Leaners of Last Resort

OSLO – With Jeremy Stein’s return to his academic post at Harvard at the end of May, the US Federal Reserve Board lost its leading proponent of the view that monetary policy should be used to lean against financial excesses.

Stein’s view, expressed in a speech earlier this spring, is that central banks should be less aggressive in their pursuit of full employment in an environment of heightened financial risk. His position is a refutation of former Fed Chairman Alan Greenspan’s doctrine that the central bank should not adjust policy in response to financial-sector excesses, but instead should concentrate on reacting to any problems that subsequently arise.

The question is whether Stein’s new view is justified. In principle, the answer is straightforward. If a central bank has two policy targets, then it needs two instruments: monetary policy to influence aggregate demand, and regulatory policy to limit financial risks.

In practice, however, the answer is more complicated, because the question has several components. What should monetary policymakers do when regulators are prone to falling down on the job? In particular, should they raise interest rates? To what indicators should they look when determining whether regulators have failed to do their part? And is monetary policy a sufficiently subtle instrument to address the resulting risks?