To Control Bubbles, the Fed Needs to First Control Itself

I’ve written before about the Fed’s de facto triple mandate:

1. Low goods-price inflation.
2. Low labor unemployment.
3. 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 the 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.

Comments

[Adam855:]

Interesting thoughts..
Ideally, the Fed would be eliminated altogether, but I think that putting some common sense limitations on it as you describe would definitely help.

I am worried though about this statement: "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."

I agree with the sentiment completely, since I'd rather have the power closer to the people (not in some unelected entity), but the recent behavior of Congress makes me think that the current group would not hesitate to waive those rules every year.
However, I suppose if your suggestions were passed, it goes without saying that Congress would have a different viewpoint at the time.

Jul 12 12:02 PM

[derryl:]

I think David has laid out some realistic first steps at reforming the obviously dysfunctional federal reserve system. If the Fed can't see bubbles forming and can't stop them in any event then the system is failing its mandate.

David: I think excess reserves leak out of banks into assets when Glass-Steagall is revoked and banks can create loans to their investment banks to play the markets.

Also, another option being discussed for controlling inflation (besides raising the Fed funds rate) is countercyclical bank capital requirements. When credit is being created too fast you increase the ratio of capital banks must hold against asset losses, and when credit is being created too slow you reduce the ratio. This puts a hard cap on credit creation whereas the 'market solution' of higher interest rates only 'discourages' credit creation. During bubble manias we are not easily discouraged and interest rate hikes may not be very successful.

Jul 12 02:09 PM

[conceptwizard:]

Already we are at a point in America that the FED has no accountability to the President or the Congress. How can that happen in a democratic society? Why do the American people allow themselves to be controlled by an entity that is not owned by the US? How is it that they have no obligations to release information on the wherabouts of 2 trillion dollars? Why is Obama setting up the FED for even greater powers than they have already? Why wont the FED allow themselves to be audited? How can the Federal reserve step outside their mandate without repercussions?
I want answers to these questions, the American public deserves answers to where their life savings went.
Why is no one accountable?

This has the nasty smell of a conspiracy, no one wants to believe that why not just come clean? If it is a consipacy then it goes clear to the top, as that is where the biggest promoter of the FED sits, at the White House. I would not want to be politically attached to something as controversial as the FED unless I had good reason.

Smelly deal at best

Jul 12 07:59 PM

[nova:]

The Glass-Steagall Act Act separated commercial banks from investment banks. It separated the WallStreet from the Main Street. Commercial banking and the market manipulations should not be allowed under the same roof.

An idea that price inflation and labor unemployment be controlled by the same entity is just ridiculous since these events are self-exclusive. It is of interest that after the recent total and complete failure of centrally-controlled economies all around world, the USA is seriously discussing possibility of such system using for this purposes the FED.

This idea is even more ridicules in light of the fact that socialist centrally-planned economies were controlled by the government agencies representating national interests instead of the FED representing special groups interests.

Jul 12 11:38 PM

[Living4Divi...:]

Terrific article, as usual, David.

As for your statement: "What Fed independence? I don’t see the Fed opposing politicians as it did in the ’50s and ’60s. "

The Fed technically is independent. Volcker proved this when he refused to be a team player. The actions of the Fed depend on who is chosen to run the Fed by the political powers that be.

Jul 13 12:05 PM

[Living4Divi...:]

In response to David's listing of the Feds mandates.
The most recent actions of the Fed has shown that the Fed's mandates are ranked in this order (1 being the most important)
1. Protect the financial system in a crisis.
2. Low labor unemployment.
3. Low goods-price inflation.

1 is far more important than 2. & 2 is far more important than 3.

QUESTION
Anyone disagree? Comments ??

Jul 13 12:08 PM