How (Not) To Prevent The Next Big Financial Bubble

The Federal Reserve should not increase interest rates in order to deflate financial asset bubbles, two progressive economists argue in a policy brief released Thursday. Dean Baker and Josh Bivens' analysis, “The wrong tool for the right job,”  tries to rebut an increasingly common argument for a Fed interest rate hike that could hit Americans in their wallets.

Baker and Bivens, of the Center for Economic and Policy Research and the Economic Policy Institute, respectively, marshal existing research to cast doubt on the idea that raising rates is an effective way to curb asset prices. And they maintain that since raising rates puts downward pressure on job growth, doing so to combat an asset bubble risks causing economic pain in the name of uncertain gains. Instead, they make the case for using targeted financial regulations to achieve the same goal without the unnecessary "collateral damage."

What economists call an asset “bubble” is when prices for a particular financial asset -- such as housing, stocks or bonds -- vastly exceed the asset’s inherent value. The proverbial asset bubble then tends to burst abruptly when investors realize there is not a rational basis for the investment craze, pushing prices into a tailspin that can send tremors throughout the economy.

The 2000s-era housing bubble is at the heart of the contemporary policy debate about the Federal Reserve, because it was the largest and most economically devastating bubble in recent U.S. history.

Some analysts believe that the Federal Reserve could have prevented that catastrophic bubble had it increased the influential federal funds rate (the interest rate at which banks lend to one another using funds held at the Federal Reserve) sooner and more dramatically. The Fed increases this benchmark rate to head off excessive inflation. The cost of borrowing throughout the economy that's tied to that benchmark, including certain kinds of home loans, then also rises. It is a cycle that ultimately lowers prices. (The knock-on effect on other interest rates is why raising the singular federal funds rate is often described as raising interest “rates.”)

If the Fed had made it more expensive to borrow in order to buy a home, the thinking goes, the housing bubble could have been much smaller or avoided entirely.

There is a trade-off baked into that decision though: Those same rate increases are designed to put a damper on economic demand, which risks slowing the pace of job growth.

Now a host of important figures, from Kansas City Regional Federal Reserve Bank president Esther George to likely Republican presidential nominee Donald Trump , are calling on the Fed to raise the benchmark rate out of concerns that we are once again enabling a financial asset bubble.

Historically, the Federal Reserve raises its influential federal funds rate to head off the rising price of goods, not assets. The central bank has a dual mandate to maintain price stability and full employment. 

But the prices of consumer goods  have grown at a rate that's consistently under the Fed's 2 percent inflation target, leaving inflation hawks with little evidence to push for a rate hike.

Bivens posited that the turn to citing asset bubble fears is "window dressing" for people who want to raise rates for various other reasons after so many years when the benchmark rate was at or near zero.  

"It is a kind of ex-post justification," he said.

Thus far, Fed chairwoman Janet Yellen and most of her colleagues have resisted these calls, rejecting the notion that there is a financial bubble driving current economic growth .

The Fed raised the benchmark rate to between 0.25 and 0.5 percent in December, the first increase since the financial crisis. It has since decided to hold off on additional increases amid fears of a slowdown in global markets and an appreciating dollar. (Esther George dissented from the Fed decision-making body's March and April rate announcements.)

Central bank officials will next convene on June 14-15 to decide once more whether it is time to raise the benchmark rate.

But progressive economists like Baker and Bivens  are not taking any chances, since they believe the Fed has a long history of prioritizing inflation fears at the expense of workers.

And the stakes are high. Despite a record streak of job creation, wage growth has been sluggish , raising the possibility that even a modest change in economic conditions could slow down progress even further.

Baker and Bivens do not directly address the question of whether an asset bubble is currently developing. Rather, they try to demonstrate why low interest rates were not in themselves responsible for the 2000s housing bubble, in order to argue that raising them is an inappropriate way to avoid future bubbles.

U.S. home prices began their sharp rise in the late 1990s, a time when the Fed was increasing the benchmark rate, they point out. And the economists note that the housing sector continued to roar from 2004 to 2006, when the Fed was steadily raising rates.

In addition, Baker and Bivens draw on 2010 research by then-Fed chair Ben Bernanke to highlight that many countries where central banks made credit harder to come by than the U.S. -- relative to the specific economic conditions -- actually had bigger housing booms during the 2000s.

In lieu of rate increases that could have unintended economic consequences, Baker and Bivens' analysis calls for the Fed to use its powers of “communication” and regulatory authority to rein in bubbles when it sees them developing. That means the Fed chair would use her bully pulpit to call out sectors of the economy that are growing irrationally, indicating her clear intention to deflate it through regulatory action or other means if investors do not act on their own.

The Fed then has the authority, according to Baker and Bivens, to raise the minimum down payment on home mortgages, for example, in order to preclude reckless borrowing. It can also raise capital requirements for the large financial institutions it oversees.

Joseph Gagnon, a monetary policy expert at the Peterson Institute for International Economics, who was an economist at the Fed for many years, agrees with Baker and Bivens that the central bank should not raise rates in order to curb potential bubbles when better tools are available.

“Raising interest rates is a shotgun approach, shooting pellets all over the economy,” Gagnon said. “But if you use regulatory policy, it is like a rifle. It focuses in on the problem and does not affect everything else.”

Mark Calabria, a Fed watcher at the libertarian Cato Institute, said he is skeptical that many of the regulatory changes needed to really prevent asset bubbles are politically feasible.

“It is highly unrealistic that we are going to start ratcheting back mortgage eligibility because we are still a country that loves homeownership that much,” he said.

Given that reality, he contended, interest rates should be “part of our tool set,” even as he acknowledged their effects on asset bubbles are not completely clear.

“Whereas [Baker and Bivens] see the connection between interest rates and asset prices as being fuzzy, I see the connection between interest rates and jobs being fuzzier,” he concluded.