Conspicuous By Its Absence
A weekend topic on this Brown Political Review editorial. “There are many things that can give financial markets jitters, but only a few do so with clockwork regularity. The United States Federal Reserve is such an entity. Shudders mainly occur when the Fed uses monetary policy to fulfill two often-contradictory tasks: minimize inflation and maximize employment. Historic mandate and conventional wisdom dictate that the Fed should keep to these tasks and these tasks alone. However, after the 2008 financial crisis turned much conventional wisdom into outright foolishness, policymakers have rightly ratcheted up their scrutiny of that mandate.”
“Thanks to the Dodd-Frank Act passed after the crisis, financial stability has been officially added to the Fed’s regulatory mandate. This is encouraging but insufficient; long leery of moving beyond the axis of low inflation and high employment, the Fed must consider financial stability a first priority of monetary policy, too. In practice, this means that the Fed must be willing to prick asset bubbles.”
“The advent of Dodd-Frank and its sweeping extension of the Fed’s mandate for supervising and regulating the financial system go some way toward fixing this. But it’s insufficient: If central banks, and the Fed in particular, are to properly ward off asset bubbles and ensure a respectable degree of financial stability, the Fed will need to direct monetary policy — not just regulation — toward this goal too.”
“Even the most nuanced regulations simply don’t exert the broad-based impact that interest rates and, by extension, monetary policy do. As Harvard Professor and previous member of the Federal Reserve Board of Governors Jeremy Stein put it, monetary policy ‘has one important advantage relative to supervision and regulation — namely that it gets in all the cracks.’ Financial institutions can evade regulations, but not the interest rate. If the Fed wants its actions to be all-encompassing, monetary policy is the best route for accomplishing that.”
“When monetary policy ignores financial stability, as it has done in the past, there are deep and long-lasting drawbacks. This is largely due to the fact that monetary policy influences financial stability whether it intends to or not. When interest rates are low, earning high rates of return through investment gets a lot harder. As such, asset managers who are obliged to maintain a rate of return and earn a slice of their clients’ profits often start looking at riskier investments that pay higher returns. This behavior is known as ‘reaching for yield.’”
“Critically, this reaching means that there are more risky assets floating around the economy, making financial crises themselves more likely to occur. In short, a low interest rate environment sows the seeds of its own demise. Governor of the Reserve Bank of India Raghuram Rajan epitomized this wisdom in a 2005 speech later made famous by the financial crisis: ‘An unanticipated and persistent low interest rate can be a source of significant distortions for the financial sector, and thence asset prices.’ Such a counter-culture claim was blockbuster stuff in the world of central bankers.”
“If it’s true that low interest rates can create the potential for excessive risk to build up in the financial system, it’s also true that they make loans much cheaper. But in addition, it means that general amounts of debt — particularly for private actors, like households and corporations — quickly accumulate. As long as there are no big economic shocks and business continues as usual, this is fine. But when there is an economic shock, such as the bursting of an asset bubble, large amounts of debt are extremely problematic.”
“Like any controversial proposal, putting the onus of financial stability on monetary policy is an imperfect solution. Bubbles are difficult to diagnose, and a misdiagnosis would be costly in terms of jobs and economic growth. Nonetheless, the destructiveness of bubbles and contagiousness of financial instability in this day and age make these counterarguments persuasive only to the extent that policymakers should tread carefully, rather than not tread at all.”
“Targeting asset bubbles with monetary policy isn’t as difficult as skeptics make it out to be. Asset bubbles that pose a serious threat to the national economy — such as the housing bubble or the dot-com burst — usually come with warning signs.”
“Ultimately, the argument for monetary policy’s stake in financial stability comes down to two things: the limits of regulation and supervision and the fact that monetary policy is a powerful tool that affects financial stability and asset bubbles anyway. Dodd-Frank codified a much greater role for the Federal Reserve in ensuring financial stability; the Fed is now tasked with identifying and overseeing institutions that are ’systemically risky,’ with a view to preventing another Lehman Brothers meltdown.”
“But its role in ensuring financial stability hasn’t gone deep enough yet. One of the first sections of the Federal Reserve Act lists the objectives for monetary policy: ‘maximum employment, stable prices, and moderate long-term interest rates.’ Still, conspicuous by its absence is any mention of asset bubbles or financial stability. In order to face these threats, frequently far from the thoughts of central bankers, the Fed must climb out of its own bubble and put that realization in writing.”
