By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
Even prior to the financial crisis of 2007, economists and policymakers actively debated whether central banks should use interest rate policy to “lean” against possible asset price bubbles or “clean” up after an asset price bubble burst, reserving interest rate policy for inflation targeting. A consensus has started to emerge: there are instances in which it would be advantageous for central banks to use interest rate policy to lean against asset price bubbles. Some current and former Fed officials have reversed their position and now embrace the consensus view. This view is consistent with the position that the Fed kept the Fed funds rate “too low for too long,” but any admission of that by Fed officials remains implicit at best. It also appears that the Fed has not generalized any lessons it might have learned from the crisis. It has committed itself to both exceptionally low interest rates for an extended period of time and now to QE despite parallels between run up to the crisis of 2007 and current developments in the currency and international capital markets.
Speeches by Vice Chair Yellen and former Vice Chair Kohn and recent testimony by Bernanke reflect this somewhat reluctant acceptance of the idea that in some cases leaning against price bubbles is appropriate policy.
It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking in the financial system.
By the same token, I would not want to argue that it is never appropriate for monetary policy to take into account its potential effect on financial stability. Regulation is imperfect. Financial imbalances may emerge even if we strengthen macroprudential oversight and control.
We should not categorically rule out using monetary policy to address financial imbalances, given the damage that they can cause; the FOMC is closely monitoring financial conditions for signs of such imbalances and will continue to do so.
For all these reasons, my strong preference would be to use regulation and supervision to strengthen the financial system and lean against developing problems. Given our current state of knowledge, monetary policy would be used only if imbalances were building and regulatory policies were either unavailable or had been shown to be ineffective.
All of the statements, as reluctant as they are, indicate a clear retreat from the position that interest rate policy should never reflect concerns about financial stability. The position that interest rates were too low for too long is most clearly reflected in the Kohn statement. Kohn lists two contingencies, which if both are met, warrant the Fed setting rates higher than inflation and the output would imply. They are 1) economic/financial imbalances must exist, and 2) regulatory policies must be absence or ineffective. (I would add that the imbalances must reflect unusually rapid credit growth.) Both of the contingencies were clearly satisfied in the period post-2001. There were numerous unsustainable economic and financial imbalances: the personal savings rate near zero, and an economy reliant on unsustainable levels of consumption and housing investment relative to income, both of which were driven by unsustainable asset prices. In addition, major financial institutions were over-leveraged and reliant on short-term funding. As we all know, regulatory policy was ineffective or nonexistent.
At the risk of putting words in Kohn’s mouth, he clearly suggests that interest rates were too low given the imbalances and the state of regulation. It is not a full confession, but perhaps a mea culpa.
Unfortunately, the Fed seems unable to generalize from the lesson that at times appropriate interest rate policy is a function of more than just inflation and the output gap. Currently, the large, unsustainable global financial and economic imbalances are parallels to the imbalances that existed in the US prior to the crisis. The international organizations charged with promoting and maintaining stability in the international markets are woefully inadequate to deal with a crisis involving the Dollar.
Nonetheless, the Fed seems bent on setting policy as if US prices and income were exclusively determined by domestic economic concerns and despite its status as the bank of issue of the world’s reserve currency. Bernanke’s recent speech made no mention whatsoever of any non-domestic policy concerns. Despite unsettled currency markets and the US’s status as a capital importer, the Fed has embraced QE and pledged to pursue a low interest rate policy for an extended period of time, presumably regardless of any international developments.
It is fair to say that the Fed is once again demonstrating its decided limitations as a risk manager. Given the current economic climate and recent developments (FX intervention and introduction of capital controls), the a risk of a Dollar crisis is much more than tail risk. The costs given a crisis are difficult to estimate as a Dollar crisis would be a currency crisis wherein the currency in crisis had been the reserve currency. Range and pattern of diffusion are anybody’s guess.
If a risk management discipline were applied to the decision to adopt QE, it would rule out the Fed’s position as stated by Bernanke. The costs to the US (and the world) economy that would be experienced should Fed policy precipitate a Dollar crisis would be much larger by orders of magnitude than any probable (or possible) benefits that might be realized if QE is able to raise inflationary expectations. In his recent speech, Bernanke alluded to a risk return analysis of QE, but he just seems to have ignored the existence of the rest of the world and any feedback on the US.