Federal Reserve Governor Jeremy Stein gave a speech yesterday that everybody—or at least everybody in the rather small world of monetary policy obsessives—is talking about. He looked at ways monetary policy can encourage bubbles in financial markets, and argued that central banks should be ready to use their control over interest rates to address them.
“I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability,” Stein said at a conference hosted by the St. Louis Fed, adding that “If the underlying economic environment creates a strong incentive for financial institutions to, say, take on more credit risk in a reach for yield, it is unlikely that regulatory tools can completely contain this behavior.”
This is a rejection of central banking orthodoxy over the last couple of decades. Chairmen Ben Bernanke and Alan Greenspan before him were reluctant to try to use their power over interest rates to fight imbalances and bubbles in the financial markets (Bernanke has become more open-minded on this question since the crisis, however).
Their logic is that hiking interest rates to combat a bubble in this or that market would be the equivalent of fumigating an entire house after finding a small patch of mold. It may do the job, but comes at a great cost: The house is unusable for days. Similarly, if the Fed hikes interest rates to combat bubbles, it might succeed, but at the cost of slowing down the entire economy or causing a recession.
By contrast, the Bernanke approach of dealing with credit bubbles through the Fed’s bank regulation tools, is the equivalent of coming in in a targeted way and removing the mold that has been found. The benefit is that the whole house doesn’t need to be shut down (No recession!). The downside is that there might be a lot more mold than what you can see, and you won’t get it with this targeted approach (risks lurking unseen elsewhere in the financial system).
It’s good to see leaders of the Fed grappling—in their cerebral, cautious way, at least—with an issue that has seemed apparent to many in financial markets for years: That low interest rate policies and unconventional easing programs such as Fed bond purchases can have hard-to-predict results throughout the financial system beyond those that traditional models of how monetary policy affects the economy would predict.
The shorthand, colloquial version of this is that when the Fed prints a lot of money, all that cash sloshing around has to go somewhere, and even if it doesn’t show up as inflation, it could turn up as an overpriced stocks (in 2000) or mortgage backed securities (in 2006). Stein’s case is a more nuanced academic effort to explain how that might happen.
In effect, the story Stein tells boils down to mismatched incentives between investors and the companies and individuals that work on their behalf. He offers the examples of an insurance company that has offered guaranteed minimum returns on its products (such as annuities) finding its solvency threatened by a long period of low interest rates and so taking on more risk than would really be justified. Those sorts of decisions, taken across the economy, could push up prices for risky assets beyond levels that their fundamentals can justify, and in the process create a boom and bust cycle that can in turn damage the economy.
Stein sees evidence in the markets for junk bonds and other risky products that this sort of behavior may be happening right now—though he isn’t sure whether the problem is so severe that it warrants much if any response from the Fed. “Putting it all together, my reading of the evidence is that we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit,” he said. “However, even if this conjecture is correct, and even if it does not bode well for the expected returns to junk bond and leveraged-loan investors, it need not follow that this risk-taking has ominous systemic implications.”
But overall, Stein’s argument is that precisely because it is so hard for the Fed to see, measure, and regulate any emerging frailties in the financial system, there is reason to use interest rate policies to combat them. When there is excess in the financial system that might endanger the economy, Stein argues, higher interest rates are the surest way of fighting it.
More than anything, Stein’s argument is one for intellectual modesty among Fed leaders’ in their ability to know where the risks are emerging and to have the power to do much about them. After a devastating crisis that had its roots in obscure financial products that almost no one understood (and even many senior regulators didn’t know about beforehand), now is not a great time for hubris about the ability of regulators to fine-tune their risks.
“While monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation--namely that it gets in all of the cracks,” Stein said. “The one thing that a commercial bank, a broker-dealer, an offshore hedge fund, and a special purpose [asset-backed commercial paper] vehicle have in common is that they all face the same set of market interest rates.”
That sounds to me like a Fed governor who will, if he sees a bubble emerging, be willing to fumigate the whole house to deal with it.