Fed Policymakers Split on Question of Deflating Asset Bubbles With Rate Hikes

Oct 2 2015 | 7:16pm ET

By Jonathan Spicer (Reuters) - The question of whether the Federal Reserve should adjust interest rates to deflate risky financial market bubbles split some of its top policymakers on Friday, suggesting the controversial idea is re-emerging as the U.S. central bank approaches an historic policy tightening.

Giving the central bank an effective third mandate - beyond its formal objectives for inflation and employment - has won more adherents since the 2007-2009 financial crisis, which some blame in part on too-easy monetary policy in the preceding years that allowed risks to take root.

As the Fed approaches its first rate hike in nearly a decade, which could come this year, one reason to act sooner than later is to head off any brewing instabilities in risky corners of financial markets like leveraged loans, high-yield debt and even automobile lending.

So far the Fed's approach has been to use targeted financial regulations and supervision of banks and other firms - so-called macroprudential tools - to head off any emerging risks that could harm the broader economy. Monetary policy has been reserved for achieving the goals of 2-percent inflation and maximum stable employment.

But Fed officials discuss financial stability quite frequently in their meetings and those discussions already do influence policy decisions, according to a paper co-authored by Boston Fed President Eric Rosengren.

"There are reasons to believe that financial stability should be an explicit consideration of monetary policymakers," concluded the paper, published Friday at a Boston Fed conference on financial stability that was attended by central bankers from around the world.

Rosengren, among the dovish Fed officials who prefers to keep rates low to boost employment, called the research "an initial foray into this area ... but it does capture I think the way we seem to behave."

He urged his colleagues to think outside the inflation-and-employment box, noting that problems like income inequality, political gridlock, and years of rock-bottom rates globally seem "much more intractable now."

The paper was based on the number of times Fed officials mentioned terms related to financial stability in policy meetings from 1987 through 2009, the latest year for which transcripts are available. References spiked in the late-1990s technology bubble and again in the recent crisis, it found, with for example "stock market" referenced 1,210 times, "bust" 982 times, "volatility" 853 times, and "froth" 30 times.

Concerns have grown about possible bubbles in the financial system as policymakers consider when to begin raising rates after nearly seven years near zero, with Fed Chair Janet Yellen and most others predicting the move will happen later this year.

Yellen and others have publicly worried that keeping borrowing costs too low for too long can fuel too much risk-taking by investors and possibly destabilize the economy.

Fed Vice Chairman Stanley Fischer said it may be left to monetary policy to bear responsibility for financial stability, even though interest rates are a blunt tool.

"The limited macroprudential toolkit ... leads me to conclude that there may be times when adjustments to monetary policy should be discussed as a means to curb risks to financial stability," Fischer said.


While the Fed is bound by the 2010 Dodd-Frank financial reform law to defend against risks to the financial system as a whole, it has generally interpreted that to mean directly supervising banks and other financial institutions, and writing tougher rules on things like capital standards.

The Boston conference, and Rosengren's paper, appeared to sharpen the divide on the role of interest rates.

Narayana Kocherlakota, another dove and the head of the Minneapolis Fed, came out strongly against adding the goal of stabilizing the financial system to the central bank's list of duties, saying that doing so would add to existing public uncertainty over the Fed's two main goals, which are enshrined in U.S. law.

Financial stability should only concern the setting of rates to the extent that it interferes with hitting inflation and employment goals, he said.

Cleveland Fed President Loretta Mester and Donald Kohn, a former Fed vice chair, sided with Kocherlakota on the traditional side, with Kohn arguing that interest rates are not likely to be very effective in tackling build-ups in leverage or mismatches in liquidity.

Policy changes would need to be quite large to have any impact, while the costs to inflation and employment "could be quite large," Kohn said. It would be "pretty adverse for monetary policy" and should only be used as a "last line of defense if financial stability is threatened," he added.

Mester cautioned that monetary and macroprudential policy discussions should probably be separated to protect the central bank's cherished independence.

"If effective monetary policy means taking away the punch bowl just as the party gets going, then effective financial stability policy might mean taking away the punch bowl before the guests have even arrived because the risks to financial stability build up over time and action likely needs to be taken earlier in order to be effective," she said.

The Bank of England has a formal financial stability mandate, while central banks in several emerging markets informally tailor their monetary policies to that end.

The U.S. central bank is still struggling to figure out its new role of ensuring financial stability, said Randall Kroszner, who was a Fed governor during the crisis.

"We don't want to have central banks to prevent risk-taking from occurring," he said. "It's a much trickier issue."

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