Posted on 02 Dec 2009
Not so long ago, Federal Reserve officials were confident they knew what to do when they saw bubbles building in prices of stocks, houses or other assets: Nothing. Now, as Fed Chairman Ben Bernanke faces a confirmation hearing Thursday on a second four-year term, he and others at the central bank are rethinking the hands-off approach they've followed over the past decade. On the heels of a burst housing-and-credit bubble, Mr. Bernanke now calls financial booms "perhaps the most difficult problem for monetary policy this decade."
With Asian property prices soaring and gold prices busting records almost daily, the debate comes at a critical time. Mr. Bernanke wants to use his powers as a bank regulator to stamp out bubbles, but the Senate Banking Committee, which will grill him later this week, is considering stripping the Fed of its regulatory power.
At the same time, pending legislation in the House could leave Mr. Bernanke running a less independent institution. The House Financial Services Committee has passed a measure that would subject the Fed's interest-rate decisions to scrutiny by the Government Accountability Office, an investigative arm of Congress. Mr. Bernanke and others at the Fed fear that with Congress looking over their shoulders, any decision they make about interest rates would be subjected to the winds of politics -- making it harder to control inflation or financial bubbles.
Any changes would be months off at best, and the Fed might be successful in fending them off. In the meantime, officials are moving ahead to come up with plans to avoid another crisis.
Fed officials used to think there was little they could or should do to prevent bubbles from inflating. For one thing, identifying bubbles with any certainty was deemed to be too difficult. And even if they could be accurately pinpointed, pricking them might do more harm than good. Raising interest rates to stop a bubble, for instance, could slow growth in other parts of the economy that were otherwise healthy.
The Fed's main strategy instead was to mop up after a bubble burst with lower interest rates to cushion the blow to the economy and restart growth. That strategy was a key conclusion of Mr. Bernanke's writings on the subject of bubbles when he was a Princeton professor, and again when he first came to the Fed as a governor in 2002. It was an approach embraced by his predecessor Alan Greenspan.
Now, Fed officials admit the stance didn't work. They're groping for alternatives. Of the two methods to prevent bubbles -- using regulations to protect the financial system from excess and changing monetary policy by raising interest rates -- Mr. Bernanke falls on the side of greater regulation, an idea he has advocated in the past.
"The best approach here if at all possible is to use supervisory and regulatory methods to restrain undue risk-taking and to make sure the system is resilient in case an asset price bubble bursts in the future," Mr. Bernanke said in answer to a question after a speech in New York last month.
Playing the interest-rate card, in contrast, is considered by many to be a more aggressive and risky move. On Tuesday, Philadelphia Fed President Charles Plosser said interest rates were "a very blunt instrument" to thwart a possible bubble. He said raising rates could "affect all other asset prices at the same time."
But some on the Fed's research staff are pushing senior officials to include interest rates in their plans -- and some officials say they can no longer rule that out. Kevin Warsh, a Fed governor who spent seven years on Wall Street before moving to Washington in 2002, says he's keeping close track of commodities prices, the dollar and movements in credit markets. The Fed, he says, has to be open-minded in its search for solutions to bubbles, including whether interest rates should be used to squash them.
With unemployment high and conventional measures of inflation low, the Fed's top priority is to get the economy moving again. The Fed has said that means leaving interest rates low for at least several more months.
Yet the question of whether and how to tackle bubbles before they burst is becoming a growing concern amid fears of new bubbles developing in commodities markets and in emerging economies. Gold prices are up more than 50% in a year's time. China's Shanghai Composite stock index is up more than 75% this year. Stocks in Brazil are up even more. Oil prices have rebounded. They remain far below last year's peaks but a return to those highs could fuel inflation in goods and services more directly than tech stocks or housing did.
"This is a very dangerous period," says Frederic Mishkin, a Columbia University economist and former Fed governor. If a new bubble threatens to emerge and the Fed decides to fight it more aggressively, he says, it could damage an already weak economy. "You don't want to be fighting the last war," he says.
The debate extends far beyond the Fed. Researchers at the Bank for International Settlements, a Basel, Switzerland-based group that coordinates central-bank activities around the world, are pushing to address bubbles more aggressively. On a recent trip to Asia, the Fed's Mr. Warsh and San Francisco Fed President Janet Yellen got an earful from finance officials in China and Hong Kong, who worry that low U.S. interest rates are prompting investors to borrow in the U.S. and drive up asset prices in Asia.
The issue of rising asset prices -- and what, if anything, to do about them -- surfaced last month at the Fed's November meeting on the economy. Minutes released last week show officials worried about "the possibility that some negative side effects might result from the maintenance of very low short-term interest rates for an extended period." One worry was "excessive risk-taking in financial markets."
