Continuing on my previous thoughts on this matter:
BOSTON--Federal Reserve Bank of New York President William Dudley said Saturday the U.S. tool kit to deal with financial imbalances remains some distance from where it needs to be.
"My own view is that while the use of macroprudential tools holds promise, we are a long way from being able to successfully use such tools in the United States," Mr. Dudley said in the text of remarks to be delivered at a conference held by the Boston Fed.
The Fed is 100 years old, and central banking in the west traces its history more than three hundred years. Yet they haven’t, to this time, developed such tools.
…he said he doesn't see any imminent threat when it comes to bubbles in the financial sector.
"While we work to sort all this out, we should take considerable solace from the fact that we have made the financial system more resilient to shocks," Mr. Dudley said. While it may be hard to spot the next round of imbalances, "with higher capital and liquidity requirements and the use of stress tests to assess emerging vulnerabilities, I think we are much better placed than we have been in the past," he said.
In this, I think he is correct. In working through my (adolescent) understand of tools available to the Fed and the complications in the analysis introduced by the unprecedented level of excess reserves, I have come to a similar conclusion. The financial system is “more resilient to shocks.” The “higher capital and liquidity requirements” are in the excess reserves.
This is not to suggest that the market will not eventually win; it always does. Only that I don’t envision an almost uncontrollable collapse as occurred in 2008.
In any case, the solution to this apparently intractable problem is simple; it can be found in the market. Bubbles of any meaningful macro-economic danger do not form when poor business judgement is allowed to meet its just ends. Profit and loss is a healthy teacher and disciplinarian. The invisible hand is very skilled at spotting and popping bubbles before they become too big to pop.
As to interest rates and the daily fawning over every word by any Fed official:
Fed officials and many others would rather use these set of facilities to quell brewing bubbles rather than to use the blunt tool of raising interest rates, which comes with a cost to the broader economy in terms of weaker employment levels and slower growth.
Raising interest rates isn’t in the Fed’s hands; as I concluded in the above-linked post, given the level of excess reserves the only plausible direct means by which the Fed can increase rates is via an increase in the interest rate paid on excess reserves – the very shortest-term rate on the most secure financial asset, digits held by the Fed. Maybe they will do this.
What do I think? The market will decide for the Fed; the Fed will not decide for the market.