Federal Reserve Vice Chairman Stanley Fischer sounds concerned that the central bank may lack some key tools needed both to prevent another financial crisis and to contain the fallout should one occur.
He told the American Economic Association on Sunday that the Fed is not as well-equipped with regulatory powers to rein in housing and other asset bubbles as some other central banks. And he questioned whether Congress had gone too far in limiting the Fed’s ability to intervene if a crisis erupted and threatened the financial system.
"We won’t know until it’s very late" whether the Fed has been constrained too much, Fischer said at the AEA’s annual meeting in San Francisco. That’s something "we have to worry about a great deal."
Fischer’s comments suggest that the central bank may need to rely more on monetary policy to restrain financial excesses than it has in the past. In fact, he told the conference that it might be necessary for the Fed to increase interest rates if financial markets were overheating, though the first line of defense should be the use of regulatory measures to head off bubbles.
In arguing that the Fed has less leeway to restrain speculative excesses than other central banks, Fischer pointed in particular to the property market, the epicenter of the last financial crisis. Faced with run-away real estate prices, many other countries have tightened loan-to-value or debt-to-income ratios to curb borrowing.
"In the United States, responding to such problems with these tools would require inter-agency coordination" between the Fed and other government regulators, he said. That "could make their use cumbersome at critical moments."
On Dec. 18 the Fed and other agencies issued a thinly veiled warning to banks in which it “reminded” them about “existing regulatory guidance on prudent risk management practices for commercial real estate lending.”
Fischer also contrasted the congressional curbs placed on the Fed’s ability to act as a lender of last resort in a financial emergency with steps taken by Britain to expand such powers at the Bank of England.
In banking legislation passed in 2010, U.S. lawmakers prohibited the Fed from engaging in rescues of individual financial firms, such as it did with Bear Stearns Cos. and American International Group Inc. during the last meltdown.
Harvard University professor Martin Feldstein told the AEA meeting that outside of the banking sector, the Fed doesn’t have the macro-prudential tools needed to restrain too much risk- taking.
He called on the central bank to raise interest rates more rapidly to rein in asset prices that are "already dramatically out of line" with where they should be.
The ratio of U.S. stock prices to earnings is well above its historical average, he said, while the yield on the 10-year Treasury note is about half of what it should be if monetary policy was more normal.
"There are serious risks" that a sudden lurch down in asset prices could lead to widespread financial losses and push the economy into recession, according to Feldstein, who is also president emeritus of the National Bureau of Economic Research. His base case though is for another good year of growth of 2 percent to 2.5 percent, led by household spending.
Not ‘Significant’ Risk
Cleveland Fed President Loretta Mester said the central bank is monitoring the potential dangers of overheating "as best we can."
"Right now, we do not see this as a significant risk," she added at an AEA panel discussion with Feldstein on Sunday.
She argued that the Fed’s decision to increase rates last month for the first time since 2006 puts it in a better position to limit threats to financial stability.
Starting to lift rates "helps to mitigate any potential for building risks to financial stability stemming from excessive leverage or from investors taking on risks they are ill-equipped to manage in a search for yield," she said.
Fed policy makers have said they intend to raise rates gradually after their initial move last month and have penciled in four quarter percentage point increases for this year, according to the median estimate of projections released on Dec. 16.
Feldstein said that would still leave real rates negative after taking account of inflation, potentially promoting yet more speculation in markets that are already seriously overvalued.
Noting that excessively inflated markets can point to overheating in the economy as a whole, Fischer suggested that a decision to use monetary policy in such situations would ultimately be based on an assessment of the overall economic risks and benefits of such a move.
“The real issue of whether adjustments in interest rates should be used to deal with problems of potential financial instability is macroeconomic,” he said. "If asset prices across the economy -- that is, taking all financial markets into account -- are thought to be excessively high, raising the interest rate may be the appropriate step."
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