Courageous Fed has eye on bubble risk

Greg Ip has a column in the WSJ arguing that the decline of potential growth predates the financial crisis and is unlikely to be reversed with demand-side policies. It is a very good read in its own right.  Sorry, there is no link because it is beyond a pay wall.

What caught my attention was this quote from Jerome Powell, which was not central to Greg’s argument, but was — as always — very striking to me:

“A long period of very low interest rates could lead to excessive risk taking and over time to unsustainably high asset prices and credit growth.”

So I guess it is a good thing that the Fed has not presided over a long period of very low interest rates, then!  You can tell from their behavior they take this issue very seriously.

Sarcasm aside, this is certainly absurd on its face.  Every six months or so, including at the last FOMC meeting, the Fed has a discussion of what role monetary policy can play in fighting bubbles. Inevitably, the same verdict comes back.  There is so far no evidence of a dangerous bubble; the first line of defense against a bubble would be macro prudential policies; the associated tools are admittedly weak; and so using monetary policy cannot be totally sworn off, although it is quite unlikely.

Janet Yellen has gone so far as to say that it is not obvious to her that monetary policy should have been different during the mid-2000s, even with the advantage of hindsight on the housing/credit bubble, its collapse, and the ensuing Great Recession.  Yellen’s view here is literally impossible to mistake and has zero nuance. It is probably not that far to the extreme within the FOMC.

The desire to fight bubbles had no effect on the timing of the start of the Fed rate raising program back in December. And it is having no effect on the pace of the tightening. This pace is appropriately quite slow, given developments in unemployment, inflation, and the link from policy rate changes to the economy as well as the asymmetric risks around that. (Incidentally, these complex considerations cannot be collapsed into a policy rule, as we have seen.)

But man is this something they love to talk about. I think one reason for this is that the Fed has trouble saying plainly what they believe: that bubbles are inevitable and that monetary policy is not well suited to fight them.  This is hard to say because the public blames the Fed, in part, for the last crisis and the Fed cannot change that. So to say they refuse to fight bubbles sounds reckless, even if it is just a reflection of how the world works. Instead, they give the concept tons of harmless lip service.

Fighting bubbles is up to Congress, the Executive and its agencies. In a democracy / pluralistic plutocracy, fighting a bubble is never popular because before it is called a bubble it is somebody else’s investment opportunity.

There is a pretty strong lobby against fighting bubbles.  Indeed, it is helpful to that lobby to leave the impression that the job of fighting bubbles is up to the Fed. That way they can rest comfortably knowing nothing will ever get done. For some reason, this super obvious point is not well circulated.  All those guys bellowing about the need for the Fed to fight bubbles? Look into which side of the bubble question their pay is on and how they feel about directed regulation that might actually work at containing whatever bubble they have identified.  Warning: don’t do this if you feel you are already too cynical and don’t want to be made sad.

There is one way that fighting bubbles enters into Fed policy, though. When the Fed has decided on traditional and sensible grounds that it is time to raise interest rates, they will judge it costless to throw into the communication mix that they are doing so partly to fight bubbles. There is a huge cost to the economy in tilting policy away from traditional objectives to fighting bubbles. But there is no cost to the economy in claiming that part of the policy action is to contain bubble risk. So, yeah, very predictably, they will do that. (It is predictable in the sense that I predicted it.)

I would interpret Jerome Powell’s comments in that light.