms. Now, that being said, two comments. One, is that I think it would be hubristic to believe that we can always identify such deviations, and on the one hand, sometimes changes in price to earnings ratios are justified by some fundamentals. Microsoft’s (NASDAQ:MSFT) stock is worth more than it was some time ago, but so far so good, right?”

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