The view that monetary policy should take financial stability concerns into account is gaining support within the FOMC and we expect soon-to-be Chairman Powell shares this view. At this point, we don’t expect monetary policy to tighten more rapidly as a result of these concerns. But they are already affecting the views of appropriate policy for some participants. Today, financial stability concerns come into play as reinforcing the case that the economy was otherwise already for another rate hike. Still, at the margin, in a close call, financial stability concerns could tilt the Committee to raise rates rather than pause.
Under Greenspan, there was a clear and unambiguous institutional view about whether monetary policy should take into account emerging financial stability concerns: Don’t do it! Under Bernanke and Yellen, the official view evolved: The Federal Reserve has an important role in containing financial stability risks, but Bernanke said the first line of defense is macroprudential policy and Yellen said using monetary policy would be the “last resort.” The focus has been on macroprudential policy because the Fed’s concern has principally been about “systemic” risk which, in turn, is associated with the largest, most complex banking and other financial institutions. Former Governor Jeremy Stein offered a wider perspective on financial stability risks that the Fed should be concerned about: risks arising from excessive risk-taking in markets. Even if these risks might not rise to a systemic proportion, the reversal of asset valuations that are substantially out of line with fundamentals can nevertheless do considerable damage to the macroeconomy. That view elevates the role of monetary policy in taking financial stability concerns into account and is gaining support within the FOMC. Importantly, Powell shares this view.
There appears to be a split within the Committee today about whether monetary policy should respond to emerging financial stability risks. We have moved from the extreme of “never,” to a “second line of defense”, to a “last resort,” and now to a more serious consideration of a role of monetary policy when there are emerging financial stability risks. First, maintaining rates low for a long time is, in the first place, a recipe for excessive risk-taking and asset overvaluation that increases the risk of damaging the macroeconomy when and if they quickly reverse. So, the monetary policy itself can be a source of rising financial stability risks. In this view, gaining support within the Committee, monetary policy should begin to withdraw accommodation sooner and proceed more steadily to lean against imbalances emerging and building in the first place. To wait until the asset valuations become truly dangerous risk simply making the Fed culpable for a disruptive tightening of financial conditions that otherwise might have happened anyway. Not only must the FOMC promote the dual mandate today, but also avoid sharp departures in the future that would become more likely if financial stability risks build to dangerous proportions.
Today, the widespread view is there are over-valuations in many asset markets, though not yet large enough to pose dangers to the macroeconomy. Still, the more hawkish members typically reinforce their case for a hike, or argue for a hike instead of a pause, by citing the risk of financial imbalances becoming dangerously large. We may hear this more often and more forcefully in 2018. At the margin, this consideration pushes the Committee to continue withdrawing accommodation steadily.
Chairman Powell: Echoes of Stein
We, of course, want to give special attention to the views of the new Chairman, Jay Powell. The recently released FOMC transcripts for 2012 reveal the degree to which financial stability concerns affected his views of appropriate policy even late in 2012. To him, financial stability concerns were “flashing red” (December 2012), which led him to be more cautious about asset purchases than many of his colleagues, especially Janet Yellen. He associated his views with Governor Stein.
I think we are actually at a point of encouraging risk-taking, and that should give us pause…we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.
Macroprudential and other supervisory policies are designed to reduce both the likelihood of such an outcome and the severity of the consequences if it does occur. But it is not certain that these tools would prove adequate in a financial system in which much intermediation takes place outside the regulated banking sector. Thus, developments along these lines could ultimately present a difficult set of tradeoffs for monetary policy.1
Below, we set out the views about the role of monetary policy in responding to emerging financial stability, in their own words, from the past three Chairs and other FOMC members, This will provide a sense of the evolution of views over this period and where the Committee is today.
Greenspan: Don’t Do It!
The degree of monetary tightening that would be required to contain or offset a bubble of any substantial dimension appears to be so great as to risk an unacceptable amount of collateral damage to the wider economy.
Do we have the capability to eliminate booms and busts?… The answer, in my judgment, is no…Indeed, were we to lower overnight rates in advance of expected break-in asset prices, we would, presumably, only exacerbate the economic and financial imbalances. Our only realistic alternative is to lean against the economic pressures that may accompany a rise in asset prices, bubble or not, and address forcefully the consequences of a sharp deflation of asset prices.
Bernanke: The Second Line of Defense
Although in principle, monetary policy can be used to address financial imbalances, the presumption remains that macroprudential tools, together with well-focused traditional regulation and supervision, should serve as the first line of defense against emerging threats to financial stability.
1 Governor Jerome H. Powell, “Recent Economic Developments, the Productive Potential of the Economy, and Monetary Policy,” At the Peterson Institute for International Economics, Washington, D.C., May 26, 2016.
This is sometimes called the “separation principle”: There are two problems, macro performance (the dual mandate) and financial stability; and two instruments, monetary policy for the dual mandate and macroprudential policy for financial stability.
Even putting aside the great difficulty of identifying bubbles in asset prices, monetary policy cannot be directed finely enough to guide asset prices without risking severe collateral damage to the economy.
