Imagine that it is 18 months from now, and that with interest rates still very low, each of the trends that I identified earlier has continued to build—to the point where we believe that there could be meaningful systemic implications. What, if any, policy measures should be contemplated? It is sometimes argued that in such circumstances, policymakers should follow what might be called a decoupling approach. That is, monetary policy should restrict its attention to the dual mandate goals of price stability and maximum employment, while the full battery of supervisory and regulatory tools should be used to safeguard financial stability…As we move forward, I believe it will be important to keep an open mind and avoid adhering to the decoupling philosophy too rigidly. In spite of the caveats I just described, I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability.
Let me offer three observations in support of this perspective. First, despite much recent progress, supervisory and regulatory tools remain imperfect in their ability to promptly address many sorts of financial stability concerns. 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…Second, 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. The one thing that a commercial bank, a broker-dealer, an offshore hedge fund, and a special purpose ABCP vehicle have in common is that they all face the same set of market interest rates. To the extent that market rates exert an influence on risk appetite, or on the incentives to engage in maturity transformation, changes in rates may reach into corners of the market that supervision and regulation cannot. Third, in response to concerns about numbers of instruments, we have seen in recent years that the monetary policy toolkit consists of more than just a single instrument. We can do more than adjust the federal funds rate. By changing the composition of our asset holdings, as in our recently completed maturity extension program (MEP), we can influence not just the expected path of short rates, but also term premiums and the shape of the yield curve. Once we move away from the zero lower bound, this second instrument might continue to be helpful, not simply in providing accommodation, but also as a complement to other efforts on the financial stability front.
I wonder how much Mr. Stein knows about Fed policy during the 1920s. The paper does not mention that 1929 was the last time the Fed tried to implement his proposed policy. Indeed the paper does not discuss Fed policy during the 1920s—a very disturbing omission. (Recall that I argued that only the very best monetary economists in the world should be allowed to serve on the FOMC. Stein’s brilliant, but isn’t he a finance guy?)
During the 1920s NY Fed President Benjamin Strong was under a lot of pressure to “do something” about the stock market boom. He resisted, arguing the Fed should focus on stabilizing prices and output. (Hmmm, what is the sum of the growth rate of prices and the growth rate in output?) He died in August 1928, and the new leaders of the Fed finally had their chance. They raised interest rates in late 1928, and then in early 1929, and then in mid-1929. But it didn’t do any good. Stocks kept soaring higher and higher. And there’s a reason it didn’t do any good. Stocks are very long lasting assets. Investors care much more about the future performance of the economy than the current setting of very short term interest rates. As long as the economy was booming and there is no inflation, why should stocks have fallen?
But the Fed didn’t give up, and by the late summer of 1929 short term rates were at 6%. Recall that this was a very high real rate, as there was deflation during the 1927-29 business cycle expansion, despite the fact that the economy was booming. So the trend rate of inflation in 1929 was almost certainly negative. Finally money got so tight that the economy tipped into depression. And it was (expectations of) the depression that caused the stock market crash, not the high interest rates. Indeed stocks hit the all time high in early September 1929, when interest rates were also near an all time high in real terms. Only when the Fed caused the economy to tank did the stock “bubble” finally burst. (BTW, studies have shown that stocks were not overpriced in 1929.)
The problem here is that monetary policy is a very blunt instrument. Stein is wrong in assuming that the Fed has specific monetary policy tools that can surgically attack bubbles. But they do have regulatory policies that can and should be used to prevent excessive risk taking in the banking system.
I know what you are thinking; “Sumner, we get that you don’t agree with Stein, but no reason to accuse him of child abuse.”
I have two responses:
1. I don’t consider spanking to be child abuse.
2. Governor Strong had this to say shortly before he died:
Must we accept parenthood for every economic development in the country? That is a hard thing for us to do. We would have a large family of children. Every time one of them misbehaved, we might have to spank them all.
Excessive NGDP growth requires a good spanking—the rest of the misbehaving children need to be addressed with regulatory measures.