The Federal Reserve is scouring the horizon for signs of new bubbles, Chairman Ben Bernanke said today in Chicago during a speech on how the central bank monitors the financial system. “In light of the current low interest rate environment,” he said, “we are watching particularly closely for instances of ‘reaching for yield’ and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals.” (Another interesting highlight: He also said the shadow banking system continues to pose risks.)
Not all bubbles are created equal, however. Inflated asset prices fueled by irrational expectations don’t necessarily pose an existential threat to the financial sector, the chairman noted. The Fed is trying to spot a particular type of bubble. One, for example, that is associated with high levels of leverage and low liquidity, or links that could spread the repercussions of a sudden, sharp drop in prices through the entire system.
More important than spotting the possible triggers of a hypothetical crisis, Bernanke remarked, is identifying the vulnerabilities that could amplify it. The triggers “are the particular events that touch off the crisis—the proximate causes, if you will.” Vulnerabilities, by contrast, are preexisting features that can, say, turn a housing downturn into a financial meltdown. And bubbly asset prices, he said, are triggers.
Focusing on the vulnerabilities makes sense. As Bernanke himself noted, economists have a poor track record on anticipating bubbles. (The New York Times‘ Paul Krugman yesterday reminded everyone that there isn’t even an agreed-upon definition of what a bubble is.) So relying for stability on the Fed’s ability to zero-in on every instance of suspiciously levitating asset prices would be risky indeed.
This “we watch for bubbles but there are caveats” approach echoes Bank of Canada Governor Mark Carney’s remarks last week in Alberta. Essentially, he said the recently expanded duties of central banks as guarantors of financial stability don’t necessarily mean they should go on a bubble-bursting spree.
And interestingly, the governor has long been discussing a caveat that Bernanke did not mention. On Canada’s record-high housing prices, Carney’s position is that monetary policy should be a weapon of last resort. That’s because the bubble (of course he didn’t use that word) affects only one sector of the economy, according to Carney. Much better to leave it to the government to try and gradually let the air out via tighter mortgage regulations than for the Bank of Canada to use the bazooka approach of an interest rate hike, which would reverberate across the entire economy.
We might soon find out whether he’s right. That would likely make Canada the first test of central bankers’ new intuitions.
Erica Alini is a California-based reporter and a regular contributor to CanadianBusiness.com, where she covers the U.S. economy. Follow her on Twitter: @ealini.