Federal Reserve Vice Chairman Stanley Fischer said it might be necessary for the central bank to increase interest rates if financial markets were overheating, though the first line of defense should be using regulatory tools to prevent bubbles from developing.
“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,” Fischer said in a speech at the annual American Economic Association meeting in San Francisco.
He suggested that might be particularly true in the U.S., where many of the so-called macro-prudential regulatory tools to tackle financial market excesses are either lacking or untested. Such tools would include, for example, adjusting lending rules to try to rein in borrowing.
Fischer did make clear that he thought “macro-prudential tools, rather than adjustments in short-term interest rates, should be the first line of defense” in tackling asset bubbles, while spelling out that “the real issue of whether adjustments in interest rates should be used to deal with problems of potential financial instability is macroeconomic.”
Fischer didn’t address the current state of financial markets, although other policy makers, including Fed Chair Janet Yellen, have indicated that they do not see them, on the whole, as being overheated.
Fischer was among three Fed policy makers who made public remarks at the AEA meeting on Sunday. San Francisco Fed President John Williams discussed estimates of long-run neutral rates, while Cleveland’s Loretta Mester delivered her outlook for the U.S. economy and explained why the Fed would not react to short-term swings in economic data.
The Fed in December raised interest rates for the first time since 2006 after holding them near zero for seven years. In making the move, the central bankers cited an improved labor market and expectations that inflation will eventually rise back to their 2 percent goal.
Officials have said they expect the pace of future rate increases to be gradual and dependent on incoming economic data.
Fischer said that the money market tools developed by the Fed to achieve liftoff had proven effective last month, while cautioning that “issues may yet arise during normalization that could call for adjustments to our tools, and we stand ready to do that.”
In his speech, Fisher, the Fed’s No. 2 policy maker, suggested that rates will probably eventually end up being lower than they have been in the past.
That’s because the equilibrium interest rate — the rate after inflation that neither expands nor contracts the economy —- has fallen. Fischer cited a number of possible reasons for the drop in what economists dub “r*,” including slower productivity growth and excess savings in emerging market countries.
“A variety of models and statistical approaches suggest that the current level of short-run r* may be close to zero,” Fischer said. “Moreover, the level of short-run r* seems likely to rise only gradually to a longer-run level that is still quite low by historical standards.”
In the last credit tightening cycle by the Fed, which ran from 2004 to 2006, the federal funds rate targeted by the central bank reached a high of 5.25 percent.
Back to Zero
The low level of the equilibrium rate increases the likelihood that the Fed will be forced to cut its target rate back to zero in the future, Fischer said. As central bankers’ experience has shown in recent years, handling such a situation would be “challenging, to say the least,” he added.
The Fed vice chair outlined a number of strategies that could be employed to try to spur the economy when rates are locked at zero. He said an expansionary fiscal policy could help the economy and lift r* in the process, by increasing borrowing.
He said policy makers could also seek to reduce long-term interest rates, either by the Treasury issuing less long-term debt or the Fed holding more of it on its balance sheet.
Fischer seemed less keen on some other suggestions by economists for dealing with the zero lower bound, including raising the Fed’s inflation target from 2 percent.
“High levels of inflation may also be associated with higher inflation variability,” he said. The costs of that “could be substantial.”
That thought was reinforced by San Francisco’s Williams, who told an earlier AEA panel that raising the Fed’s inflation target would be “really problematic, especially in today’s context given that central banks around the world can’t reach their inflation targets as they are.”
While European policy makers have shown that it was possible to reduce rates below zero, Fischer voiced several possible concerns about taking such action in the U.S. Money markets could be destabilized and securities transactions undermined, he said.
Difficult to Implement
“All of these are, of course, transitional problems, but they might be sufficient to make a move to negative rates difficult to implement on short notice,” Fischer said.
The Fed cut interest rates effectively to zero at the end of 2008 and undertook a series of asset buying programs after the bursting of the housing market bubble and a massive unwinding of leverage in the financial markets drove the economy to its deepest recession since the Great Depression.
Since then, policy makers have been debating how best to respond if asset prices again became overheated.
In Sunday’s speech, Fischer seemed a bit more open than some of his fellow Fed colleagues in using monetary policy as well as regulatory strategies to cope with financial excesses.
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