Governor Jeremy Stein of the St. Louis Federal Reserve gave a speech on February 7 called “Overheating in Credit Markets: Origins, Measurement, and Policy Responses.” Overheating is a term he uses to describe a credit market with low interest rates, lax lending standards, and high risk-taking by investors “reaching for yield.” The problem with overheating is that it can contribute to financial instability. A boom followed by a bust can create harmful spillovers for the economy.
Both monetary policy and regulatory policy can potentially address overheating. In the speech, Stein describes an approach called decoupling, which holds that monetary policy should restrict its attention to the goals of price stability and maximum employment, while supervisory and regulatory tools should be used to safeguard financial stability. Stein does not completely buy this decoupling approach. He recognizes that low interest rates are a cause of overheating, and that the Fed, by its power to control interest rates, can address overheating in ways that regulators cannot.
I believe it will be important to keep an open mind and avoid adhering to the decoupling philosophy too rigidly… I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability…Supervisory and regulatory tools remain imperfect in their ability to promptly address many sorts of financial stability concerns…While monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation–namely that it gets in all of the cracks. The one thing that a commercial bank, a broker-dealer, an offshore hedge fund, and a special purpose ABCP vehicle have in common is that they all face the same set of market interest rates. To the extent that market rates exert an influence on risk appetite, or on the incentives to engage in maturity transformation, changes in rates may reach into corners of the market that supervision and regulation cannot.
In the New York Times, Binyamin Applebaum writes that Stein’s speech “underscored that the Fed increasingly regards bubbles, rather than inflation, as the most likely negative consequence of its efforts to reduce unemployment by stimulating growth.” In fact, the Fed’s concern about bubbles is not so new. After the Great Depression, it was widely believed that the stock market overheated in the 1920s, leading to the Great Crash in 1929 and the onset of the Depression. In those days, the word for bubbles or overheating was speculation, and it became a dirty word indeed. After the Great Depression, speculation remained a major concern of the Fed. The Fed very explicitly regarded bubbles as the most likely negative consequence of its efforts to reduce unemployment by stimulating growth.
For example, the United States economy was in a recession in 1953-54. In 1955, as the economy was recovering, the minutes from the Federal Open Market Committee refer multiple times to concerns about “speculative developments” or “speculative excesses.” The March 2 minutes note:
The critical problem for credit and monetary policy in the United States, the review [from the Board’s Division of Research and Statistics and Division of International Finance] said, was how to thread its way along the narrow ledge that encourages sound economic growth and high employment and, at the same time, limits speculative developments and discourages financial over commitments by businesses and consumers.
Minutes from May 10, 1955 say:
Business, financial, and consumer confidence is extraordinarily high–possibly too high for sound growth. At this stage, the task of monetary and credit policy is to foster stable growth in line with expanding manpower and industrial resources, at the same time restraining financial over-commitments and dampening speculative excesses.
In 1958, William Phillips published “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom.” This really kicked off the now-common idea that inflation is the most likely negative consequence of the Fed’s efforts to reduce unemployment. If the Fed is now starting to regard bubbles, rather than inflation, as the most likely negative consequence of its efforts to reduce unemployment, this is not a new trend. It is history of thought repeating itself.