Quantitative Easing

Reviews | The Fed can do more than fight inflation and unemployment

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Bad-mouthing the Federal Reserve to unclog inflation has become a parlor game – never mind that the Fed also saved the nation from a pandemic depression and inflation is about to fall sharply. But another line of criticism is barely mentioned. For the third time this century, the Federal Reserve reacted late to signs of a bubble. As a result, tech stocks, cryptocurrencies, and even a few analog assets are crashing. The fallout could be unpleasant.

The Fed’s bubble tolerance goes unnoticed because of a dubious argument. Overall, Fed watchers agree that irrational exuberance is not the Fed’s problem. According to this line of thinking, the central bank‘s job is to control inflation in the real economy: it should focus on the price of eggs, not nest eggs. The Fed should not be blamed for causing bubbles. Nor should he be expected to deflate them.

People who work in finance tend to regard these claims as outlandish. If central bankers cut interest rates, people will borrow cheaply to speculate in stocks, real estate, or cryptocurrencies: Sure the Fed can cause bubbles. But the central bank and its allies have subverted this logic with three demands. This Fed policy only slightly affects asset prices; that the Fed’s core inflation-fighting mission is so important that distractions should not be allowed; and that it is easier to clean up bubbles after they burst than to worry about them prospectively.

These arguments, which date back to the 1990s, have always been exaggerated. But given the experience of the last quarter century, not to mention the last two weeks, it’s time to let them go.

The idea that monetary policy affects asset prices only weakly has its origins in the bubbling dot-com era. Day-traders in pajamas and pissed off financial media were said to explain the mania; interest rates were a sideshow. In fact, the bubble was unleashed after a series of panicked interest rate cuts following the implosion of a major hedge fund in 1998; it erupted in 2000 after the Fed began to tighten. But the Fed got away with the narrative that the bubble had been a cultural, not monetary, phenomenon.

Whatever the arguments from this period, the allegation of monetary irrelevance should have disappeared with the Fed’s quantitative easing policy after the crash of 2008. The idea behind such easing is that Fed policy Affects Markets: As then-Fed Chairman Ben Bernanke explained, easing removes the interest rate on bonds, pushing investors to seek returns on stocks and other assets. So much for the claim that Fed policies are incidental to animal spirits.

Next, consider the idea that the Fed should not be distracted from its core mission of fighting inflation. No one doubts that inflation is indeed underlying. But after 2008, the Fed began to focus on jobs as a secondary objective; and in 2020, it replaced its clear inflation target of 2% with an average wave of 2%. With these changes, the Fed was saying that simply targeting inflation was not enough to ensure its broader objective of stabilizing economic growth. Well, if so, why not add bubble avoidance to the framework?

Finally, there’s the idea that cleaning up after bubbles is better than avoiding them. Again, this was never convincing. The mortgage bubble of 2008 was extremely expensive to clean up; and the dotcom bubble, softer because it involved less financial engineering and debt, was nevertheless more toxic than is usually admitted. The dot-com implosion caused a collapse in capital spending, prompting the Fed to respond with dramatic interest rate cuts, which sparked the borrowing frenzy that culminated in subprime mortgage mania.

Will this time be different? It is too early to be certain. Housing market forecasters still look remarkably cheerful; but with rising mortgage interest rates, come back in a month or two. The tech-heavy Nasdaq index has fallen by a quarter since the start of this year, incinerating nearly $5 trillion, and tech companies are announcing a hiring freeze. More bad news will likely follow. Crypto trading may be too small to affect the wider economy. But it’s not great for the psychology of alienated internet users when an Icarus token like Luna incinerates $28 billion in imaginary wealth in just one week; or when Bitcoin’s more than 50% decline since November wipes out $700 billion.

None of this is to say the Fed is wrong to tighten. On the contrary, once a bubble exists, it is best to burst it quickly. But would it have been better to mitigate the disruption by acting before the bubble grew so big? If the Fed’s mandate is to smooth the path of the economy and avoid the pain of disruption, of course it would.