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.