To Control Bubbles, the Fed Must First Control Itself
I’ve written before about the Fed’s de facto triple mandate:
- Low goods-price inflation.
- Low labor unemployment.
- Protect the financial system in a crisis.
Number 3 is the implicit obligation of the Fed, for several reasons:
- The Fed carries out monetary policy (in ordinary times) through the banks.
- Banks in the Federal Reserve System have close ties to the regional Federal Reserve Banks.
- Bankers and those sympathetic to bankers comprise a large portion of the leadership and staff of the Federal Reserve.
- Regulating banks gives jobs to many at the Fed.
Stepping back, let me tell you a story. In the mid-90s, I became worried about inflation going out of control again, given the degree of monetary growth that I saw. I’m not sure where I got the idea, but eventually it struck me that in the ’70s, when inflation was running hot, we had a lot of spenders and few savers. In the ’90s, more savers and fewer spenders. (You have to add in agents of the baby boomers, including the defined benefit plans, and the growth in 401(k)s, and products like them.) Goods weren’t inflating from excess money, assets were being inflated as the baby boomers were socking away funds for retirement.
(Note to stock investors: be wary when market P/Es rise dramatically — there are limits to what is reasonable in P/Es for any level of corporate bond yields. This applies to price-to-book and -sales ratios as well.)
As one more example of how monetary policy affects the asset markets, consider how the Fed temporarily flooded the banks with liquidity to avert problems regarding Y2K, and the stock markets reacted to the excess liquidity with a two month lag. The Fed helped put in the top of the tech bubble. I don’t know how the money leaked out of the banks to the stock market, but excess reserves under good conditions will produce loans.
Thus, I came to the conclusion that the Fed ought to look at asset inflation as well as goods inflation somewhere in the late ’90s. But doesn’t the implicit third mandate cover that? Alas, no, the third mandate is reactive, not proactive. It kicks in after a crisis hits — Greenspan then floods the market with liquidity, and only steps back when things are running hot again.
A proactive policy would limit the degree of easing that the FOMC could do — once the spread of ten-year Treasuries over two-year Treasuries exceeds 1%, all easing would stop. The banks can easily make money with a yield curve that steep… not much money, but enough to keep them alive (the financial sector would shrink under these rules). There would be a second rule that when he spread of ten-year Treasuries over two-year Treasuries is less than 0%, all tightening would stop. During times of extreme inflation or unemployment, these rules could be waived by Congress for a year at a time. But that lays the policy back at the door of Congress, which represents the people and the states, where the decision belongs.
A policy like this eliminates the risk that the Fed can steepen the yield curve dramatically, leading to bubble creation — the excess credit has to go somewhere. Another limit on the Fed could be a limit on total leverage in the economy — above a certain limit, such as 2x GDP, the Fed raises the Fed funds rate, regardless of the unemployment situation, until indebtedness falls.
Bubbles are financing phenomena. Controlling bubbles can be done by controlling credit, and that is what the Fed tries to do — control credit, which is money in our era. (Until we go back to something better, and get the government out of the money business — some sort of commodity standard.)
The present Fed holding action inflates assets not goods. By offering financing to asset markets that are in disarray, it supports asset prices. For now, none of that balance sheet expansion leaks out to the general public, and thus, little goods inflation. But also, little true stimulus.
In short, the Fed should limit its powers to reliquefy the economy, because sloppy efforts in the past 25 years produced the popped bubbles that we are now dealing with. Better to leave policy tight longer, and not loosen so much in troubles. Don’t worry, we might have to wait longer for recovery, but the recoveries will be sounder when they come.
Parting Shots
- Can the Federal Reserve spot bubbles? I think so, but it cuts against their unemployment mandate. They would need to keep policy much tighter in good times.
- Would it threaten Fed independence? What Fed independence? I don’t see the Fed opposing politicians as it did in the ’50s and ’60s.
- Mishkin is too optimistic about the competency of the Fed, given its past failures that created bubbles.
- Finally, the chief economist at the Bank of International Settlements gets proven right, as he predicted the bubble that we got into.
- My view is, since the Fed is the major creator of the bubbles, let them be the systemic risk regulator, and then limit their powers of easing monetary policy. (It would be better to move to a commodity standard, but that’s not on the table now.) Make the third policy goal of the Fed explicit, and ask them to preserve the banks solvency in the long run, though not necessarily the short run.
July 12th, 20098:52 am at
I was a member of a Los Angeles financial group that debated the Fed’s including asset prices in its “inflation” measures. In about 1999, we came to a consensus, it should; the Fed was creating too much money. The bubble showed up in Tech stocks as opposed to consumables, therefore the Fed claims it didn’t see it. We said it didn’t mean the Fed wasn’t creating too much money, that which asset prices increased was irrelevant to Fed policy. Further, that the failure to include asset prices in the “price level” was a political decision.
July 12th, 200912:29 pm at
The fed “independence” scam… independent of whom? the people, of course, contrary to intention of founders. and constituiontal congressional monetary “purse” powers.
Murray Rothbard (History of Banking) in his very last book – The Case Against The Fed – had it right
when he stated:
“If government becomes ‘independent of politics’ it can only mean that that sphere of government becomes an absolute self-perpetuating oligarchy.”
Ruthless, self-serving, monetary Oligarchy is what we have. Time to take back the “Fed”
Kent Welton,
PublicCentralBank.com
July 13th, 20092:00 am at
There is a reason Greenspan once said he would not prevent bubbles even if he knew how. In the 1980’s, when the government was faced with bankruptcy from the costs of Social Security and Medicare, the government failed to act and Greenspan instead falsified the CPI to reduce the expense of the Cost of Living adjustments to those benefits.
This also created a hidden inflation and a hidden stimulus to the economy. It also removed the Fed’s tools for regulating the economy. It can’t raise interest rates to fight the inflation it claims is very low. There are similar problems with it’s monetary tools.
The only thing regulating this overstimulated economy is bursting asset bubbles letting off some pressure.
The Fed is not interested in any real measure of inflation because that would send the U.S. into bankruptcy because of Social Security and Medicare. We’re stuck with either bubbles or bankruptcy.
The financial sector (including business executives who earn based on stock price and financing deals instead of production) are making fortunes by understanding there is a forced inflation. No wonder the financial setor has grown so much in recent years.
July 13th, 200910:48 am at
How naive can you possibly be? The first two mandates are just cover for the Fed’s true mandate — save the banks when they (inevitably) need saving. The whole Fed regional bank structure is a farce intended to create a false of impression of some interest in regional America. The fed is interested in only one region and it runs from the East River to the Hudson River acress Wall Street.
July 14th, 20091:48 am at
Can you make a cogent argument to support: “Until we go back to something better, and get the government out of the money business — some sort of commodity standard.”? I’m intrigued by the idea of a “harder” monetary base, though I’ve yet to hear someone who isn’t clearly crazy attempt to make a rational case. I’m generally dismissive of the gold standard kooks as 19th century panics (and crushing deflation) is pretty convincing evidence that a gold standard is no more and potentially much less stable than fiat currency. A commodity basket approach…maybe works?