In response to the Great Recession, the Federal Reserve has kept the short-term interest rate (the federal funds rate) near zero since December 2008 and taken other steps (like purchasing longer-term Treasury securities) to strengthen the recovery and avoid deflation of wages and prices. Although the recovery has not been as fast as hoped—in part because of “headwinds” arising from fiscal policy, the after-effects of the financial crisis, and other factors—today the jobs situation in the United States is much better than a few years ago, and the risk of deflation is very low. Fed policies have had a lot to do with that.

Despite the substantial improvement in the economy, the Fed’s easy-money policies have been controversial. Initially, detractors focused on the supposed inflation risks of such policies. As time has passed with no sign of inflation, that critique now looks rather threadbare. More recently, opposition to accommodative monetary policy has mostly coalesced around the argument that persistently low nominal interest rates create risks to financial stability, for example, by promoting bubbles in asset prices or stimulating excessive credit creation.

Let there be no mistake: In light of our recent experience, threats to financial stability must be taken extremely seriously. However, as a means of addressing those threats, monetary policy is far from ideal. First, it is a blunt tool. Because monetary policy has a broad impact on the economy and financial markets, attempts to use it to “pop” an asset price bubble, for example, would likely have many unintended side effects. Second, monetary policy can only do so much. To the extent that it is diverted to the task of reducing risks to financial stability, monetary policy is not available to help the Fed attain its near-term objectives of full employment and price stability.

For these reasons, I have argued that it’s better to rely on targeted measures to promote financial stability, such as financial regulation and supervision, rather than on monetary policy. Or, as I put it in my very first speech as a Fed governor, “use the right tool for the job.” In that spirit, during my time leading the Fed, policymakers and staff worked to develop a “macroprudential,” or systemic approach to financial oversight and regulation. In particular, we began to regularly monitor and evaluate developments in the financial system as a whole—even parts that the Fed is not assigned to regulate. My colleagues at the Fed and I also supported measures to make the financial system more resilient, such as requiring large banks to hold more capital and to keep more cash on hand. And we began making regular use of “stress tests” to see if banks were strong enough to withstand very severe economic and financial shocks.

However, the macroprudential approach remains unproven, and we know that, for a variety of reasons, financial regulators did not do enough to avoid the crisis of 2007-2009. So, even if we agree that regulation and supervision should be the first line of defense, we can’t rule out of hand the possibility that monetary policy decisions should also take into account risks to financial stability. To do that in a sensible way, however, requires some weighing of benefits and cost. Even if keeping monetary policy tighter than it otherwise would be has the benefit of lowering the risk of a future crisis (although not everyone agrees with this premise), doing so also has the cost of driving employment and inflation away from the Fed’s near-term targets. Before we make major changes in the conduct of monetary policy, it’s essential to understand the tradeoffs involved.

A new paper by Andrea Ajello, Thomas Laubach, David López-Salido, and Taisuke Nakata, recently presented at a conference at the San Francisco Fed, is among the first to evaluate this policy tradeoff quantitatively. The paper makes use of a model of the economy similar to those regularly employed for policy analysis at the Fed. In this model, monetary policy not only influences near-term job creation and inflation, but it also affects the probability of a future, job-destroying financial crisis. (Specifically, in the model, low interest rates are assumed to stimulate rapid credit growth, which makes a crisis more likely.) For a variety of alternative assumptions about the parameters of the model and the objectives of policymakers, the authors assess whether the benefit of keeping rates meaningfully higher than they otherwise would be (thereby reducing the risk of a future financial crisis and the associated damage to the economy) exceeds the cost of higher rates (lower near-term job growth and inflation below target).

Although, in principle, the authors’ framework could justify giving a substantial role to monetary policy in fostering financial stability, they generally find that, when costs and benefits are fully taken into account, there is little case for doing so. In their baseline analysis, they find that incorporating financial stability concerns might justify the Fed holding the short-term interest rate 3 basis points higher than it otherwise would be, a tiny amount (a basis point is one-hundredth of a percentage point). They show that a larger response would not meet the cost-benefit test in their estimated model. The intuition is that, based on historical relationships, higher rates do not much reduce the already low probability of a financial crisis in the future, but they have considerable costs in terms of higher unemployment and dangerously low inflation in the near- to intermediate terms.

To check the robustness of the results, the authors consider what happens if the likelihood of a crisis is much more sensitive (for stats geeks: two standard deviations more sensitive) to monetary policy than is consistent with historical data. They find that, in this case, setting the short-term interest rate 25 to 45 basis points higher than it would otherwise be could be justified on cost-benefit grounds. They also analyze the effects of assuming that every financial crisis leads to output losses and deflation as catastrophic as in the Great Depression of the 1930s—again, a very strong assumption. In this case, a short-term interest rate 30 to 75 basis points higher than it otherwise would be could pass a cost-benefit test. Given the extreme assumptions, these are surprisingly small deviations from a policy that simply ignores financial stability concerns. Again, the bottom line is that large increases in the short-term rate based on financial stability considerations alone would involve costs that well exceed the benefits.

Lars Svensson, who discussed the paper at the conference, explained, based on his own experience, why cost-benefit analysis of monetary policy decisions is important. Lars (who was also my colleague for a time at Princeton) served as a deputy governor of the Swedish central bank, the Sveriges Riksbank. In that role, Lars dissented against the Riksbank’s decisions to raise its policy rate in 2010 and 2011, from 25 basis points ultimately to 2 percent, even though inflation was forecast to remain below the Riksbank’s target and unemployment was forecast to remain well above the bank’s estimate of its long-run sustainable rate. Supporters justified the interest-rate increases as a response to financial stability concerns, particularly increased household borrowing and rising house prices. Lars argued at the time that the likely benefits of such actions were far less than the costs. (More recently, using estimates of the effects of monetary policy on the economy published by the Riksbank itself, he showed that the expected benefits of the increases were less than 1 percent of the expected costs). But Lars found little support for his position at the Riksbank and ultimately resigned. In the event, however, the rate increases were followed by declines in inflation and growth in Sweden, as well as continued high unemployment, which forced the Riksbank to bring rates back down. Recently, deflationary pressures have led the Swedish central bank to cut its policy rate to minus 0.25 percent and to begin purchasing small amounts of securities (quantitative easing). Ironically, the policies of the Swedish central bank did not even achieve the goal of reducing real household debt burdens.

As academics (and former academics) like to say, more research on this issue is needed. But the early returns don’t favor the idea that central banks should significantly change their rate-setting policies to mitigate risks to financial stability. Effective financial oversight is not perfect by any means, but it is probably the best tool we have for maintaining a stable financial system. In their efforts to promote financial stability, central banks should focus their efforts on improving their supervisory, regulatory, and macroprudential policy tools.



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