Thursday, January 14, 2010

Monetary Policy and Bubbles

In the WSJ today, David Wessel criticizes the paper prepared by Ben Bernanke and the Fed staff that Bernanke delivered at the AEA earlier this month. The million dollar question everyone wants to know is whether a low federal funds rate stimulates excessive risk taking and bubble formation. Bernanke argues that empirically the answer seems to be, "not much," but Wessel argues (1) that common sense suggests such a role, and (2) that Raghuram Rajan's point about global savings seeking out high returns implicates a low fed funds rate.

Of the two, the second and less emphasized point is something that seems to be more of an open question. Bernanke's paper does a good job of sketching out the empirics of the link between fed funds rate and subprime lending, for example. The role of the global savings glut is something he raises as well in the paper, and Rajan's insight sounds relatively well-taken. When agents have absolutely no idea what the riskiness of securities is, or are seemingly misled by horribly incorrect ratings from Moody's and S&P, it's plausible that a low fed funds rate and low returns on risk-free government bonds would lead toward an asset bubble.

But if that is true, is it (a) the perceptions of or taste for risk, (b) the rating agencies, or (c) the fed funds rate that is responsible? It seems like if either of the first two issues had been fixed, the Fed would be off the hook.