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News from EPI Raising interest rates is a terrible way to fight bubbles, especially imaginary ones

In The wrong tool for the right job: The Fed shouldn’t raise interest rates to manage asset bubbles, EPI Research and Policy Director Josh Bivens and Center for Economic and Policy Research Co-Director Dean Baker argue that higher interest rates are the wrong tool to combat asset bubbles. Instead, they point out that the Federal Reserve has more effective tools at its disposal to fight bubbles that will not inflict as much collateral damage on the labor market.

Usual debates over the pace and timing of interest rate increases concern balancing the benefits of a tighter labor market against the costs of accelerating inflation. Because wage and price inflation both remain remarkably subdued, the case for quickly raising interest rates anytime soon is quite weak. Recently, the case that higher interest rates are necessary for avoiding the type of bubbles that caused the recessions of 2001 and 2008 has been thrown into current debates. Kansas City Federal Reserve President Esther George is the most prominent current policymaker to recently make this argument.

“If we attack bubbles with higher interest rates, we will do little to slow the bubble and a lot to damage the real economy. Interest rate increases are bad tools for bubble fighting, and are mostly good tools for slowing growth and blocking further progress in reducing unemployment,” said Bivens. “Instead of going straight for the shotgun, we should look at more precisely targeted tools for controlling bubbles.”

The authors highlight data showing that low interest rates were not a significant cause of the housing bubble in the early 2000s. First, the timing of interest rate changes and home price growth is much less clear-cut than commonly thought. Second, international data makes a compelling case that high interest rates would not have prevented the housing bubble—other countries with relatively tighter interest rate policies nevertheless experienced housing bubbles at the same time the United States did. Third, the authors survey research indicating that higher interest rates are much more effective at slowing economic growth and increasing unemployment than containing bubble-inflated home prices. Ultimately, the scale of interest rate increases that would have been necessary to significantly reduce home price growth during that time would have led to sharply higher unemployment.

Bivens and Baker provide a list of alternative tools that policymakers should use if an economically important bubble were to re-appear. Chief among these tools is one commonly cited as important in other aspects of Federal Reserve policymaking: communication.

“Communication issued by the Federal Reserve is hugely influential in shaping financial markets. It should be no different when it comes to preventing bubbles, yet the Federal Reserve was silent leading up to the crash while the bubble grew to ever more dangerous proportions,” said Baker. “They should use their communication channels to give people information about shrinking, or at least slowing, bubbles before thinking about raising interest rates.”

Other tools available to the Fed to contain asset bubbles are deleveraging and supervision. The Fed could deleverage demand for assets in response to a growing bubble with focused regulatory tools. If the bubble is in housing, they could increase the share of a home’s price that must be paid up front. And finally, the Federal Reserve can better supervise financial institutions to make sure that these institutions themselves do not become overleveraged or illiquid enough to either enable bubbles or amplify the effects of bursting bubbles.

“While there’s no obviously significant bubble in the economy right now, bursting asset market bubbles have caused the last two American recessions,” said Bivens. “Fighting the formation of these bubbles is serious business, but invoking bubbles as an argument to raise interest rates today is not a serious way of addressing this concern.”