Yellen: A “Last Resort”
Tighter monetary policy would have been a very blunt tool: Substantially mitigating the emerging financial vulnerabilities through higher interest rates would have had sizable adverse effects in terms of higher unemployment.
Calibrating the magnitude of a monetary policy response to address financial imbalances–even assuming that these can be identified at an early stage–is difficult at best given the bluntness of the monetary policy tool and the uncertain lags with which it operates. For these reasons, the use of monetary policy to address financial imbalances should generally remain the last resort.
Jeremy Stein: In Principle, Yes, But Operationally Challenging
Should financial stability concerns, in principle, influence monetary policy decisions? …In my view, the theoretical answer is a clear “yes.” 2
I am going to try to make the case that, all else being equal, monetary policy should be less accommodative- -by which I mean that it should be willing to tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level–when estimates of risk premiums in the bond market are abnormally low.
The credit risk premium… maybe an operationally useful measure of financial market vulnerability. When this risk premium is low, there is a greater probability of a subsequent upward spike in credit spreads. Moreover, such upward spikes, when they do occur, are associated with significant adverse economic effects.
To be clear, we are not necessarily talking about once-in-a-generation financial crises here, with major financial institutions teetering on the brink of failure. Nevertheless, the evidence suggests that even more modest capital market disruptions may have consequences that are large enough to warrant consideration when formulating monetary policy. If so, the indicated directional adjustment would be to be less aggressive in providing monetary accommodation in the face of above-target unemployment, all else being equal when risk premiums are abnormally low.
2 Governor Jeremy C. Stein, “Incorporating Financial Stability Considerations into a Monetary Policy Framework, “At the International Research Forum on Monetary Policy, Washington, D.C., March 21, 2014.
The scope of our regulatory authority does not extend equally to all parts of the financial system…While the 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.3
I am taking a capital-markets-centric view of financial stability, as opposed to a purely intermediary-centric view.
Rumblings on the Committee
A number of other participants have revealed their views on whether monetary policy should take the emerging risk to financial stability into account when setting monetary policy. Split decision, but several say that it should. A “yes” signifies that the participants see a meaningful role for monetary policy in responding to emerging financial stability risks.
My view is that low-interest rates tend to feed bubble processes. The Fed should hedge against the possibility of a third major macroeconomic bubble in the coming years by shading interest rates somewhat higher than otherwise. The benefit would be a longer, more stable economic expansion.
We need to be very watchful to see if our monetary policy regime is creating financial stability issues. A lot of people think there’s monetary policy and then there’s financial instability over here. I think monetary policy and financial stability are joined together. So of course we care about financial stability in terms of the conduct of monetary policy.
Our short-term interest rate tools are too blunt to have a significant effect on those pockets of the financial system prone to inappropriate risk-taking without, at the same time, significantly damaging other markets, as well as the growth prospects for the economy as a whole. Therefore, stepping away from otherwise appropriate monetary policy to address potential financial stability risks would degrade progress towards maximum employment and price stability. This approach would be a poor choice if other tools are available, at lower social costs, to address financial stability risks.
Harker: Leans toward No
I would never say never. I think in my mind, it doesn’t make sense to take a tool off the table and say you’ll never, ever use it, because you never know what you’re going to face in life. That said, there’s a pretty high bar for me to consider using that tool as opposed to other macro-prudential tools.
3 Governor Jeremy C. Stein, “Overheating in Credit Markets: Origins, Measurement, and Policy Responses,” At the “Restoring Household Financial Stability after the Great Recession: Why Household Balance Sheets Matter” research symposium sponsored by the Federal Reserve Bank of St. Louis, St. Louis, Missouri, February 07, 2013.
Kaplan said he had decided to support higher rates (in December) from a “risk management point of view”, with an eye on potential financial imbalances: While I would prefer to rely primarily on macroprudential policy tools to manage financial imbalances, I am nevertheless monitoring various measures of potential financial excess. I monitor these and other market measures because I am aware that, as excesses build, we are more vulnerable to reversals which have the potential to cause a rapid tightening in financial conditions, which in turn, can lead to slowing in economic activity.
Really we have a third mandate and the third mandate is financial stability.
U.S monetary policy should remain focused on promoting price stability and maximum employment, and financial stability should not be added as a third objective for monetary policy. First, it isn’t clear that monetary policy would be very effective against emerging financial stability risks. While interest rates affect the fundamental value of assets, it is not clear that they affect the speculative or bubble portion; the impact may depend on the underlying nature of the financial imbalance. Second, monetary policy tends to be a blunt instrument, so any benefits of using it to stem financial imbalances, mispricing of assets, or excessive leverage need to be weighed against the economic costs in terms of price stability and employment.
The financial stability concerns that could arise from a low interest rate policy continuing for an extended period of time should be considered in conjunction with how best to achieve the dual mandate goals, now and over time.
I am unconvinced that monetary policy should be used as an explicit tool [for stabilizing financial markets]. The tradeoffs are not favorable at all.