Why Monetary Policy Should Ignore Financial Stability

Financial stability is apparently the new hot reason to tighten monetary policy, and in this article for Quartz I go in on some reasons for why this is a horrible idea. An excerpt

Janet Yellen’s confirmation hearing showed signs that US monetary policy will soon adopt a third mandate. She said: “Overall, the Federal Reserve has sharpened its focus on financial stability and is taking that goal into consideration when carrying out its responsibilities for monetary policy.” While Yellen has traditionally downplayed this mission, the December FOMC meeting minutes also revealed a growing chorus of FOMC participants who believe that monetary policy should do more than just ensure full employment and price stability. Rather, they believe that monetary policy should look out for bubbles and pop them before they jeopardize financial stability. 

At first glance, this sounds like a good idea. After all, who wants financial instability? 

But back in 2002, Bernanke outlined several reasons why tightening monetary policy in response to bubbles is unlikely to work in practice. First, there’s no reason to believe that the Fed can accurately identify bubbles in advance. Second, even if a bubble appears, it’s not clear that raising short term interest rates could pop it. Third, even if monetary policy ends up bringing asset prices down, it is likely to do so only through hurting the livelihoods of average Americans.

Something that should be added, though, is that I still believe research on how monetary policy affects financial stability can be useful. Such research can help us better understand how monetary policy transmission might work, and what things regulators should look out for as the monetary policy landscape changes. However, none of this is any reason why the central bank should base the stock of money on the caprices of the financial markets.