Adding a risk mandate: A 5 bumper shot in billiards?
By Scott Sumner
Jeremy Stein gave a speech that advocated adding financial risk to the Fed’s traditional dual mandate. Or at least targeting risk in the hope that it makes it easier to fulfill its traditional mandate. I see lots of potential problems, and not much upside:
1. Can the Fed correctly judge the stance of monetary policy? My general fear has been that the Fed will wrongly associate easy money with low interest rates. And then assume that low interest rates lead to lax financial conditions. In fact, low rates are highly correlated with low NGDP, which means it usually reflects a tight monetary policy. The perception that money is easy may have caused the Fed to taper recently, when more monetary stimulus is probably needed to hit their inflation/employment targets. Now in fairness, Stein seems to have a better understanding of the stance of monetary policy than most Fed officials:
I am going to try to make the case that, all else being equal, monetary policy should be less accommodative–by which I mean that it should be willing to tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level–when estimates of risk premiums in the bond market are abnormally low.
That’s right, money is actually fairly tight right now as inflation and employment are both likely to be below target next year. However I worry the Fed will forget this perspective in a crisis, and revert to the usual “low rates = easy money.”
2. Because low rates can reflect either easy money (liquidity effect) or tight money (income, price level, expected inflation effects) the stance of monetary policy is often misidentified in empirical studies. This gives me little confidence that we can accurately estimate the impact of monetary policy on risk premiums—a key precondition for Stein’s proposed policy.
3. How much does risk premium instability lead to NGDP instability? Stein’s proposal assumes the causation goes from risk instability to NGDP instability, but the reverse causation seems far more plausible to me. And note that this issue cannot be addressed via “Granger causality” studies, as financial markets are forward-looking.
4. Can monetary policy outperform regulatory fixes? Monetary policy would certainly seem to fall into the “second best” policy category. One of my professors complained that 2nd best policies are generally enacted by 3rd best policymakers and get 4th best results.
5. Even if monetary policy can impact the time path of risk premiums, can we be confident that the policy succeeds in reducing NGDP volatility? The last time I recall the Fed diverging from macro stabilization and focusing on risk was 1929. They did succeed in impacting the financial markets exactly as they hoped, but it did not have the NGDP stabilization effects that they expected from popping the stock market bubble. In fairness, Stein is not calling for bubble popping, but I still have doubts about the link between using policy to move the risk premium, and greater NGDP stability.
Common sense suggests that a stable path of NGDP will result in more financial market stability than a highly unstable path of NGDP. And many financial crises are associated with unstable NGDP (although causality can go either way.) It seems to me to be quite a leap of faith to assume that we can get more stable NGDP growth by (at times) deliberately aiming for less stable NGDP growth, in the hope that the policy will cause our economy to evolve in such a way as to make it easier in the future to use monetary policy to stabilize NGDP.
Obviously Stein might be correct. But the proposal is far from having the empirical and theoretical support necessary for policymakers to even consider such a policy today. It would be better to focus first on NGDP stabilization, and then see what other policies are needed once we have a track record with that policy regime.
Unfortunately, I believe that not only is the policy being considered, it is already (to some degree) in effect.
PS. Ryan Avent has a post making similar arguments, albeit much more effectively.