Examining the Fed’s Role in Financial Stability
As the economy continues to recover from the 2008 financial crisis, a few advocates are pressuring the Federal Reserve Board to take a more active role in ensuring the stability of the financial system. Fed Governor Jeremy Stein has warned that the current policy of indefinite low interest rates to help drive growth may inadvertently produce distortion in financial markets. Stein and his supporters believe the Fed should be more concerned about the emergence of asset bubbles, even if taking corrective actions means compromising on the traditional goals of maximum employment and two percent inflation.
In retrospect, every financial crisis is preventable. Many economists believe the Fed should have done more to defuse the mortgage bubble during the run-up to the last financial crisis. The Fed’s power to tighten the currency supply is a formidable tool that can be used to pop financial bubbles before they reach large proportions—by curbing speculation with a well-timed interest rate hike, for example.
Identifying asset bubbles as they inflate, however, is more challenging than spotting them in hindsight. It’s highly unlikely that speculative investment will ever disappear entirely, and the Fed’s economists are unlikely to reach a timely consensus that any particular distortion in asset prices poses an immediate threat to the stability of financial markets in time to prevent any future bubble.
The current distortion fear—that the indefinite continuation of low interest rates has weakened discipline in the bond market by driving risk premiums to negligible levels—is unlikely to produce widespread alarm among the Board of Governors. Even if current interest rate policies are encouraging unwarranted speculation, most of Governor Stein’s colleagues are skeptical that worries about as-yet unseen asset bubbles should trump the troubles of the unemployed.
The traditional goals will likely stand. Inflation and employment, unlike asset bubbles, are easily tracked and inarguably very important to the real economy. If the Fed were to adopt an additional goal of maintaining financial stability and preventing asset bubbles, the Governors would be hard-pressed to come to an agreement that objective measures of growth should be secondary to subjective worries about market distortion.
The current concern over artificially-low interest rates inflating asset prices will likely dissipate on its own. As the recovery continues, the Fed will further clarify its timeline for increasing interest rates, and corresponding bond yields will slowly rise towards normal levels. Although few would argue the Fed should ignore the lessons of the past, the relationship between monetary policy and financial instability will likely remain an argument fought in hindsight and not actively engaged during an economic recovery.