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.

Fed Officials Want to Tackle "Reaching for Yield"

Cleveland Fed President Sandra Pianalto gave a speech on February 15 called "Providing Balance while Managing Uncertainty." She says that the Federal Reserve "has been aggressive and creative in its response to a very challenging economic environment, and our actions have been beneficial for the economy." Nonetheless, her outlook is not among the most optimistic. She predicts that the unemployment rate will be 7.5% at the end of this year, and around 7% at the end of 2014. According to the Fed's threshold rule, the Fed won't raise the funds rate until unemployment falls below 6.5% or inflation rises above 2.5%. By Pianalto's estimation, that won't be happening until 2015 at the earliest.

Pianalto's counterpart at the St. Louis Fed, James Bullard, expounded upon the threshold rule in a speech the day prior to Pianalto's speech. Both Bullard and Pianalto address the Fed's balance sheet policy, QE3.  While Bullard describes the asset purchase program as "potent," Pianalto fears that it will have both "diminishing benefits" and increasing costs:

Over time, the benefits of our asset purchases may be diminishing. For example, given how low interest rates currently are, it is possible that future asset purchases will not ease financial conditions by as much as they have in the past. And it is also possible that easier financial conditions, to the extent they do occur, may not provide the same boost to the economy as they have in the past. In addition to the possibility that our policies may have diminishing benefits, they also may have some risks associated with them.

The first such risk that she notes is the following:

First, financial stability could be harmed if financial institutions take on excessive credit risk by “reaching for yield” —that is, buying riskier assets, or taking on too much leverage—in order to boost their profitability in this low-interest rate environment. 

This is reminiscent of John Taylor in an Op-Ed in the Wall Street Journal called "Fed Policy is a Drag on the Economy." Taylor writes that

The Fed’s current zero interest-rate policy also creates incentives for otherwise risk-averse investors—retirees, pension funds—to take on questionable investments as they search for higher yields in an attempt to bolster their minuscule interest income.

Miles Kimball challenged the logic of this "reaching for yield" concern in two posts. Karl Smith weighed in on Forbes, and I did too on this blog. Kimball argues,

The often-repeated claim that low interest rates lead to speculation cries out for formal modeling. I don’t see how such a model can work without some combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance and irrationality...

I have no problem believing that, indeed, investor ignorance and irrationality and schemes that prey on that ignorance and irrationality do indeed cause people to take on more risk as a result of low interest rates than they otherwise would. This 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.

Interestingly, Kimball's point about the appropriate domains of financial regulation versus monetary policy brings up yet another February Fed speech, this one by Governor Jeremy Stein of St. Louis. Stein argues that the Fed should take on what has typically been the role of financial regulators in alleviating "overheating" in credit markets. No surprise, he cites as one cause of overheating the fact that "a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to `reach for yield.'"

Stein alludes to the same sort of model that Kimball has in mind. Stein admits both irrationality ("changes in the pricing of credit over time reflect fluctuations in the preferences and beliefs of end investors such as households, where these beliefs may or may not be entirely rational") and fraudulent schemes ("At any point, the agents try to maximize their own compensation, given the rules of the game. Sometimes they discover vulnerabilities in these rules, which they then exploit in a way that is not optimal from the perspective of their own organizations or society.")

Their models for the causes of reaching for yield are roughly the same, but their policy prescriptions are polar opposites. Kimball says that tighter monetary policy is the worst solution to reaching for yield, and improved financial regulation is the better option. Stein says that monetary policy has benefits over financial regulation. Pianalto apparently comes down on the side of Stein, tentatively suggesting that tighter monetary policy may be necessary to reduce the threat of financial instability caused in part by reaching for yield. She says that "we could aim for a smaller sized balance sheet than would otherwise occur if we were to maintain the current pace of asset purchases through the end of this year, as some financial market participants are expecting."

Reaching for Yield: A Simple Model

Miles Kimball poses an interesting question: How can we model "reaching for yield?" He poses this question in response to a claim by John Taylor that the Fed's zero interest-rate policy creates incentives for investors
"to take on questionable investments as they search for higher yields in an attempt to bolster their minuscule interest income." Kimball writes that

The often-repeated claim that low interest rates lead to speculation cries out for formal modeling. I don’t see how such a model can work without some combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance and irrationality.

"Modeled Behavior" blog has a complementary post today, also questioning how "reaching for yield" squares with economic theory. So here is my morning modeling exercise. It is a really simple, partial equilibrium model, but a model nonetheless. I'm not saying it's incredibly realistic, but I wanted to come up with the simplest model of "reaching for yield" I could think of. It has neither investor ignorance, nor irrationality, nor fraudulent schemes.