Blogs & Comment

Expect the Fed to keep the pedal to the metal, even if there's a bubble brewing

As universally expected, the Federal Reserve left things as they were after yesterday’s Federal Open Market Committee meeting: the target for the Fed funds rate stays between 0 and 0.25 per cent and the bank will continue to buy $40 billion-worth of mortgage-backed securities, plus $45 billion of longer-term treasuries per month. A series of positive signs from the economy—from healthy retail sales to a housing recovery that seems to be gaining traction—and a surprisingly strong February jobs report didn’t convince the Fed it was time to rein-in the monetary stimulus. If anything, the bank seemed to take the good news as indication that pumping money into the economy is starting to yield results.

Also unsurprisingly, Federal Reserve Bank of Kansas City President Esther George, dissenter-in-chief at the bank, voted against the motion to stay the course, citing “economic and financial imbalances,” as well as, further down the road, “an increase in long-term inflation expectations” as reasons for concern.

Now,  the hawks have getting their feathers ruffled over inflation fears for so long one might wonder whether they still believe their own warnings. On asset and financial bubbles, though, they sound a lot more persuasive. Four-plus years after the collapse of Lehman Brothers, interest rates are still at rock bottom, punishing savers and forgiving big spenders. Americans can still get a 30-year fixed-interest mortgage at a 3.5 per cent rate. And as the appetite for risk returns, the Fed’s near-zero policy rate could push investors to look for yield in places they shouldn’t. Are we heading into the same trouble that got us here in the first place?

The risk of new imbalances is real, and the doves at the Fed say they take the issue seriously. But they’ve also said they don’t want to use monetary policy to deal with it. As a recent client note from BNP Paribas pointed out last week, Chairman Ben Bernanke laid out the bank’s strategy on “threats to financial stability” quite neatly in his latest public address. It goes like this: first of all, the bank is constantly scanning the horizon for smoke signals, looking for possible incipient trouble in big banks as well as the so-called “shadow banking system” (non-bank institutions that perform some bank-like functions) and trading information with other regulators. Second, “recognizing that … monitoring of the financial sector will always be imperfect,” the Fed is also relying on tighter regulations and stress tests to ensure the biggest financial institutions can weather another crisis without brining down the house. Third, the Fed goes to great lengths to communicate its policy decisions to avoid misperceptions and undesired reactions in the markets. Monetary policy was the last thing Bernanke listed, as a weapon of last resort.

All this should sound familiar to Canadians: leaving it to stricter rules to tame bubble risks is the same strategy Bank of Canada Governor Mark Carney hopes will keep the Canadian housing market in check. It’s easy to see why central bankers like that approach: monetary policy, though more nimble a tool than fiscal policy (which, as economist Stephen Gordon recently noted, acts with a considerable lag and can be easily derailed by partisan interests), is still a pretty blunt instrument. Raise interest rates in the U.S. and you could kill the recovery and exacerbate the problem of long-term unemployment, with lasting effects of labour productivity, economic growth and, yes, even government revenues. Hike it up in Canada and you’d hurt exports, one of the things that are supposed to help keep the economy growing as real estate and consumer spending slow.

Regulations, are a better precision tool, though, of course, they too cause distortions. Unfortunately, they’re also a less well-tested weapon than good, ol’ monetary policy.

Erica Alini is a California-based reporter and a regular contributor to, where she covers the U.S. economy. Follow her on Twitter: @ealini.