Inquiring minds may wish to take a peek inside a Fed ‘War Games’ Exercise conducted this past summer, just recently reported on by the Wall Street Journal.
Commercial real-estate prices have continued to rise and are projected to far exceed levels they reached before the 2007-09 financial crisis, adjusted for inflation. Debt is building up at companies through the issuance of junk bonds and loans to low-rated firms. Small banks, money-market funds, mutual funds and government-sponsored enterprises have become big players feeding the financial system with credit. However, the large banks subject to heavy regulatory oversight aren’t big providers of credit. Borrowers are increasingly reliant upon short-term loans, which could dry up quickly in a downturn. The economy could tumble into recession if a new financial bubble bursts.
What should the Fed do?
The question was posed to five regional Fed bank presidents in early June in a “war games” exercise. The presidents—the Boston Fed’s Eric Rosengren, Kansas City’s Esther George, New York’s William Dudley, Cleveland’s Loretta Mester and Minneapolis’s Narayana Kocherlakota, had to devise a response. They met at a regional Fed branch in Charlotte, N.C., and worked over three hours, with a whiteboard, briefing papers and lots of coffee. They emerged with a list of the pros and cons of various approaches, but no concrete road map for how to proceed.
Fed officials also looked at whether they could demand that banks require larger down payments on loans to ensure borrowers weren’t as exposed to a large drop in real-estate prices. These “loan-to-value” rules also would have required agreement among several slow-moving regulatory agencies. Another problem was that in this scenario, large banks weren’t at the root of the problem.
In addition, Fed officials looked closely at a little-used power the central bank has under the 1934 Securities Exchange Act to set so-called margin requirements on securities transactions, which could limit how much borrowed money banks, brokers and others can use in securities transactions.
Perhaps the most challenging part of the discussion related to monetary policy. Former Fed governor Jeremy Stein once argued that the most effective way to stop a bubble from building might be to raise interest rates, because that approach “gets in all of the cracks” of the financial system. Some of the Fed officials in Charlotte gravitated toward raising rates for that reason, and because they thought they could use it quickly and without consultation with other bank regulators.
Mr. Rosengren said he emerged from the exercise sympathetic to these arguments, but others disagreed. Among them was Ms. George, who said rates weren’t the right tool to address bubbles. She argued the best approach was to ensure the banks at the core of the financial system are required to have larger amounts of capital.
It was an odd turnabout. During most of this expansion, Mr. Rosengren has been a policy “dove” who supported the use of low interest rates to promote economic growth and reduce unemployment. Ms. George was a “hawk” who wanted rates higher because she thought low rates were causing bubbles.
Mr. Rosengren, in an interview, said low rates in this hypothetical scenario were less justified than they were in the years after the financial crisis because the economy in the scenario was back to a normal footing. Ms. George, in an interview, said she didn’t support low rates in the first place, but that didn’t mean that raising them was the best solution to a bubble after it had already been set in motion.
The disagreement was another sign that six years since the last financial crisis, Fed officials still don’t have an answer for dealing with the next boom-bust cycle.