If the financial crisis taught us anything, it was how badly a big burst bubble (in this case, overvalued mortgage debt) can soak the economy. Lesson learned: Avoid bubbles! But the next one may be inflating already. The Federal Reserve’s quantitative-easing program — in which it buys bonds, pumping money into the banking system but lowering the return on traditionally safe products — has pushed investors elsewhere. They are rushing into the stock market and so-called junk bonds (which have low marks from rating firms and offer higher returns to compensate for their riskiness), and policymakers have done little to stop them. “We are seeing a fairly significant pattern of reaching-for-yield behavior,” Jeremy Stein, a Harvard economist and one of the Fed’s newest governors, said in a speech last month, referring to the practice of taking on risky investments that could reap greater-than-average rewards.
“Reaching for yield” can lead to a bubble, which occurs when an asset becomes unmoored from its fundamental value. It’s a product of psychology: More people pile into a certain type of investment, believing that prices will continue rising; and, for a time, they do. (Such behavior is particularly likely when interest rates are low, as they are today because the Fed has kept its benchmark rate near zero since 2008 in an effort to jump-start the economy.) But at some point, the bubble bursts, and prices plummet as investors flee. The dot-com bubble of the 1990s is another recent example.
Once, the Fed didn’t think it could fight these trends with interest-rate hikes. In the late 1990s and early 2000s, there was a belief — articulated by Ben Bernanke, then a Princeton professor, and Fed Chairman Alan Greenspan — that monetary policy was the wrong tool for stopping asset bubbles. Fed officials thought “safe popping” was impossible. Better to wield the central bank’s regulatory and supervisory tools to ensure the financial system’s stability, and to use its monetary-policy tools to mop up after a bubble burst.
One reason economists thought monetary policy couldn’t pop bubbles is that they are very difficult to spot. Bubbles often rest on some real improvement in the quality of assets, so knowing just how much to “lean against” (that is, tighten policy to deflate) a bubble is tricky. Perhaps high-enough interest rates might deter investors, but these would inflict large-scale harm on the economy — the same outcome that bubble-pricking hopes to avoid, Greenspan pointed out in 2002. Or maybe higher rates wouldn’t deter investors at all, given the outsized returns they expect from their investments during a bubble.
Still, the housing crisis caused plenty of soul-searching at the central bank. The risks of a bubble might be too great for officials to simply ignore them and hope for the best. In 2011, after five tumultuous years running the Fed, Bernanke said that the central bank could no longer consider conducting monetary policy its chief responsibility; ensuring financial stability was just as important, and monetary policy just might have a role in advancing it. This January, he said that while monetary policy wasn’t “the first line of defense” against asset bubbles — he’d still prefer to use regulatory and supervisory power to shore up the financial system — “if necessary, we will adjust monetary policy as well” to address the threat of a bubble.
Now the worry about an asset bubble is rising. Days before Bernanke made those remarks at the University of Michigan, Esther George, president of the Federal Reserve Bank of Kansas City and a voting member of the central bank’s policy-setting committee, noted in a speech, “Prices of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels.” George voted against continuing the Fed’s easy policies at the January meeting, citing the risk of a bubble. Stein gave his widely read speech on credit markets just over a week later. And at an event hosted by The Atlantic on Wednesday, former Fed Chairman Paul Volcker said that too much quantitative easing could encourage “speculative activity undermining the very process of restoring sustainable growth and financial stability.”
Bernanke has dismissed the concerns so far as insufficient to raise interest rates or to put an end to the Fed’s large-scale quantitative easing. “Although a long period of low rates could encourage excessive risk-taking, and continued close attention to such developments is certainly warranted, to this point we do not see the potential costs of the increased risk-taking in some financial markets as outweighing the benefits of promoting a stronger economic recovery and more-rapid job creation,” the chairman said in congressional testimony last month. Because risk-taking is part of a healthy economy, clamping down on it too soon could stunt growth, he implied.
A number of economists agree that the risks appear contained at the moment. “The stock market is probably getting a little carried away, but not a lot,” says Nariman Behravesh, chief economist at IHS Global Insight. Corporate earnings are strengthening, after all, as is the broader economy. And low long-term yields aren’t necessarily creating a bubble in the bond market, Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics, said in testimony before a House Financial Services subcommittee last week, so long as they reflect expectations about the path of interest rates set by the Fed and supported by its holdings of long-term securities. These one-hand, other-hand musings are pretty typical of the debate over bubbles — that is, until they burst.