Federal Reserve Chairman Ben S. Bernanke said financial stability is no longer a “junior partner” to monetary policy and central banks should try to fend off threats in the future.
“The crisis underscored that maintaining financial stability is an equally critical responsibility,” Bernanke said today in Washington. “As much as possible, central banks and other regulators should try to anticipate and defuse threats to financial stability and mitigate the effects when a crisis occurs,” Bernanke said.
Bernanke’s comments represent a break from the Fed’s past hands-off stance toward asset bubbles such as the housing boom that triggered the 2007-2009 crisis. Former Chairman Alan Greenspan was skeptical of the Fed’s ability to identify bubbles or decide when asset prices were too high, and he said it should focus on cleaning up the damage after bubbles popped by lowering interest rates.
That approach was criticized by officials such as Otmar Issing, the former chief economist for the European Central Bank, who argued that leaning against credit-fueled financial bubbles was a responsibility of central banks.
Fed officials may still not use interest-rates as a first tool to pop a bubble, said Lou Crandall, chief economist at Wrightson ICAP in Jersey City, New Jersey.
“They have seen the costs of ignoring incipient bubbles can be unacceptably high,” said Crandall. Fed officials “have a variety of other resources” they can bring to bear against bubbles before using monetary policy, which is likely to be reserved for the objectives of stable prices and full employment, Crandall said.
Federal Reserve Bank of New York President William C. Dudley has said regulators have three tools to respond to bubbles: talk, regulatory policy, and monetary policy. Dudley, in a 2010 speech, said monetary policy was “inferior” to regulatory tools, although he didn’t rule out using tighter credit to reduce leverage in the financial system.
The Fed has set up an Office of Financial Stability Policy and Research headed by Nellie Liang, who was co-leader of the Fed’s 2009 stress tests intended to see if banks had adequate capital. The office was instrumental in spotting falling standards in the leveraged loan market, prompting the Fed this week to issue tougher guidance to banks involved in high-risk, high-yield corporate lending.
Bernanke commented today in the last of four lectures to undergraduates at George Washington University. He is using the lectures as part of a broader effort by the Fed to explain its policies and role to the public as lawmakers and political candidates scrutinize its actions. The chairman has also started holding press conferences after meetings of the Federal Open Market Committee.
Bernanke defended the Fed’s $2.3 trillion of large-scale asset purchases, or quantitative easing, saying they had helped “promote recovery, though the effect on housing was weaker than hoped.” He said the purchases reduced the risk of deflation, or a general decline in prices and wages.
The Fed embarked on the asset purchases after lowering its target overnight interest rate to a record of zero to 0.25 percent in December 2008 as it battled the 18-month recession, which ended in June 2009.
Last September, the Federal Open Market Committee announced a move, dubbed Operation Twist, to replace $400 billion of short-term debt in its portfolio with longer-term Treasuries in an effort to reduce borrowing costs further and support the economic rebound. In January, the panel said rates were likely to stay low at least through late 2014, extending an earlier date of mid-2013.
While Fed policy has helped the economy heal, the pace of expansion has been “extremely sluggish” compared with previous recoveries since World War II, he said, and unemployment remains “quite high” at 8.3 percent.
At the same time, banking system is “significantly stronger” than it was three years ago, in part because of strengthened oversight by the Fed and other regulators, and credit is more available to households and businesses.
Bernanke used his March 27 lecture to focus on the Fed’s response to the financial crisis, asserting that policy makers helped prevent it from becoming a worldwide catastrophe. In previous lectures, he examined the roots of the crisis, including the boom and bust in home prices and the Fed’s failure to recognize vulnerabilities in the financial system.
Today, Bernanke, a scholar of the Great Depression, received a gift from the students: a framed front page of the April 20, 1933, edition of The New York Times, with a four- column headline that said: “Gold Standard Dropped Temporarily to Aid Prices and Our World Position; Bill Ready for Controlled Inflation.”
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