Counterparties: When two mandates aren’t enough

February 8, 2013

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Should the Fed try to use interest rates to control not just inflation and unemployment, but financial markets too?

In a speech earlier this week, Fed governor Jeremy Stein pushed for the Fed to change the way it approaches overheated markets, arguing that the Fed should consider raising interest rates to prevent financial bubbles. Along the way, Stein warned that the market for junk bonds and REITs might be overheating.

Stein is honest about limitations of the Fed’s bubble-spotting abilities: “We should be humble,” he says, “about our ability to see the whole picture”. What’s more, even when Fed members do warn of possible bubbles, the Fed has been generally terrible at stopping them.

As Neil Irwin points out, the Fed has generally been opposed to avoid raising interest rates to stop bubbles, on the grounds that doing so is “the equivalent of fumigating an entire house after finding a small patch of mold”. Or, as Ben Bernanke said, surveying the economic consensus in 2011, “monetary policy is too blunt a tool to be routinely used to address possible financial imbalances”. Much better than raising rates, Bernanke said, is to use the Fed’s regulatory powers instead.

But Stein sees an advantage in using interest rates rather than regulatory brute force. Raising rates, to Stein, is a way to get past what the Fed doesn’t know and into “all of the cracks” of the financial world. What the Fed doesn’t know extends beyond the banks that the Fed regulates, and to the shadow banking system too:

In principle, what we’d really like to know, for any given asset class–be it subprime mortgages, junk bonds, or leveraged loans–is this: What fraction of it is ultimately financed by short-term demandable claims held by investors who are likely to pull back quickly when things start to go bad?

Mark Thoma worries about the broader effects of higher rates, however. “If monetary policymakers begin getting skittish, then the unemployed will lose the one institution that seemed to actually care about their struggles”. Ryan Avent agrees: “There are worse things than overheating credit markets, and America has them.”

And Scott Sumner wonders if Stein knows his history. In the late 1920s, the Fed tried to kill a stock market boom by repeatedly raising interest rates. Those interest rates helped push the economy into a Depression: “Only when the Fed caused the economy to tank did the stock ‘bubble’ finally burst,” Sumner notes. — Ryan McCarthy

On to today’s links:

Billionaire Whimsy
Bloomberg owns a sacrificial Roman altar – NYT

Alpha
Henry Blodget and David Einhorn disagree about the theoretical value of money – Business Insider

Right On
Schiller: housing is “not really an investment” – Pragmatic Capitalism

Crisis Retro
Justice Department: oh, right, Moody’s — we might sue them too – Reuters

Wonks
“The tyranny of political economy” — a must-read essay – Dani Rodrik

When Regulators Stop Being Polite
Bundesbank says banker pay must be capped – Bundesbank

New Normal
The sad rise of self-employment in the UK – Coppola Comment
North Carolina residents discover that they don’t own the ground beneath them – Hallie Seegal

Comebacks
Vikram Pandit and Bob Diamond might soon be “shadow bankers” (i.e. run a PE firm or hedge fund) - NY Post

Yuck
The livestock industry consumes four-fifths of America’s antibiotics – Mother Jones

Liebor
How Libor fixing “morphed from coveted asset to liability” in the arc of one career – WSJ

Leaders
Howard Buffett has spent his whole life drinking Cherry Coke and learning to play the ukulele – Bloomberg

TBTF
Bob Rubin is not impressed by Sandy Weill – American Banker

Hot Money
“About $3 billion is wagered on sports every day, most of it on soccer, most of it in Asia” – Brian Phillips

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