Should monetary policy take into account risks to financial stability?

Blogger Bernanke does not think so. He says financial regulation is the best way to manage financial stability, even if it is limited in scope.

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.


Interesting to see blogger Bernanke express views …

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