The Federal Reserve’s job is to maintain economic growth via its so-called dual mandate, which was set by Congress, with the goal of maximizing employment and stabilizing prices. But many people believe that the Fed should have a third job — to keep financial markets from spinning out of control.
This idea manifests itself in the periodic calls for the Fed to hike interest rates to pop asset bubbles before they get too big. It is evident whenever people worry that zero interest rates are causing financial instability or a reach for yield — taking on lots of risk to boost returns. It is implicit in the idea that rising stock prices during the era of quantitative easing represented asset price inflation, even though assets are not traditionally part of how economists measure inflation. And it can be seen in the fairly common belief that the crisis of 2008 was caused by interest rates being kept too low for too long. The idea that the Fed should raise rates to suppress asset prices is deep-rooted, widespread and enduringly powerful.
Central bankers themselves haven’t yet embraced the idea, but they’ve definitely considered it. Former Fed Chairman Ben Bernanke flirted with the concept in 2009, when the threat of another bubble was laughably remote. In 2014, his successor, Janet Yellen, said that rate increases might be used to pop bubbles, but only as a last resort. And James Bullard, president of the Federal Reserve Bank of St. Louis, has warned that keeping rates at zero might eventually cause financial instability.
To me this always seemed like a dubious idea, for three main reasons. First, as Yellen said in her 2014 remarks to the International Monetary Fund, interest rates are a blunt instrument. Rate hikes don’t just affect financial prices; they also have power over the prices of real goods and services and on economic activity. Raising rates might tame asset markets, but it could also send the economy into a sharp recession and cause damaging deflation.
Second, bubbles are by definition hard to recognize. What the Fed thinks is a bubble might be a perfectly normal rise in asset prices, due to fundamental shifts or changes in investors’ level of patience. The Fed is easily able to tell when unemployment or inflation is high, but inflated asset prices are much, much harder to identify.
Third, it isn’t clear that raising interest rates even can pop bubbles. They certainly can’t do it in laboratory experiments. I have tried and failed to use interest rates to suppress asset prices in an experiment, so I should know.
And in real life, we have the example of former Fed chief Alan Greenspan, who boosted rates in early 1994, in part to calm what he thought was an overheating stock market. Stock prices dipped, but then started their inexorable rise, and a bubble happened anyway, in the late ’90s. If anything, Greenspan probably called the bubble too early — even after the 2000 stock-market crash, prices never dipped back to their 1994 levels:
The idea of using monetary policy to calm financial markets is a very hot topic in the academic literature.
Since the crisis, macroeconomists have scrambled to incorporate finance into their models of the business cycle. But in general, these models don’t say that using rates to stabilize financial markets is a good idea.
For example, Fed economists Andrea Ajello, Thomas Laubach, David Lopez-Salido and Taisuke Nakata have a paper in which they use a New Keynesian model — the dominant type of macro model used at most central banks — modified to include financial crises. In their model, too much debt can cause a financial crisis, which then crashes the real economy. But when they calibrate the model to fit real data, they find that even with this mechanism in place, central banks probably shouldn’t move interest rates very much in response to movements in the debt markets.
Economists Philippe Bacchetta, Eric van Wincoop and Elena Perazzi have their own model, another New Keynesian variant with debt crises that slowly build up over time. Yet these authors also find that the cost of stabilizing credit conditions with interest rates would be incredibly high — too high for practical use.
The International Monetary Fund has its own paper on the topic. It relies on a totally different kind of financial market imperfection to generate crises, but the result is the same — hiking rates to prevent crises damages the economy. They conclude:
An implication of our analysis is that the weak link in the U.S. policy framework in the run up to the Global Recession was not excessively lax monetary policy after 2002, but rather the absence of an effective regulatory framework aimed at preserving financial stability.
Again and again, different methods yield the same results. I don’t believe strongly in any macroeconomic model, but when the models pile up like this, a pattern becomes clear. Empirical evidence is hard to come by, but what we have seems to indicate that interest rates don’t do a good job of controlling financial markets.
Now, there’s never a consensus in macroeconomics, so I should point out that you can find papers out there that reach the opposite conclusion, if you look hard enough. And Ajello, et al. do give some conditions under which uncertainty is so extreme, and fear of a crisis so great, that interest rate increases can be rational. So as with all things in macro, it isn’t an open-and-shut case.
But the weight of evidence and theory seems to be against the idea of using interest rates to tame financial markets. A better approach is probably to use regulation to prevent bubbles, while saving interest rates for battling unemployment and inflation.