Mr. Bernanke helped to launch his central-banking career while a Princeton University professor in 1999 with a paper he presented to Fed officials at their annual Jackson Hole, Wyo., conclave, in which he warned against trying to prick bubbles. Mr. Bernanke and his co-author, Mark Gertler, a New York University economist, argued that the Fed should focus on controlling inflation, not trying to manage the cycle of booms and busts.
Mr. Greenspan agreed, and let the tech-stock bubble run its course. The strategy looked like a winner. The 2001 recession was mild; the unemployment rate never exceeded 6.3%. Gross domestic product, the value of the nation's output, declined just 0.3% from its peak in the fourth quarter of 2000. As late as 2006, Fed officials were congratulating themselves and being applauded by many economists for the deft handling of that episode.
One of the few doubters was William Dudley, then chief economist at Goldman Sachs and now president of the New York Fed. He is one of the Fed's more outspoken proponents of preventing bubbles, and has said it's not as hard to spot them as many economists believe. "I can identify at least five bubbles that one could reasonably have identified in real time," including the tech boom, Mr. Dudley said in 2006 speech. He knew, he said, because he had speculated against three of them himself when he was at Goldman.
Fed officials are now debating the differences between bubbles as a way to understand them better and come up with the right solutions. Two economists influencing the debate are Tobias Adrian, a New York Fed researcher, and Hyun Shin, a Princeton professor. Their work shows that the credit bust was preceded by an explosion of short-term borrowing by U.S. securities dealers such as Lehman Brothers and Bear Stearns.
For instance, borrowing in the so-called repo market, where Wall Street firms put up securities as collateral for short-term loans, more than tripled to $1.6 trillion in 2008 from $500 billion in 2002. As the value of the securities rose, so did the value of the collateral and the firms' own net worth. That spurred firms to borrow even more in a self-feeding loop. When the value of the securities started to fall, the loop went into reverse and the economy tanked.
The lesson: The most dangerous part of a bubble may not be the rise in asset prices, but the level of debt that builds up at financial institutions in the process, fueling even higher prices. That means keeping these debt levels down might be one way to prevent busts.
The New York Fed's Mr. Dudley and others want to stop these kinds of borrowing spirals. The New York Fed, for example, is looking to increase its oversight of the repo market. It's considering whether to toughen collateral requirements on these loans so it's not as easy for firms to ramp up their borrowing in a boom.
Daniel Tarullo, the newest Fed governor, is organizing a new Washington-based swat team of analysts, supervisors, lawyers and accountants whom Fed officials dub the "quantitative surveillance" group. They are to troll through data on big financial firms looking for risks lurking in the system that officials will try to stamp out.
Bank regulators in the U.S., Europe and elsewhere are also considering rules that would require banks to have bigger capital cushions to discourage them from expanding too aggressively.
Mr. Adrian and Mr. Shin find low rates feed dangerous credit booms, and thus need to be a factor in Fed interest-rate calculations. Small additional increases in rates in 2005, they say, might have tamed the last bubble. "Interest-rate policy is affecting funding conditions of financial institutions and their ability to take on leverage," says Mr. Adrian. That, in turn, "has real effects on the economy."
His co-author, Mr. Shin, says "clumsy financial regulations" aren't enough to stop boom-bust cycles. "This would be like trying to erect a barrier against the incoming tide using wooden planks with big holes," he says. Using interest rates is the "most effective instrument" for regulating risk-taking by firms, he says in a new paper.
No one at the Fed has yet come out in favor of raising interest rates to stop the next bubble, but the idea is being discussed more seriously among Fed officials. Mr. Bernanke has been following Mr. Adrian's work closely.
One problem is that economists don't have models that prescribe how much interest rates should go up when asset prices or financial leverage run to excess, though several leading researchers, including Mr. Shin and Mr. Adrian, are starting to work in this area.
Donald Kohn, the Fed's vice chairman, was one of the strongest proponents of the old don't-pop-bubbles view. Today, he says, he has much less conviction about that strategy. Still, he worries that using higher interest rates to tame an asset boom would be like using a sledgehammer to drive a tack -- it might stamp out the boom but it would do a lot of peripheral damage in the process.
"You raise interest rates [to fight a bubble] and you damp all kinds of capital spending and consumer durable spending," said Mr. Kohn in an interview.
Mr. Bernanke is leaving himself hedged. If he felt stamping out a bubble with higher rates would forestall a rise in inflation or stabilize the economy, "We'd have to think about that very seriously," he told the New York Economic Club recently. "We can never say never."