Here’s Ben Bernanke on the idea of using monetary policy to address financial imbalances:
Let there be no mistake: In light of our recent experience, threats to financial stability must be taken extremely seriously. However, as a means of addressing those threats, monetary policy is far from ideal. First, it is a blunt tool. Because monetary policy has a broad impact on the economy and financial markets, attempts to use it to “pop” an asset price bubble, for example, would likely have many unintended side effects. Second, monetary policy can only do so much. To the extent that it is diverted to the task of reducing risks to financial stability, monetary policy is not available to help the Fed attain its near-term objectives of full employment and price stability.
For these reasons, I have argued that it’s better to rely on targeted measures to promote financial stability, such as financial regulation and supervision, rather than on monetary policy.
One of the “unintended side effects” of the Fed’s 1928-29 attempt to pop the stock market bubble was the Great Contraction of 1929-33. Another was Hitler taking power in Germany. And another was WWII. So if anything, Bernanke is being too polite to those who favor using monetary policy to prevent financial imbalances.
Now of course they’d insist that they also favored macroeconomic stabilization, and merely wish to use monetary policy at the margin. But even those more reasonable proposals are highly questionable. Bernanke cites one study (links further down) that does find that monetary policy might play a role, but not a very large one:
Although, in principle, the authors’ framework could justify giving a substantial role to monetary policy in fostering financial stability, they generally find that, when costs and benefits are fully taken into account, there is little case for doing so. In their baseline analysis, they find that incorporating financial stability concerns might justify the Fed holding the short-term interest rate 3 basis points higher than it otherwise would be, a tiny amount (a basis point is one-hundredth of a percentage point). They show that a larger response would not meet the cost-benefit test in their estimated model. The intuition is that, based on historical relationships, higher rates do not much reduce the already low probability of a financial crisis in the future, but they have considerable costs in terms of higher unemployment and dangerously low inflation in the near- to intermediate terms.
And even this is doubtful, as it depends on the very dubious assumption that low interest rates imply easier money:
A new paper by Andrea Ajello, Thomas Laubach, David López-Salido, and Taisuke Nakata, recently presented at a conference at the San Francisco Fed, is among the first to evaluate this policy tradeoff quantitatively. The paper makes use of a model of the economy similar to those regularly employed for policy analysis at the Fed. In this model, monetary policy not only influences near-term job creation and inflation, but it also affects the probability of a future, job-destroying financial crisis. (Specifically, in the model, low interest rates are assumed to stimulate rapid credit growth, which makes a crisis more likely.)
Indeed a tighter monetary policy during the famous housing bubble of 2005-06 would have probably been associated with lower interest rates, not higher. Thus in a counterfactual where in 2001-03 the Fed had cut rates to 3%, not 1%, the level of interest rates in the 2005-06 bubble would have had to be lower than the actual path of rates, as the economy would have been in depression.
What most caught my attention is that Bernanke comes down strongly in support of his former colleague Lars Svensson, who quit the Riksbank in disgust over its tightening of monetary policy around 2010-11:
Lars Svensson, who discussed the paper at the conference, explained, based on his own experience, why cost-benefit analysis of monetary policy decisions is important. Lars (who was also my colleague for a time at Princeton) served as a deputy governor of the Swedish central bank, the Sveriges Riksbank. In that role, Lars dissented against the Riksbank’s decisions to raise its policy rate in 2010 and 2011, from 25 basis points ultimately to 2 percent, even though inflation was forecast to remain below the Riksbank’s target and unemployment was forecast to remain well above the bank’s estimate of its long-run sustainable rate. Supporters justified the interest-rate increases as a response to financial stability concerns, particularly increased household borrowing and rising house prices. Lars argued at the time that the likely benefits of such actions were far less than the costs. (More recently, using estimates of the effects of monetary policy on the economy published by the Riksbank itself, he showed that the expected benefits of the increases were less than 1 percent of the expected costs). But Lars found little support for his position at the Riksbank and ultimately resigned. In the event, however, the rate increases were followed by declines in inflation and growth in Sweden, as well as continued high unemployment, which forced the Riksbank to bring rates back down. Recently, deflationary pressures have led the Swedish central bank to cut its policy rate to minus 0.25 percent and to begin purchasing small amounts of securities (quantitative easing). Ironically, the policies of the Swedish central bank did not even achieve the goal of reducing real household debt burdens.
When someone leaves an important policy position, where a person is not really free to speak their mind, to blogging, which is all about speaking one’s mind, you quickly learn a great deal about their views on controversial issues. Anyone want to wager with me on what Bernanke and Svensson think of the ECB’s decision to twice raise rates in 2011?
I was only disappointed by one aspect of the post—Bernanke continues to (implicitly) use a conventional measure for the stance of monetary policy.
Despite the substantial improvement in the economy, the Fed’s easy-money policies have been controversial. Initially, detractors focused on the supposed inflation risks of such policies. As time has passed with no sign of inflation, that critique now looks rather threadbare. More recently, opposition to accommodative monetary policy has mostly coalesced around the argument that persistently low nominal interest rates create risks to financial stability, for example, by promoting bubbles in asset prices or stimulating excessive credit creation. (emphasis added)
In 2003, Bernanke correctly pointed out that conventional measures such as interest rates are highly flawed:
The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth. In addition, the value of specific policy indicators can be affected by the nature of the operating regime employed by the central bank, as shown for example in empirical work of mine with Ilian Mihov.
. . .
Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart.
Of course by that criterion (averaging inflation and NGDP growth), money was tighter in 2008-2013 than in any 5 year period since Herbert Hoover was president.