Gavyn Davis has tears in his eyes saying good-bye:
The FOMC meeting this week is not likely to see any policy fireworks, but it will mark the departure of Governor Jeremy Stein, who returns to academic life at Harvard at the end of May. He has only been on the Board for two years, but he has made an intellectual mark in a critical area where leading members of the FOMC have been largely silent – how to set monetary policy when the need to maintain financial stability is conflicting with the near term outlook for inflation and employment.
The issue can be simply stated: should the Fed tighten policy solely because they are worried about the emergence of bubbles in asset prices?
Macro-prudential measures may not be sufficient to handle all circumstances, mainly because parts of the financial system are unregulated. There is a long history of direct controls being avoided by aggressive financial institutions, working “off balance sheet”. Therefore higher interest rates may be needed to supplement these macro-prudential measures, because they “get in all the cracks” of the financial system.
This raises the paradoxical possibility that an early tightening in monetary policy might actually reduce not only the variability of unemployment in the future, but its average level as well. This is not so crazy. If the Fed had raised interest rates more aggressively in 2002-06, the financial crash, and the current level of unemployment, might have been less severe. We may not be there yet in the current cycle, but we soon could be.
When your argument appeals to the interest rates stayed “too low for too long” in 2002-06 it is a sure sign you have a losing argument.
There´s at least one argument for the contrary, to which Gavyn Davies gives short shrift:
Paul Krugman rightly points to an opposite example. In Sweden, a tightening in monetary policy in recent years seems to have worsened the deflationary pressures in the economy. But that will not always be the case.
I have also commented on the Swedish case here.
Update: Don´t miss Mark Sadowski ‘guest post’ in the comments below!