Federal Reserve Bank of St. Louis president Jim Bullard recently noted an important debate within the Fed about how to respond to financial bubbles. Reacting to a speech by Federal Reserve governor Jeremy Stein, President Bullard said “My main takeaway … was that he pushed back against the Bernanke doctrine … that we’re going to use monetary policy to deal with normal macroeconomic concerns, and … regulatory policies to try to contain financial excess.” Stein argues that regulatory policy will not always work to curb financial excess, and that interest rate increases may be needed instead. As Bullard says, “raising interest rates is a way to get into all the corners of the financial markets that you might not be able to see, or you might not be able to attack with the regulatory approach.”
The Federal Reserve has evolved quite a bit on this issue since the pre-bubble days of the Greenspan doctrine. Chairman Greenspan believed that bubbles are hard to detect, and that there was little need to respond to bubbles in any case since the Fed can always limit the damage after a bubble pops. Why take the chance of falsely identifying a bubble and slowing the economy unnecessarily when there is little cost to allowing bubbles to run their course?
Federal Reserve governor and vice-chair Janet Yellen endorsed the Greenspan doctrine in September 2005: “the … decision to deflate an asset price bubble rests on positive answers to three questions. First, if the bubble were to collapse on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble? My answers … are, ‘no,’ ’no,’ and ‘no.’”
She deserves credit for at least recognizing the housing bubble, and for her change of mind in 2009 after bubbles proved far costlier than the Greenspan doctrine assumed: “…it is now patently obvious that not dealing with some bubbles can have grave consequences..., in my view, recent painful experience strengthens the case for using such policies, especially when a credit boom is the driving factor.”
The Fed has come to this realization more generally, and both the Bernanke and Stein approaches assume the Fed will respond to signs of overheating in asset markets. But which approach is best, the targeted, regulatory- based approach that Bernanke prefers, or the broad-based approach of slowing all markets with interest rate increases that Stein argues is often necessary?
An approach that successfully attacks and limits the problem to specific markets is certainly best, the question is whether such an approach is feasible. Can we identify bubbles in particular markets with sufficient precision to allow this approach to work?
The difficulty in measuring risk levels in financial markets is highlighted in Governor Stein’s speech, but bubble detection may not be as hard as it’s portrayed. As the quote from Janet Yellen makes clear, she knew or at least strongly suspected that a housing bubble was inflating in 2005, and others recognized the bubble as well. The problem wasn’t a lack of data pointing to the risks, it was the inability of far too many policymakers to interpret the data correctly.
It may have also been the unwillingness to take a highly unpopular policy stance. If policymakers at the Fed had taken action against the bubble in housing markets in 2005, they would have been severely criticized for killing the boom, harming long-run growth, causing people to lose their jobs, and so on. And it won’t be any different the next time. The mania that allows bubbles to inflate in the first place assures that the Fed will face strong resistance to any attempt to temper an asset-price boom. In that environment, it’s easy for policymakers to find excuses for inaction or to deny that a bubble even exists. The courage to assert the Fed’s independence and stand-up to the intense pressure is essential.
Both Ben Bernanke and Jeremy Stein agree that overheated asset markets are not a big worry right now, and that unemployment is a much bigger concern. But someday another asset-price bubble will appear, and the Fed will once again be tempted to look for reasons to avoid policies that would bring a storm of criticism.
Perhaps this can be fixed. Central bankers seem to be selected in part for their ability to hold the line on inflation despite public and political pressure to pursue more expansionary policies. But inflation hawkishness in the face of pressure has been an impediment to effective monetary policy during the crisis, particularly in Europe. Perhaps it’s time to worry less about the ability of “conservative” central bankers to hold the line on inflation, and more about their willingness to stand up to the intense industry, political, and public pressure they face when they try to address problems in financial markets.