Monetary PC

At Chicago Booth School’s US Monetary Policy Forum in NY on Friday, former Fed Chairman Ben Bernanke delivered a much deserved and long overdue smackdown of the financial stability hairshirts.

The context was discussion of the main paper by Hamilton et al, which argues that uncertainty about the location of equilibrium fed funds rate means that the Fed should delay the beginning of its rates renormalization program, in order to avoid having to return to zero, but should then tighten more quickly than would be appropriate if they had started sooner.

The President of the Federal Reserve Bank of Cleveland, Loretta Mester, noted that the paper’s policy prescription was biased in a dovish direction because it did not take account of the need to incorporate so-called “financial stability” considerations. This set up the wonderful smackdown by Bernanke, who noted in a lunch address that he knew of no historical example where monetary policy had been directed at managing financial instability risks and been successful doing so.

The problem is not that financial instability does not matter.  We all still have fresh memories of the giant credit bubble from the mid-2000s and the global financial crisis that attended its bursting. The problem is that the Fed cannot ward off all bad things, and monetary policy is particularly ill-suited to containing bubbles.  Small deviations of policy away from the pursuit of employment and price objectives don’t work at containing bubbles. And larger deviations are implausible because they deliver too much collateral damage to the economy.

To me, an interesting question is why people often seem to believe – or to claim to believe – otherwise.  We might say there are three groups of people involved here.

I would call the first group mistaken but sincerely so. They honestly believe that incipient bubbles are sensitive to small deviations of policy interest rates and that monetary policy can therefore lean into the financial wind without doing too much damage to the economy.  I do not agree with these people, but I know from personal experience – having met several – that they exist.

The second group includes the financial hairshirts mentioned above. They cast about for any reason at all to raise interest rates, either because they have a partisan interest in delaying a full recovery of the labor market or because they have a homely pre-analytical sense that zero interest rates are abnormal, something their fathers and grandmother’s did not experience.  People who hold this view sometimes literally describe low interest rates as “unnatural”, as if innocent of the fact that money is a social convention and that monetary policy is therefore inevitably unnatural. If we want “natural”, we are all going to have a much lower standard of living. So I guess we don’t really want natural.

The third group is the Fed leadership itself. They paid too little attention to the inflation of the credit bubble during the mid-2000s.  And as the resulting subprime crisis began to unfold, Ben Bernanke made that extremely unfortunate claim that subprime was “contained.”  With that very awkward history front of mind, the Fed leadership is simply not in a position to state clearly that they have no intention of allowing monetary policy to be distracted by the pursuit of financial stability, which is a worth objective, but not something monetary policy can make much contribution towards, beyond delivering on the conventional goals.

Accordingly, the leadership comes out with bromides, like the idea that they will use “macroprudential” policy to fight bubbles or the claim that they might in the future be willing to use monetary policy if conditions required, which inevitably they do not quite yet.  One problem with the macroprudential red herring is that people can figure out that the macroprudential tools are weak and then they infer – wrongly – that the Fed will end up having to resort to monetary policy.

But there is no reason to believe the Fed will ever be so distracted, because the leadership actually believes what Ben Bernanke believes.  They are not yet at liberty to say it, but they will be when they too retire from the Fed.

In any case, it is now too late for the financial stability argument to be the true justification for a funds rate renormalization, because the case for that program to begin on purely conventional grounds has almost arrived. Still, when the Fed does pull the trigger and raises rates, they may throw a bone to the hairshirts and claim they are doing so partly on “financial stability” grounds – as well as because they truly love America.

That may not satisfy the hairshirts, who will realize that they lost the debate in 2010, 2011, 2012, 2013 and 2014. But it may convince onlookers that the hairshirts had some influence in the debate.  People seem to be quite gullible on this point.

If monetary policy cannot be used to contain bubbles, then what is to be done? The practical answer, sadly, is probably nothing.  The dirty little secret of the financial stability debate is that it is not really a “technical” problem. If our political culture had the stones actually to identify an incipient bubble and to accept the costs to special interests of containing that bubble, then the offending financial activities could easily be shut down by legislation.

But we don’t have the stones, because we are too deferential to the idea that markets basically work and that bureaucrats should not go around sticking their nose into the market process. We effectively believe this and act on the belief right up until the crisis comes, and then all suffer amnesia.

Indeed, this brings me to the main practical cost of the mistaken view that monetary policy can be used to contain bubbles. It is a too convenient excuse for having an honest discussion.  To say the Fed shuld stop blowing bubbles is a meaningless applause line that costs the speaker nothing and makes him responsible for nothing.  Standing up in Congress and proposing to shut down some specifically offending financial practice, in contrast, takes actual courage. And it will not happen.

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