There has been some interesting conversations on the stance of monetary policy in the past few days between Arnold Kling, Scott Sumner, and Josh Hendrickson. Part of the challenge in measuring the stance of monetary policy is that there are multiple transmission channels through which monetary policy can work: the interest rate channel, the balance sheet channel, the bank lending channel, the wealth effect channel, unanticipated price level channel, the exchange rate channel, and the monetarist channel. (See here and here for a discussion of these channels.) Knowing the true stance of monetary policy depends in part on knowing which monetary transmission channels are most important at a given time.
Tobias Adrian and Hyun Song Shin make the case that one of more important channels in recent years is one that really hasn’t been considered yet: the risk-taking channel. This channel measures the stance of monetary policy by looking at balance sheet quantities of financial intermediates:
We reconsider the role of financial intermediaries in monetary economics. We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets. Our findings suggest that the traditional focus on the money stock for the conduct of monetary policy may have more modern counterparts, and we suggest the importance of tracking balance sheet quantities for the conduct of monetary policy.
While this channel works through balance sheet quantities of financial intermediates, it is important to note that changes in the federal funds rate are important in influencing the size of the balance sheets. This, then, provides another reason why the Fed’s low interest rate policy in the early-to-mid 2000s was highly distortionary. The WSJ recently ran a story that highlighted Adrian and Shinn’s work. Here are some key excerpts:
Fed officials are now debating the differences between bubbles as a way to understand them better and come up with the right solutions. Two economists influencing the debate are Tobias Adrian, a New York Fed researcher, and Hyun Shin, a Princeton professor. Their work shows that the credit bust was preceded by an explosion of short-term borrowing by U.S. securities dealers such as Lehman Brothers and Bear Stearns.
For instance, borrowing in the so-called repo market, where Wall Street firms put up securities as collateral for short-term loans, more than tripled to $1.6 trillion in 2008 from $500 billion in 2002. As the value of the securities rose, so did the value of the collateral and the firms’ own net worth. That spurred firms to borrow even more in a self-feeding loop. When the value of the securities started to fall, the loop went into reverse and the economy tanked.
The lesson: The most dangerous part of a bubble may not be the rise in asset prices, but the level of debt that builds up at financial institutions in the process, fueling even higher prices. That means keeping these debt levels down might be one way to prevent busts.
Mr. Adrian and Mr. Shin find low rates feed dangerous credit booms, and thus need to be a factor in Fed interest-rate calculations. Small additional increases in rates in 2005, they say, might have tamed the last bubble. “Interest-rate policy is affecting funding conditions of financial institutions and their ability to take on leverage,” says Mr. Adrian. That, in turn, “has real effects on the economy.”[emphasis added]
His co-author, Mr. Shin, says “clumsy financial regulations” aren’t enough to stop boom-bust cycles. “This would be like trying to erect a barrier against the incoming tide using wooden planks with big holes,” he says. Using interest rates is the “most effective instrument” for regulating risk-taking by firms, he says in a new paper.
No one at the Fed has yet come out in favor of raising interest rates to stop the next bubble, but the idea is being discussed more seriously among Fed officials. Mr. Bernanke has been following Mr. Adrian’s work closely.
I find this very encouraging. Apparently, Ben Bernanke is taking this risk-taking channel seriously along with its implications: the low federal funds rates in the early-to-mid 2000s was a mistake. Maybe we won’t repeat the same mistakes after all.