The Fed's 'Blunt Instrument' Drives Financial Instability
If you were to give Federal Reserve policy makers a word-association test, their answers would be fairly predictable. Say the word inflation, and the response would be: monetary policy. Unemployment? Monetary policy. Financial instability? Macroprudential regulation.
In fact, every time the subject of financial instability comes up, as it has in recent reports from the International Monetary Fund and Bank for International Settlements, most Fed officials insist that monetary policy is a blunt instrument; that raising interest rates to rein in asset prices, reduce the use of leverage and decrease reliance on short-term funding would have adverse effects in terms of higher unemployment.
When was the last time you heard a central banker use the blunt-instrument argument as a reason not to lower interest rates? The goal of accommodative monetary policy may be to stimulate demand, but it encourages the kind of risk-taking and debt accumulation that leads to financial instability.
The Fed is fond of saying that monetary policy at the zero lower bound works by forcing investors to take risks and reach for yield, buying assets such as corporate and high-yield bonds, stocks and collateralized debt obligations. If you prefer a more traditional explanation of how monetary policy works, the central bank lowers interest rates, which reduces the incentive to save and (typically) spurs borrowing and spending. Either way -- by design or as a side-effect -- risk-taking is the result.
And it's a risk the Fed seems willing to take. In its June 29 annual report, the BIS said that such an asymmetric bias to policy - a failure to lean against booms and aggressive easing during busts - "induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy." Over time, these policies may lose their effectiveness and foster "the very conditions they seek to prevent," according to the report.
No one is suggesting Congress impose another legislative mandate on the Fed to complement full employment and price stability. Nor is the BIS advocating a finger-to-the-wind approach for central bankers to identify "froth" in asset markets, to quote that great wordsmith, Alan Greenspan. To the contrary, BIS economist Claudio Borio has developed metrics to assess the build-up of systemic risk.
Recent experience, including the depth and duration of the Great Recession and its lingering hangover, should raise the Fed's awareness of the potency of monetary policy in driving asset prices and the important role the financial cycle plays in the business cycle. Relying on regulation, dressed up as "macroprudential" nowadays, to contain the excesses is the equivalent of trying to apply the brakes with the other foot planted on the gas pedal.
This isn't to say the Fed is blasé about asset prices, leverage and financial excesses. Regulators have increased capital adequacy requirements and designed stress tests for banks deemed systemically important financial institutions. Basel III introduces a countercyclical capital buffer.
Yet a brief history of lending excesses over the last few decades - loans to Latin America's less developed countries (1980s), which morphed into Asia's emerging markets (1990s); commercial real estate loans (late 1980s); loans to Internet and technology companies (late 1990s) and to subprime borrowers (2000s) -- would make a reasonable person skeptical of the ability of regulators to prevent the next crisis.
In many cases, it was the regulators, not the lack of regulations, that bore responsibility. Harry Markopolos hand-delivered evidence of Bernie Madoff's Ponzi scheme to the Securities and Exchange Commission five times over eight years before the fraud was exposed. Until human nature changes, or until regulators' incentives to enforce the rules trump the benefits of regulatory capture, central bankers will eventually learn to associate financial instability with monetary policy.