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Jackson Hole Bubble Clash Shows Challenge for Central Bankers

Stanford Professor John Taylor
Former Treasury Undersecretary John Taylor. Photographer: Matthew Staver/Bloomberg

Central bankers and economists at a Federal Reserve symposium clashed over how to best contain asset-price bubbles three years after a crash in U.S. housing prices led to the worst global recession since World War II.

Bank of England Deputy Governor Charles Bean told the meeting in Jackson Hole, Wyoming, yesterday that regulatory tools would be most efficient at deflating a boom without inflicting broad economic damage. Stanford University Professor John Taylor, creator of an interest-rate-setting formula used by central banks, said the tools are “unproven” and using them may cause central bankers to lose focus on adjusting rates properly.

“In a sense, the Fed caused the bubble” in home prices, said Taylor, a former Treasury undersecretary for international affairs. “A priority would therefore be not to create bubbles in the first place,” he said in an interview during a break.

The disagreement highlights the challenges Fed Chairman Ben S. Bernanke and other central bankers face as they seek to sustain the global recovery through unprecedented stimulus measures while not encouraging investors to take excessive risks. Kansas City Fed President Thomas Hoenig, the conference’s host, has warned this year that the Fed’s near-zero rate policy risks creating new, potentially destructive price bubbles.

The discussions are especially timely because of possible bubbles in Treasury bonds and housing debt that may expose investors to the risk of an interest rate increase, Harvard University Professor Martin Feldstein said during a conference break.

‘Big Risk’

“It could well be that anybody’s who’s buying 20-year, 30-year Treasuries is taking a big risk,” said Feldstein, who chaired former President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. “Those prices could come down. I think the Fed is keeping those rates below any kind of long-term equilibrium.”

The yield on the 10-year Treasury note slid on Aug. 25 to 2.4158 percent, the lowest level since January 2009. The yield rose to 2.64 percent on Aug. 27 after Bernanke said in the opening speech at Jackson Hole that the “preconditions” for growth in 2011 are “in place.” The yield on the 30-year bond was 3.6896 on Aug. 27, down from 4.8395 on April 5.

The debate, part of the annual mountainside symposium in Grand Teton National Park, followed a presentation the previous day from Northwestern University Professor Lawrence Christiano, who said the Fed should consider smoothing U.S. stock market booms by tightening monetary policy in response to credit growth.

Done Little

Yesterday, Bean, 56, followed with a 49-page paper arguing in part that if the Fed had raised interest rates higher last decade, it would have done little to damp the housing boom or limit the fallout that followed.

“Monetary policy is too weak and ill directed to moderate a credit and asset-price boom without inflicting unacceptable collateral damage,” Bean said. “Instead if central banks want to manage credit growth and asset prices in order to avoid future financial instability, another instrument is necessary, and that’s obviously macroprudential policy.”

The discussion represents a shift from debate before the crisis, when Bernanke and his predecessor, Alan Greenspan, “advocated something closer to benign neglect during the boom phase, coupled with aggressive relaxation if an asset-price bust occurred,” Bean said.

Former Fed Vice Chairman Alan Blinder, who delivered remarks on Bean’s paper, said the preference for regulatory intervention in credit bubbles may represent the “dim outlines of a new consensus developing on this question.”

Combination of Strategies

Bernanke may have a combination of the strategies in mind. In a January speech, he said the Fed’s low interest rates didn’t cause the housing bubble and the best response to the problem would have been “regulatory, not monetary.” At the same time, he said that if the next wave of regulation proves “insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks.”

Putting the two together is essential, Henry Kaufman, president of New-York based Henry Kaufman & Co., said during the debate. “If that prudential responsibility is to work at all, it has to work with monetary policy, and therefore the Federal Reserve’s role has to be a coordinated role,” said Kaufman, a former Salomon Inc. vice chairman and Fed economist.

No Sure Thing

Using regulation isn’t a sure thing, some participants said. Randall Kroszner, a former Fed governor, said it was politically difficult to tackle the housing boom because “it could be contrary to many other government policies” intended to make housing more affordable. Other political interests “may make it very difficult for the central bank to get in the crosshairs,” Kroszner, now a professor at the University of Chicago’s Booth School of Business, said during the debate.

Taylor said regulatory tools, such as requirements for banks to raise more capital, are “unproven” compared with interest rates.

The effectiveness of rates against a bubble may depend on how much of it was due to financial advances, said Agustin Carstens, governor of Mexico’s central bank.

“The bubble that we saw was based on huge innovation,” Carstens said during the audience discussion period. Without such advances, the sensitivity to interest-rate movements “would be quite different.”

The disagreements among the attendees, which included central bankers from more than 40 countries, may not be resolved any time soon.

“The debate is still going on and won’t be over in the short run,” Pier Carlo Padoan, chief economist at the Organization for Economic Cooperation and Development, said in an interview during a break.

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