Federal Reserve Governor Jeremy Stein said Wednesday that the large amount of bank reserves does not pose an inflation threat – provided the Fed is willing to raise interest rates soon enough and high enough.
Stein said that one of the main contributors to the housing bubble and subsequent financial crisis of 2007-08 was that the Fed held rates too low earlier in that decade.
Stein reiterated his belief that the Fed’s policymaking Federal Open Market Committee needs to keep an eye on risk premiums in the bond market, particularly spreads between Treasury bonds and less safe corporate bonds, in setting monetary policy.
If those premiums are too low, he said the FOMC should think about raising rates, although he acknowledged that would involve a trade-off between preserving financial stability and achieving its employment objectives.
Appearing on a panel with famed monetarist economist Allan Meltzer, Stein countered the of Carnegie-Mellon University professor’s argument that the Fed’s expansion of reserves through large-scale asset purchases posed an eventual inflation threat.
“Money, once it’s interest-bearing, is a red herring,” Stein said, referring to the Fed’s ability to pay interest on reserves and thereby incentivize banks to continue holding reserves at the Fed rather than convert them into loans and in turn money circulating in the economy.
Stein, who is leaving the Board of Governors May 28, said “the quantity of reserves is not an inflationary worry per se,” but he added, “We may have inflation ultimately because we fail to raise rates at the right time.”
Therein lies the rub, Meltzer rejoined. He quoted unnamed Fed officials as saying the Fed will raise the interest rate on excess reserves (IOER) as “high as it has to go,” but he said history suggests it will not be willing to do that.
Once short-term rates reach 5%, he warned political pressures will preclude the Fed from raising rates as high as they need to go.
Unlike some Fed officials and unlike former Fed Chairman Ben Bernanke, Stein contended monetary policy did play an important role in causing the financial crisis.
After holding the federal funds rate at 1% from July 2003 until late June 2004, the FOMC began slowly and incrementally raising the overnight money market rate to 2% by the end of 2004 and to 4.25% by the end of 2005.
Monetary policy “wasn’t well calibrated in 2003-04,” said Stein, who said those low rates were “not unrelated to the fact that we had a housing boom.”
The housing boom occurred “coincidentally or not when the funds rate was very low,” Stein said, adding that if that period could be done over again, “given the enormous cost of the financial crisis … I would probably think the Fed should have been tighter.”
Reiterating points he made in a formal presentation, Stein argued the Fed should take financial conditions into greater consideration in setting monetary policy.
Other things being equal, Stein said monetary policy should be tighter when risk premiums observed in the difference between short- and long-term Treasury yields (term premiums) and in the difference between Treasury and corporate bond yields (credit risk premiums) are “abnormally” low.
He suggested that “more attention” should be paid to credit spreads than to term premiums.
Stein said that risk premiums and financial conditions more generally should factor into monetary policy decisions regardless of financial stability issues or concerns about asset price “bubbles.”
“The whole bubbles thing is imprecise, a bit emotional,” he said, adding that, “It is reasonable to have monetary policy calibrated to risk premiums … aside from financial stability.”
For example, if credit spreads widen and financial conditions tighten, he said the Fed should “adjust monetary policy accordingly.”
Stein maintained that “quantitative easing” has been “beneficial on net.” He acknowledged there have been “some distributional consequences,” particularly for those who rely on earnings on savings.
“But you’ve got to look at the broader picture,” he said. “If you’re concerned about the lower level of the income distribution, savers are also borrowers; they are more likely to borrow to buy a car.”
To benefit low income Americans, “the best thing is to keep the economy going,” he said.