Fed Needs A Balanced Framework---Official Rates Must Be Used To Ensure Price & Financial Stability

The Federal Reserve framework needs to be more balanced. It only uses its interest rate policy for employment and price stability mandates, not for the financial stability mandate—but changes in official and market interest rates significantly influence finance, maybe even more so than the economy and inflation. Ignoring the linkage between interest rates and finance overlooks hundreds of years of evidence, especially the last twenty-five.

The current crisis in the banking industry has the potential to curtail access to credit and reduce liquidity, pushing the economy into recession. If that happens, it would be the third finance-driven recession in the past twenty-five years. Each one is unique. The banking crisis reflects excessive risk-taking and poor risk management linked to the official interest rate policy. The tech-bubble downturn resulted from extreme investor optimism and high leverage in many new start-ups and industries. The housing-bubble downturn reflected excessive household borrowing and relaxed credit standards.

During these episodes, the Fed relied on a new simple, informal, and later formal rule-based price-targeting approach for its inflation mandate while using macroprudential tools for financial stability. That unbalanced approach failed to recognize that no simple rule-approach policy could anticipate all outcomes and trade-offs while neglecting that interest rates fill many of the 'holes" that macroprudential tools miss. And when those "holes" go unfilled for long, the risk of financial crises increases with each passing day.

Finding the right balance is complex and might compel policymakers to choose one mandate over another. Policymakers must realize that, at various times, interest rates set too low for too long for finance can lead to financial instability, just as it could generate general price inflation and economic instability. And the longer that"mismatch" of too low-interest rates last, the greater the risk of financial instability. If the Fed doesn't continue to raise official rates to reverse the cyclical rise in inflation, it will increase the risk that the next bout of financial instability is worse than the current one.

One suggested change in the policy framework would elevate financial stability to equal that of the employment and price stability mandates. That would signal that policymakers would be willing to use interest rates for financial stability like it does to combat high inflation. That would resurrect the old "preemptive" policy approach and provide insurance against adverse financial outcomes.

Policymakers also need to put risk back into investing---telling investors what they plan to do and when they will do it offers a blueprint for speculation and additional risk. Transparency and forward guidance have not led to an improved macroeconomic environment but unprecedented asset inflation cycles and excessive leverage in banking. That is not a coincidence. The price-rule policy approach of the past twenty-five years has shifted instability from the economy (inflation) to finance.

In baseball, after three strikes, a batter is out. Three financial crises under the same policy framework tell me that a fundamental change in Fed policy is near. If the Fed does not change, Congress will legislate a change.