Bernanke, Bankers, Bubbles

In 1999, at the height of the dot-com bubble, Ben Bernanke and Mark Gertler argued emphatically against central banks responding to movements in asset prices.  Monetary policy could react to the macroeconomic consequences of asset price movements, but not to asset prices themselves. In other words, monetary policymakers should not raise interest rates solely to address a potential bubble.

After the dot-com bubble burst, they held firm in their opinion in a 2001 paper titled "Should Central Banks Respond to Movements in Asset Prices?" Their answer to the title question is a firm no. They build and simulate a model of the economy that includes both technology shocks and "stock price bubble" shocks and find that "an aggressive inflation-targeting rule stabilizes both output and inflation when asset prices are volatile, whether the volatility is due to bubbles or to technological shocks; and that, given an aggressive response to inflation, there is no significant additional benefit to responding to asset prices."

The housing bubble prompted a number of challenges to the Bernanke-Gertler dictum. A fairly common view is that expansionary monetary policy contributed to the housing bubble. Dean Baker and John Taylor have both argued that the housing bubble was caused by the Fed keeping interest rates too low for too long. (In 2001 the Federal Funds Target rate was lowered from 6.5 to 1.75 percent. In 2003 it was lowered to 1 percent and held there for a year.) Bernanke counters that increased use of variable-rate and interest-only mortgages and the decline of underwriting standards were more to blame than low interest rates.

Now, interest rates are again very low, and have been for quite some time. Challenges to the Bernanke-Gertler view are more vociferous than ever, and come not only from John Taylor but also from Chairman Bernanke's committee members and his contemporaries at other central banks. Fed Governor James Bullard, for example, says that "maybe you should think about using interest rates to fight financial excess a little more than we have in the last few years.” Kansas City Fed President Esther George and Fed Governor Jeremy Stein express similar views that the Fed should use its control of interest rates to do something about "overheating." However, Fed Vice Chairwoman Janet Yellen shares Bernanke's view that the benefits of accomodative monetary policy at this point outweigh the risks of any potential financial overheating.

When Bernanke wrote his 1999 and 2001 papers with Gertler, he was a professor at Princeton University. Another Princeton professor, Lars Svensson, is the Deputy Governor of the Swedish Riksbank. At the Riksbank last month, Governor Stefan Ingves warned that low interest rates are driving up household debt. But Svensson is a strong proponent of his former colleague's views. At the February Rikbank meeting, he argued against the committee's concerns that low interest rates could be leading to financial instability. He cites a 2012 paper by Kenneth Kuttner called "Low Interest Rates and Housing Bubbles: Still no Smoking Gun," whose title summarizes its conclusion.  In particular, Kuttner estimates that a 25 basis point expansionary monetary policy shock raises house prices by about 0.3% to 0.9%, which is "too small to explain the previous decade's real estate boom in the U.S. and elsewhere... Credit conditions, broadly defined, may play a larger role in house price booms than interest rates per se. In market-oriented financial systems, like that of the U.S., a loosening of credit conditions plausibly resulted from financial innovation, such as securitization, and a relaxation of lending standards."

Svensson's long list of publications and speeches reveals a longstanding interest in monetary policy and financial stability, with views consistently in accord with Bernanke's. In a 2011 lecture called "Central-Banking Challenges for the Riksbank: Monetary Policy, Financial-Stability Policy, and Asset Management" Svensson notes:

"Monetary policy and financial-stability policy are distinct policies, with different objectives, different instruments, and different public authorities having responsibility for them... Monetary policy should be conducted taking the conduct of financial-stability policy into account, and vice-versa. But they should not be confused with one another. Confusion risks leading to a poorer outcome for both policies and makes it more difficult to hold the policymakers accountable."

One of the most interesting blog posts I have read on this topic is from Miles Kimball, who writes that people taking on more risk as a result of low interest rates is "a genuine cost to the Fed stimulating the economy with low interest rates. But— especially once we figure out the details—it has much bigger implications for financial regulation than for monetary policy...Regulation has serious costs, but so does tight monetary policy in the current environment." This seems to be the view of Bernanke, Yellen, and Svensson, but is still far from a settled issue among the world's monetary policymakers.