Alice Rivlin: Financial Instability now more a Concern than Inflation

Alice Rivlin has a wonderful speech about Fiscal & Monetary Policy in a Post-inflation World. Her basic point among many keen insights is that financial instability should be more of a priority now than inflation.

I agree with her. Monetary policy should focus on the wild beasts of the economy, not the domesticated pets. Inflation is not the wild beast it was before the 80’s. It is a domesticated pet now, not likely to run away.

The wild beasts are now financial instability and the growing power of capital. The Fed should put financial instability as a priority above inflation in their mandate. She does not recommend that the Fed raise interest rates, but something needs to be done.

Alice Rivlin…

“But suppose that the major advanced economies actually face a new “normal,” in which inflation is low on the list of threats. In this new world the top-of the-list threats to prosperity in large advance economies are financial instability, slow growth with tendencies to deflation, and the concentration of income, wealth and political power in the hands of a small number of people”

Financial instability in the advanced economies is a far greater threat to world prosperity than the risk that inflation could get out of control. Unfortunately, if central banks keep interest rates low enough for a slow growth world, they risk creating asset price bubbles based on cheap credit that can end in financial catastrophe. Raising rates is not the right response to containing asset price bubbles or avoiding financial meltdown.”

She does contradict herself a bit here by saying that while low interest rates risk financial instability, raising rates is not the response. She prefers other tools, but those other tools are not working.

“An array of sharper tools is needed. Dodd-Frank was an attempt to create those sharper tools, but, like all major legislation, it was an elaborate compromise among multiple stakeholders. We are still a long way from agreement on how the tools should work and how to use them. The hydra-headed financial regulation structure that survived the crisis has not demonstrated an ability to work effectively together.”

So the Fed may be left with raising rates as the most effective tool to control the wild beast of financial instability.