Question

: Fed's New Strategy Confronts Old Questions on Financial Trade-Offs, Wall Street Journal, 9/30/2020

Directions: Read the article and answer the questions. Remember to make specific references to the article, and to make connections to the theory in the assigned text reading(s). Questions: 1) Briefly explain in your own words the dilemma, or trade-offs, policy makers at the central bank will be facing over the next year or two, as described in the article. 2) Do you think the phrases from the article 'financial bubble' and 'financial stability concerns' relate to each other? If so, explain? 3) Based on the article, what might be your concern if you were someone who has very weak time preferences, and is very conscientious about saving for retirement or future college expenses at their local bank?

THE ARTICLE IS:

Federal Reserve promises to hold interest rates very low for a long time could pose a dilemma once the pandemic is over: how to deal with the risk of asset bubbles.

Those concerns flared when Dallas Fed President Robert Kaplan dissented from the central bank's Sept. 16 decision to spell out those promises. The Fed committed to hold short-term rates near zero until inflation reaches 2% and is likely to stay somewhat above that level -- something most officials don't see happening in the next three years.

"There are costs to keeping rates at zero for a prolonged period," Mr. Kaplan said in an interview. He added that he worries such a commitment "causes people to take more risk in that they know it's much less likely that they're going to be able to earn on savings."

The question of whether the Fed should raise rates to prevent bubbles from forming has long vexed officials. Mr. Kaplan's concerns show how the lack of consensus could one day sow doubts over the central bank's ability or willingness to follow through on the new lower-for-longer rate framework Fed Chairman Jerome Powell unveiled last month.

The new strategy, adopted unanimously by the Fed's five governors and 12 reserve-bank presidents, alters how the central bank will react to changes in the economy. The Fed is now seeking periods of inflation above its 2% target to compensate for periods like the current one, when inflation is running below that goal and short-term rates are pinned near zero. This means the Fed will effectively abandon its prior approach of raising rates pre-emptively, before inflation reaches 2%.

The Fed's statement spelling out the new framework included an escape clause of sorts by saying that achieving its inflation and employment goals "depends on a stable financial system."

The Fed's subsequent Sept. 16 rate guidance alluded obliquely to financial bubbles by saying officials would adjust their current lower-for-longer policy stance "if risks emerge that could impede the attainment of the committee's goals."

Mr. Kaplan said his concerns were reinforced in March after the coronavirus pandemic triggered a near financial panic. "I saw...a lot of forced selling," he said. "There were just some people who came into this with too much risk."

To be sure, with millions of Americans displaced from work and loan defaults on the rise, no one at the Fed is worrying that their policies are too easy right now. Rather, the question is about the trade-offs they might face if, after the pandemic has passed, inflation remains slow to rise to their goal of averaging 2%.

"I share a lot of Rob's concerns," said Boston Fed President Eric Rosengren, who doesn't have a vote on the Fed's rate-setting committee until 2022. "I am worried about financial-stability aspects of this policy. I think we're going to need to address it over the next couple of years," he said in an interview.

Financial-stability concerns motivated Mr. Rosengren to vote against three separate interest-rate cuts last year. He has warned for years of potential excesses building in commercial real estate that would worsen a downturn, a prophecy he worries the pandemic will fulfill.

"People reach for yield in commercial real estate when interest rates get quite low, and you start doing riskier projects, and when the economy hits a shock -- in this case, it was a pandemic -- it means that big losses are going to likely occur," Mr. Rosengren said.

He also pointed to bankruptcies of many larger retailers, hastened by the pandemic. "One of the reasons they're failing is they took on a lot of debt," he said.

Mr. Rosengren expects a difficult economic recovery and said he had no concerns signaling that the central bank expects to keep rates very low for several years. But he said he "would have preferred a more muscular financial-stability statement."

While Mr. Powell hasn't ruled out using interest rates to one day address financial bubbles, he has repeatedly played down such prospects. "Monetary policy should not be the first line of defense," he said this month.

When pressed on whether the Fed would raise rates if other defenses didn't materialize or were inadequate, Mr. Powell implied the bar was high. "It's not something we've done," he said.

Before the mid-1990s, recessions were triggered by an overheating economy that generated higher inflation. The Fed raised interest rates, and spending fell. Setting the right interest rate could achieve both low, stable inflation and low unemployment, which economists dubbed the "divine coincidence."

But, as Mr. Powell said in a 2017 speech, this doesn't mean the same interest rate will achieve those two goals plus a third one: a stable financial system.

"Monetary policy is one tool. It can't take care of everything," said Nellie Liang, a former Fed economist who is now at the Brookings Institution.

Ms. Liang and Mr. Rosengren are among those who say it would be easier for the Fed to execute its new framework if Congress granted the central bank or other regulators better so-called macroprudential tools to address problems such as high levels of indebtedness or the heavy use of short-term borrowings to finance long-term assets.

The more effective those other tools are, the lower the costs of keeping interest rates lower for longer, they say. "We don't have anybody that has authority like the Bank of England to think about, 'Is the household sector or the corporate sector unduly leveraged?' " Mr. Rosengren said.

--Michael S. Derby contributed to this article.

Answer 1

1) Policy makers at the central bank will be facing trade-offs such as people taking more risks according to Mr. Kaplan as the interest rates are quite low on savings. As the central bank will keep interest rates low until inflation doesn't go beyond 2% at the cost of financial stability as people will try to invest in risky projects, but incur big losses when the economy hits a shock according to Mr. Rosengren.

2) Financial bubble is when the economy experiences a drop in asset prices. Financial stability concerns are addressed in terms of the policy which the central bank is taking and what will be the repercussions of these. It is alluded that financial stability concerns being expressed could lead to financial bubbles as asset prices could decline drastically in a downturn. Thus they are related wherein financial stability concerns are addressed in order to avoid the occurrence of financial bubbles.

3) My concern would be the extremely low return which I would get if I want to save in a local bank because there is potentially zero return, and in the future the inflation rate would likely rise, reducing the real value of savings and purchasing power. This will increase by potential to invest in risky assets as the returns on those assets will be greater.