Commentary Type

Gagnon: Yellen vs. the BIS: Whose Thesis Makes Better Sense?

Comment in the International Economy, Summer Issue [pdf]


Janet Yellen is right to resist diverting monetary policy from its primary objective of stabilizing economic activity and inflation.

Everyone agrees that it is essential to fix the flaws in financial regulation and supervision that allowed a dangerous bubble to form, and central banks are uniquely placed to help in this regard. Governments need the right tools to do the job, including the ability to place limits on leverage and to raise capital standards.

Setting monetary policy on any basis other than the stabilization of employment and inflation is more likely to harm financial stability than to help.

Where there is disagreement is over the role of monetary policy in enhancing financial stability. Even if it were clear that loose monetary policy feeds asset bubbles (and my colleague Adam Posen has argued convincingly that it is not), it does not follow that tighter monetary policy is necessarily the right response to a bubble. The damage caused by a bursting bubble arises from the deadweight costs of bankruptcy and the panic engendered by the fear that a counterparty may go bankrupt. The solution is to reduce debt and increase equity throughout the economy and to ensure that systemically important financial institutions are well capitalized.

During the housing bubble, restrictions on leverage needed to be tightened dramatically. But limits on private borrowing would have reduced spending. To prevent the economy from falling into recession, the Fed would have needed to lower interest rates, not raise them, in order to encourage firms and households with healthy balance sheets to spend more.

BIS economists point to historically low interest rates as a sign that policy is dangerously loose. However, there are many reasons why returns on safe instruments should be low or even negative now in real terms. These include deleveraging and heightened risk aversion after the financial crisis, slower growth of working-age populations, continued large capital inflows into advanced economies from governments in emerging markets, and possibly a slower rate of technological progress. (Larry Summers has been making similar points.) When the equilibrium required return on assets is at a historical low, then asset prices of necessity will be historically high. This does not imply that we are experiencing a risky bubble.

Sweden recently provided a clear test of the dangers of diverting monetary policy from its primary function to fight a perceived bubble. Despite inflation below target and no signs of an overheating economy, the Swedish Riksbank raised its policy rate in 2010–11 out of concern that the debt burden of Swedish households was too high. But the Riksbank was forced to reverse its actions to prevent outright deflation, recently returning its policy rate to essentially zero. Lars Svensson has pointed out that the Riksbank raised the real burden of household debt by undershooting its inflation target, so that its policy tightening may have been counterproductive even in terms of its original financial-stability motivation.

Bottom line, there is no tradeoff between macroeconomic stability and financial stability. Setting monetary policy on any basis other than the stabilization of employment and inflation is more likely to harm financial stability than to help.

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