The Fed Should Raise Rates, But Not the Ones You're Thinking

August 20, 2018

The Federal Reserve has kept rates too low for too long. I'm not referring to interest rates. It's high time for the Fed to raise countercyclical capital-buffer rates, which govern the amount of extra equity and cash banks are supposed to hold in good times. Increasing the capital buffer would reduce the risk of financial instability, set a precedent for sound macroeconomic management, and build up a bigger cushion for the next downturn.

Banking regulation naturally has a procyclical bias. When times are good, there's a de facto easing of standards, which exacerbates lending booms. Then when asset values crash and defaults proliferate, regulations become tougher to meet, which worsens credit crunches and recessions.

Optimal regulation from the perspective of a single bank, which ignores these economic spillover effects, therefore will be suboptimal for the system as a whole. Knowing this, smart regulators should work consciously to be countercyclical, increasing what is termed "macroprudential" regulation during booms and relaxing it during recessions. This doesn't necessarily mean raising the average level of regulation or reversing the Trump administration's deregulatory efforts, which are separate debates.

Policymakers in the United States have a limited set of macroprudential tools compared with other advanced economies. The Fed can raise required capital-asset ratios when warranted (allowing 12 months for compliance) by up to 2.5 percentage points. The Dodd-Frank Act specified that capital requirements should increase in "times of economic expansion." The Fed has interpreted that phrase narrowly as "during periods of rising vulnerabilities in the financial system," defined as financial activity that is "not well supported by the underlying economic fundamentals."

The Fed's own standards, which focus on financial indicators, suggest that now is the time to increase countercyclical capital buffers. The Fed's latest monetary policy report to Congress, submitted last month, lists several risks, including elevated price/earnings ratios, stretched commercial-property valuations and rising delinquency rates for some consumer loans. The United Kingdom, France, and eight other European countries already have raised their capital-buffer requirements by up to 2 percentage points, reacting in many cases to less financial excess than is evident in the United States.

The Fed should not, however, lean too heavily on financial indicators in making this decision. It has a poor track record of trying to evaluate financial risks in real time. Eric Rosengren, president of the Boston Fed, has shown that in meetings of the Federal Open Market Committee from 1987 through 2008, mentions of financial instability have generally not increased until after the fact. Financial vulnerabilities often become apparent only when the economy starts to struggle, by which point tightening regulations becomes counterproductive. Moreover, basing decisions on the Fed's risk assessment could turn any announcement of higher capital requirements into a distress signal.

An even stronger rationale for raising capital standards now is the macroeconomic situation. The unemployment rate is below 4 percent, and growth is well above 2 percent. Acting while the economy is robust would set a precedent, moving the Fed's decision making on capital standards toward a more predictable approach, like the one for setting interest rates.

Finally, raising capital buffers today would give the Fed the ability to lower them during a recession, which could soften the downturn by helping banks avoid cuts to lending. This could be an especially important new tool because the conventional responses may be limited. When the next recession hits, the Fed probably won't be able to cut interest rates by its recent average of about 600 basis points. And although there is still substantial economic space for fiscal stimulus, politicians may not see it that way.

It's difficult to predict the precise macroeconomic and financial effects of a countercyclical policy, given the American economy's lack of experience here. Raising capital buffers would increase the cost of lending somewhat, though probably not as much as some banks claim. Such uncertainty is precisely the argument for learning to work this tool while the economy is strong. If it seems appropriate, the Fed could slow the path of rising interest rates and instead rely on the potentially more-direct tool of increased capital requirements to cut some of the financial froth.

Asking banks to lay more capital aside while the sun is still shining would strengthen their ability to withstand the next rainy day. It would lessen the risk of future bailouts. And by calming the markets it would reduce the chances of another crisis in the first place. For the Fed's initial foray into a strong countercyclical policy, that sounds like a pretty good start.