Rate rises may be appropriate when asset prices are high, Fischer says

It may be appropriate to raise interest rates if asset prices reach "excessively high" levels across the economy, said Federal Reserve vice-chair Stanley Fischer on January 3.

The standard response to the question of whether monetary policy should be used to address financial instability is that macro-prudential tools should be the first line of defence – a point acknowledged by Fischer in his speech in California.

The Fed, however, has fewer tools at its disposal than other central banks. "There remain cases in which macro-prudential tools are either not available or have not been sufficiently tested in the US, or they may be in conflict with other objectives," he said.

To lean or not to lean

This, said Fischer, means relying more on structural reforms to the financial system and considering whether monetary policy should be used to "lean against the wind of financial stability risks".

He noted the trade-off between financial stability and more traditional objectives for monetary policy – inflation and employment in the US – could be "small or even non-existent" in some cases, but may be "much more difficult to assess" in others.

There remain cases in which macro-prudential tools are either not available or have not been sufficiently tested in the US

"I believe the real issue of whether adjustments in interest rates should be used to deal with problems of potential financial instability is macroeconomic," Fischer said. "If asset prices across the economy – that is, taking all financial markets into account – are thought to be excessively high, raising the interest rate may be the appropriate step."

In his remarks, Fischer touched on a wide range of issues facing central banks, including the constraint posed by the zero lower bound (ZLB) on rates. He assessed a host of ideas floated by economists to remove it.

Higher targets and lower rates

Raising the inflation target, as some economists have suggested, could have the unwanted consequence of making inflation more "variable", said Fischer, with the potential for "substantial" welfare costs as a result. This would include making long-run planning more difficult for households and business.

Andrew Haldane, the Bank of England's chief economist, has also discussed potential solutions to the constraint, concluding it would be a "brave step" to move the inflation target. The Bank of Canada, meanwhile, is analysing similar issues as part of its research agenda.

Fischer spent more time discussing the potential for negative interest rates, deployed in Denmark, the eurozone, Sweden and Switzerland, saying their use "appears to have been transmitted to assets of longer maturity and greater risk".

Bond yields and bank lending rates declined while, specifically in the eurozone, lending to households and corporations "picked up notably". Moreover, some of the anticipated problems had not emerged.

Nonetheless, he highlighted concerns about the "potential for destabilising effects in money markets" in the US, as well as the ability of the infrastructure underpinning securities transactions to adapt.

No easy solution

Another option could be to eliminate physical currency altogether, as its existence "likely still limits how deeply interest rates can be pushed into negative territory", Fischer said. He acknowledged the development of new payments technology, but stressed a "transition to a cashless economy in the US seems very far off".

"As a practical matter, at least for the US, it seems highly unlikely that the constraints associated with the ZLB could be meaningfully addressed by steps to encourage a transition to a cashless economy," he said.

Many believe a reduction in the long-run equilibrium interest rate has or may lead the central bank to encounter the ZLB more frequently in the future. Fischer said it would be "ambitious" to try to raise the rate.

This could be achieved, he suggested, through expansionary fiscal policy, perhaps by investing in infrastructure, while "additional effective investment in education" would boost the nation's capital.

He concluded that "none of these options for dealing with the difficulties of the [ZLB] suggest it will be easy either to raise the equilibrium real rate or to mitigate the constraints associated with the [ZLB]".

Nonetheless, when the real rate is close to zero, "even small effects can make a noticeable difference", said Fischer, adding that "such issues are clearly worthy of additional research".