Three speeches by top Federal Reserve officials offer a preview of what is likely to be the most important debate over U.S. monetary policy in the years ahead. And they set the stage for the most important single decision President Obama will make this year to shape the future of the U.S. economy.
On one side of the debate there is Jeremy Stein, a Fed governor since last May. He argued in a Feb. 7 speech that there are already signs of overheating in the markets for certain kinds of securities, including junk bonds and real estate investment trusts that invest in mortgages. And if those or other potential bubbles get so large that if they popped the whole U.S. economy could be in danger, he argued, there is a case for using the Fed’s most blunt tool to combat them—raising interest rates across the economy.
Stein isn’t ready to do that just yet—he has been voting to maintain the Fed’s ultra-low interest rate policies—but some of his colleagues are taking the same logic further. Kansas City Fed President Esther George dissented at the central bank’s January policy meeting because she thought easy money policies “increased the risks of future economic and financial imbalances.”
The nub of the argument that George and Stein are making is that when financial bubbles arise, it's hard to know with certainty where they are and how big a risk they pose, so it's not enough for regulators to try to stamp them out. Higher interest rates may be a blunt tool, but at least you know they will be effective. If the last 15 years have taught us anything, it is that financial bubbles can wreak huge damage to the economy, so it’s worth it to try to nip them in the bud.
The two most powerful Fed officials have offered, in speeches Friday night and Monday morning, what amounts to a riposte to these arguments. “Long-term interest rates in the major industrial countries are low for good reason,” Chairman Ben Bernanke said Friday evening at an event in San Francisco. “Premature rate increases would carry a high risk of short-circuiting the recovery, possibly leading--ironically enough--to an even longer period of low long-term rates.”
Vice-chair Janet Yellen chimed in Monday morning at a National Association for Business Economics conference. “At this stage,” she said, “there are some signs that investors are reaching for yield, but I do not now see pervasive evidence of trends such as rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would clearly threaten financial stability.”
So the Bernanke-Yellen response to the Stein-George argument boils down to a polite version of this: Are you crazy? Unemployment is really high! Inflation does not appear to be much of a threat! Why should we cripple the prospects of economic recovery just because investors may be paying too much for certain types of corporate bonds and end up losing money.
In these speeches, we have, in effect, a glimpse into the future of the U.S. monetary policy debate. Inflation has been remarkably well-contained, and even the monetary hawks have lately been emphasizing these risks of financial bubbles in arguing against easy money policies. So the debate for the coming years will likely come down to some variety of that which has played out in this round of Fed speeches.
So where does Barack Obama come in? Bernanke’s term as chairman ends January 31, 2014, less than a year from now. In his decision of whom to appoint to the job, Obama will have to decide which broad philosophy around this question he finds most persuasive.
Yellen is likely to be a leading candidate for the job, and she has made her views rather plain in speeches like the one today. Stein could emerge as a dark horse candidate, and he would be an option if Obama and his inner circle find the deep concern over financial bubbles to be more compelling. (Both Yellen and Stein were previously appointed by Obama). Other candidates the president might wish to entertain will surely be pressed on this issue in confirmation hearings—and, if they’re doing their job right, by Obama and his aides during the interview process.
The answers they hear—and who Obama chooses to appoint to the chairmanship—will go a long way to settling which side of this debate the Fed of the future comes down on. And that, in turn, will determine how soon we might see the Fed hiking interest rates, lest financial bubbles blow again.