Monetary policy is suddenly exciting again

What is it that Mervyn King, the head of the Bank of England, once said, "Monetary policy should be boring?" The job of central banks all around the world has become anything but boring lately, particularly in countries where asset bubbles are bursting.

Today's New York Times story A Fear That the Cure Could Be Poison, by Edmund L. Andrews, is but one more in a long series of reports in recent days, week, and months that question the level of excitement that contemporary monetary policy is now providing.

Even as the Federal Reserve grapples with the collapse of a speculative bubble in housing — the second speculative bust in less than a decade — is it at risk of repeating recent mistakes?

One day after the Fed slashed its benchmark interest rate to head off a possible recession, a small minority of economists warned on Wednesday that the central bank was in danger of invoking the same remedies that it did after the bubble in dot-com stocks burst seven years ago.

Though most experts agree that the economy is on the brink of a recession, and some even contend the recession has already begun, critics say the Fed’s attempted rescue looks uncomfortably similar to the aggressive rate reductions that aggravated the speculative bubble in housing.
For Mr. Bernanke, the biggest risk now is that financial markets will become paralyzed by fear and that investors, corporations and consumers will pull back on their investing and spending, setting in motion a spiral of economic decline.
...
Mr. Bernanke and other Fed officials are well aware of the risks, and of criticism by some experts that the Fed’s cheap-money policies from 2001 to 2004 may have aggravated the bubble in housing.

Indeed, Mr. Bernanke resisted demands from Wall Street to reduce interest rates faster. As recently as three weeks ago, the Federal Reserve’s official stance was that the risks of slowing growth were still roughly balanced against the risk of higher inflation.

If the Fed continues to lower interest rates, as many Wall Street analysts predict, Mr. Bernanke is nonetheless likely to absorb as many lessons as possible from its experience after the dot-com bubble burst.

Frederic S. Mishkin, a Fed governor with close ties to Mr. Bernanke, suggested in a speech in August what one of those lessons might be. If housing prices plunged, Mr. Mishkin said, the Fed should cut rates quickly and substantially. But once the economy begins to recover, he continued, the Fed should raise them back to normal almost as quickly.

If the Greenspan Fed had just kept an eye on the housing bubble instead of cheering it on, things might have been much different today.

If they had raised interest rates a little quicker and if they had sat around that big table and said, "Look, we have no choice but to flood the system with money. That money is going to go somewhere, so let's keep an eye on things. At the first sign of another bubble forming, let's try to head it off".

That would have been about 2003 when Fannie and Freddie and their regulators first started having problems with accounting for their securitized debt and derivatives.

The Fed's solution?

Outsource that work to Wall Street where, absent any regulation in the subsequent few years, it grew into the multi-headed Hydra more commonly known as the 2007 "subprime crisis".

With short-term interest rates now plunging faster than home prices, it's natural to wonder if the Fed really has learned anything from the last two bubbles.

Mishkin's idea of raising rates quickly next time, that is, if there is a next time (see Japan) holds promise that some progress is being made.