Here is the full text of my 47th Quartz column, “Meet the Fed’s new intellectual powerhouse,” now brought home to supplysideliberal.com. It was first published on March 24, 2014. Links to all my other columns can be found here.
I wrote this column just in time. On April 3, 2014, Jeremy Stein announced he was resigning from the Fed. But we might see him again in the future in high government office. And this column is at least as much about enduring issues of monetary policy as it is about Jeremy.
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© March 24, 2014: Miles Kimball, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2017. All rights reserved.
I have two related columns not directly linked in this piece: “Monetary Policy and Financial Stability“ and my discussion of Janet Yellen’s views: ”Janet Yellen is Hardly a Dove: She Knows the US Economy Needs Some Unemployment.”
What I say in the column about how a low elasticity of intertemporal substitution affects how the Fed should respond to risk premia is informed by the discussion I gave of a paper of Mike Woodford and Vasco Curdia at a Bank of Japan conference (which I mentioned and linked to here.) Claudia Sahm, Matthew Shapiro and I are working on literature review of empirical work on the elasticity of intertemporal substitution for our paper on that topic. I will have more to say on that in the future.
Janet Yellen led her first monetary policy meeting as chair last week. But with Yellen’s emphasis so far on consensus and continuity, the key news from the Fed last week wasn’t anything Janet Yellen said, but what Federal Reserve Board Governor Jeremy Stein said at the International Research Forum on Monetary Policy on Mar. 21.
Jeremy Stein is currently the junior member of the Federal Reserve Board, having served only since May 30, 2012. (Several recent nominees to the Federal Reserve Board have yet to be approved.) But with Ben Bernanke’s departure, Stein now has the most distinguished academic record of anyone currently making decisions about US monetary policy. His background as a Harvard Professor of Economics and former President of the American Finance Association shows. He holds office hours for staff at the Federal Reserve Board, and from the half hour that I once spent with him, I can say that he stands ready to debate the fine points of economic models with anyone. In his speech last Friday, Governor Stein showed how much genuine light an academic approach can shed on practical monetary policy questions in the right hands.
Victoria McGrane and Jon Hilsenrath at the Wall Street Journal summarize Stein’s speech with the headline, “Financial Stability Considerations Should Influence Monetary Policy.” But Stein’s message is subtler than that headline suggests. He asks first: “Should financial stability concerns, in principle, influence monetary policy decisions? … This question is about theory, not empirical magnitudes, and, in my view, the theoretical answer is a clear ‘yes.’”
As he clearly spells out, the key to his argument is his “third and final assumption … that the risks associated with an elevated value of [financial market vulnerability] cannot be fully offset at zero cost with other non-monetary tools, such as financial regulation.” Stein summarizes:
Thus one way to think of my construct of FMV [financial market vulnerability] is that it is a stand-in for the level of financial vulnerabilities that remain after regulation has done the best that it can do, given the existing real-world limitations.
To explain what he is saying, let me make the analogy to cancer treatment. Because the newer targeted chemotherapies are still not 100% effective, they are still often combined with the older chemotherapies that attack any and all growing cells—leading to the all-too-familiar side effects of hair loss, nausea, anemia, and so on. Similarly, if targeted policies such as financial regulation can’t fully prevent financial crises, then it might sometimes make sense to add a bit of tight monetary policy to help rein in financial excesses.
But the same logic says that the better we get at using targeted tools to prevent financial crises, the less we will need to rely on a monetary broadside—with all of its undesirable side effects—as a secondary preventative measure. So it matters when Anat Admati and Martin Hellwig make a careful argument that high equity requirements for banks have very few true social costs or when I argue that a US Sovereign Wealth Fund would not only stabilize the financial system, but also make money for US taxpayers. (I am not alone in advocating for contrarian debt-financed sovereign wealth funds. UCLA Economics Professor Roger Farmer is just as strong an advocate, as well as top-flight economics journalist John Aziz and my fellow Quartz columnist and coauthor Noah Smith.)
Governor Stein, after making the case that financial stability concerns should play at least some role in monetary policy-making, however small, makes an excellent suggestion of how to guess when financial excess is a concern. He suggests focusing on the size of risk premiums in the bond market. If people are willing to pay almost as much—or equivalently, willing to accept interest rates almost as low—for junk bonds as they are for the very safest bonds (still US Treasuries, despite all of our government debt follies), that is the time to worry.
In addition to all the reasons Governor Stein gives for focusing on risk premiums in the bond market as a way to guess the extent of financial dangers, a focus by the Fed on risk premiums in the bond market has another benefit. Too much discussion of monetary policy has proceeded under the fiction that there is only one interest rate. As soon as one recognizes that there are as many different interest rates as there are types of assets, an obvious question arises: “Which interest rates give the best idea of the cost of borrowing for the home-building, consumer spending, and business investment that drive aggregate demand for the economy?” The obvious—and correct—answer is that it is rates for mortgages, consumer loans, and loans to businesses (of which the lending represented by corporate bonds is an important part) that best represent the borrowing costs that matter for aggregate demand.
So even when the Fed states its policy in terms of the safe fed funds rate, it should be looking past that safe rate to the mortgage rates, consumer-loan rates, and corporate borrowing rates that result. Even before considering the risk of a financial crisis, the Fed should react to an increase in bond risk premiums almost one-for-one by a reduction in the safe rate, and should react to a narrowing of bond risk premiums almost one-for-one by an increase in the safe rate. (The reason I write “almost” one-for-one is that the risk premium has an effect on savers as well as on borrowers, but evidence suggests that savers are not very sensitive to interest rates, so it is the effect of the key rates on borrowers that is of greatest concern.)
The metaphor of an ivory tower is used to contrast academia to the “real world.” But differences among academics in how much they understand the real world are just as big as any gap between academics in general and non-academics. The details of Jeremy Stein’s academic publications and government experience indicate that he combines a respect for theory with a practical bent. And the fact that his specialty is finance is a good sign in that regard: the abundance of good financial data anchors the field of finance into the real world, as reflected in the lack of a divide within finance to match the divide in macroeconomics between “Freshwater” and “Saltwater” macroeconomists. In intellectual style, Jeremy Stein reminds me of the brilliant Larry Summers, but Stein is free of the political baggage that led to Summers being passed over for Chairman of the Federal Reserve Board. My crystal ball is often cloudy, but if I make no mistake, I see an exhilarating trajectory ahead for Jeremy Stein.