Bernanke: Fed should keep a sharper eye on financial bubbles

October 18, 2011

Federal Reserve Chairman Ben S. Bernanke said Tuesday that he is more open to using the Fed’s interest rate policies to combat financial bubbles, arguing that in the wake of the economic crisis, central bankers must rethink their assumptions.

Before the economic upheaval, Bernanke acknowledged, central banks viewed financial stability as a “junior partner” to the task of tweaking interest rates to try to boost growth. But both stability and monetary policy are of vital importance to the U.S. economy, he said.

“In the decades prior to the crisis, monetary policy had come to be viewed as the principal function of central banks,” Bernanke said at a conference sponsored by the Federal Reserve Bank of Boston, according to a prepared text. “Their role in preserving financial stability was not ignored, but it was downplayed to some extent. The financial crisis has changed all that. Policies to enhance financial stability and monetary policy are now seen as coequal responsibilities of central banks.”

During the late-1990s stock market boom and then the housing price boom in the early 2000s, the Fed largely avoided using its power to control interest rates and the supply of money as a way to fight off what were in hindsight dangerous bubbles. The argument at the time was that monetary policy is too blunt an instrument to address out-of-whack prices in an individual marketplace. For example, raising interest rates in 2003 to combat rising home prices might have risked dragging the entire economy into recession.

Bernanke was not repudiating that line of thought entirely, arguing in Tuesday’s speech that regulation is the best tool to rein in financial excesses. But he appeared open to using monetary policy to keep those excesses in check as well.

“The possibility that monetary policy could be used directly to support financial stability goals, at least on the margin, should not be ruled out,” Bernanke said.

The Fed chief spoke approvingly of a wide range of regulatory tools that central banks around the world are using to ward off financial bubbles that could wreak severe damage on their economies.

In particular, he noted policies aimed at forcing banks to behave more cautiously during good times so that they will be less prone to crisis in bad times. In Korea and Hong Kong, for example, central banks require different loan-to-value ratios on mortgages depending on the economic cycle.

Bernanke did not specifically discuss the outlook for U.S. monetary policy, except to say that the Fed’s policy committee “continues to explore ways to further increase transparency about its forecasts and policy plans.” At its last meeting, the Federal Open Market Committee considered whether to begin announcing the specific economic indicators — such as the unemployment rate and the inflation level — that might prompt it to back away from its low-interest-rate policies.

But there was no resolution of the issue, and Bernanke’s comments merely confirm that it will be an ongoing discussion.

Charles Evans, the president of the Federal Reserve Bank of Chicago, argued in a speech Monday that the Fed should pledge to keep easy-money policies in place until the unemployment rate falls below 7 percent or projected inflation rises above 3 percent. But others on the Fed policy committee are uncomfortable with anything that could push inflation above the 2 percent or so that the Fed prefers.

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