Bernanke versus Stein

While watching Ben Bernanke's speech on Friday night, I wrote two notes to myself. The first was "regulation versus interest rates (debate with Stein)" and the second was "interest rate on reserves."

Bernanke's comments on the interest rate the Fed pays on bank reserves came in response to a question after the speech. He was asked why the Fed hasn't lowered interest on reserves to zero, or even made it negative to promote bank lending. As in the past when asked this question, Bernanke emphasized that the Fed was worried about the effect this might have on money markets -- an objection that has never been adequately explained in my view -- but it was clear this is not and will not be on the Fed's agenda. The Fed might raise the IOR to address inflation worries, but lowering it further isn't going to happen.

The other (more) notable part of the speech was about how the Fed should respond to asset price bubbles. Should the Fed use regulatory/supervisory authority to target individual asset markets that appear to be overheated (the Bernanke approach), or does the difficulty of detecting bubbles in individual markets mean the Fed should use interest rate increases that calm markets across the board (as Fed governor Stein has suggested)? Bernanke made it clear that he preferred the approach of targeting individual markets, and that he anticipated interest rates would remain low well into the recovery (and Janet Yellen echoed this today).

Neil Irwin has a nice summary of this debate:

Jeremy Stein, a Fed governor since last May ... argued in a Feb. 7 speech that there are already signs of overheating in the markets for certain kinds of securities, including junk bonds and real estate investment trusts that invest in mortgages. And if those or other potential bubbles get so large that if they popped the whole U.S. economy could be in danger, he argued, there is a case for using the Fed’s most blunt tool to combat them—raising interest rates across the economy.

Stein isn’t ready to do that just yet ... but some of his colleagues are... The nub of the argument ... is that when financial bubbles arise, it’s hard to know with certainty where they are and how big a risk they pose, so it’s not enough for regulators to try to stamp them out. Higher interest rates may be a blunt tool, but at least you know they will be effective. If the last 15 years have taught us anything, it is that financial bubbles can wreak huge damage to the economy, so it’s worth it to try to nip them in the bud.

The two most powerful Fed officials have offered, in speeches Friday night and Monday morning, what amounts to a riposte to these arguments. “Long-term interest rates in the major industrial countries are low for good reason,” Chairman Ben Bernanke said Friday evening... “Premature rate increases would carry a high risk of short-circuiting the recovery, possibly leading–ironically enough–to an even longer period of low long-term rates.”

Vice-chair Janet Yellen chimed in Monday morning... “At this stage,” she said, “there are some signs that investors are reaching for yield, but I do not now see pervasive evidence of trends such as rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would clearly threaten financial stability.”

So the Bernanke-Yellen response to the Stein-George argument boils down to a polite version of this: Are you crazy? Unemployment is really high! Inflation does not appear to be much of a threat! Why should we cripple the prospects of economic recovery just because investors may be paying too much for certain types of corporate bonds and end up losing money. ...