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In recent months, concern has intensified among the world’s financial experts and news media that overheated asset markets—real estate, equities, and long-term bonds—could lead to a major correction and another economic crisis.

The general public seems unbothered: Google Trends shows some pickup in the search term “stock market bubble,” but it is not at its peak 2007 levels, and “housing bubble” searches are relatively infrequent.

But the experts’ concern is notable and healthy, because the belief that markets are always efficient can survive only when some people do not completely believe it and think that they can profit by timing the markets. At the same time, this heightened concern carries dangers, too, because we do not know whether it will lead to a public overreaction on the downside.

International agencies recently issued warnings about speculative excesses in asset markets, suggesting that we should be worried about a possible crisis. In a speech in June, International Monetary Fund Deputy Managing Director Min Zhu argued that housing markets in several countries, including in Europe, Asia, and the Americas, “show signs of overheating.” The same month, the Bank for International Settlements said in its Annual Report that such “signs are worrying.”

Newspapers are sounding alarms as well. On July 8, the New York Times led its front page with a somewhat hyperbolic headline: “From Stocks to Farmland, All’s Booming, or Bubbling: Prices for Nearly All Assets around World Are High, Bringing Economic Risks.” The words “nearly all” are too strong, though the headline evinces the newfound concern.

It is not entirely clear why the alarms are sounding just now, after five years of general expansion in markets since they hit bottom in early 2009. Why aren’t people blithely expecting more years of expansion?

It seems that this thinking is heavily influenced by recent record highs in stock markets, even if these levels are practically meaningless, given inflation. Notably, just a month ago the Morgan Stanley Capital International All Country World Index broke the record that it reached on October 31, 2007.

The International Monetary Fund announced in June a new Global Housing Watch website that tracks global home prices and ratios. The site shows a global index for house prices that is rising, on a GDP-weighted basis, as fast as during the boom that preceded the 2008 crisis, though not yet reaching the 2006 record level.

There is also the US Federal Reserve’s announcement that, if the economy progresses as expected, the last bond purchase from the round of quantitative easing that it began in September 2012 will be in the month after the Federal Open Market Committee’s October 2014 meeting. That kind of news story seems also to affect observers’ thinking, though it is not really much in the way of news, given that everyone has known that the Fed would end the program before long.

The problem is that there is no certain way to explain how people will react to such a policy change, to any signs of price overheating or decline, or to other news stories that might be spun as somehow important. We simply do not have much well-documented history of big financial crises to examine, leaving econometricians vulnerable to serious error, despite studying time series that are typically no more than a few decades long.

Until the recent crisis, economists were talking up the “great moderation”: economic fluctuations were supposedly becoming milder, and many concluded that economic stabilization policy had reached new heights of effectiveness. As of 2005, just before the onset of the financial crisis, the Harvard econometricians James Stock (now a member of President Barack Obama’s Council of Economic Advisers) and Mark Watson concluded that the advanced economies had become both less volatile and less correlated with each other over the course of the preceding 40 years.

That conclusion would have to be significantly modified in light of the data recorded since the financial crisis. The economic slowdown in 2009, the worst year of the crisis, was nothing short of catastrophic.

In fact, we have had only three salient global crises in the last century: 1929-33, 1980-82, and 2007-9. These events appear to be more than just larger versions of the more frequent small fluctuations that we often see, and that Stock and Watson analyzed. But, with only three observations, it is hard to understand these events.

All seemed to have something to do with speculative price movements that surprised most observers and were never really explained, even years after the fact. They also had something to do with government policymakers’ mistakes. For example, the 1980-82 crisis was triggered by an oil price spike caused by the Iran-Iraq war. But all of them were related to asset-price bubbles that burst, leading to financial collapse.

Those who warn of grave dangers if speculative price increases are allowed to continue unimpeded are right to do so, even if they cannot prove that there is any cause for concern. The warnings might help prevent the booms that we are now seeing from continuing much longer and becoming more dangerous.

Robert J. Shiller, a 2013 Nobel laureate in economics, is Professor of Economics at Yale University and the co-creator of the Case-Shiller Index of US house prices.

© 2014 Project Syndicate.

The United States Federal Reserve System is one of the most powerful governmental organizations in the history of the world. America’s central bank has control over the supply of dollars, and currently exerts great influence over interest rates, both for short-term and long-term borrowing.

And, though the Fed was partly responsible for the regulatory failures that led to the global economy’s near-meltdown in 2008-2009, post-crisis reform has left it with even greater authority and more responsibility for overseeing the financial system.

That is a worrying outcome, because senior Fed officials seem to have slipped back into their pre-2008 ways, ignoring concerns about dangerous financial-sector behavior—even when those concerns are expressed by members of the US Senate Banking Committee. This is not only unfortunate; it is also dangerous, because the Fed’s political position is much more precarious than its leadership seems to realize.

In many countries, people on the right of the political spectrum provide a bastion of support for the central bank. In northern Europe, for example, the European Central Bank’s independence is seen as essential for price stability—and politicians on the right typically attach a higher priority to this goal.

The situation is quite different in the US. Here, the right, represented by the Republican Party, has long been suspicious of the Fed, reflecting its opposition to a powerful federal government, as well as nostalgia for the days of the gold standard (particularly the version that operated before the Fed was created in 1913). The Fed as it currently operates is being protected by the left (the Democratic Party).

For example, I recently testified at a hearing of the House Financial Services Committee on Republican-proposed legislation that would impose on the Fed greater limitations on both monetary policy and regulation. House Democrats oppose the bill and invited me to the hearing, where I explained that the proposed constraints would, in my view, greatly hamper the Fed’s effectiveness—including its ability to help the economy return to full employment and to prevent the financial system from spinning out of control again.

Under current circumstances, the Democrats are strong enough—with control of the Senate and of the presidency—to fend off these assaults. Consequently, senior Fed and White House officials seem rather confident that nothing dramatic will happen that would undermine the Fed’s independence.

I would not be so sure. The main problem is that the Fed has not moved with alacrity to implement fully key provisions of the Dodd-Frank financial reforms, which were passed in 2010.

For example, the Dodd-Frank legislation specifies that all large financial institutions should draw up meaningful “living wills”—specifying how they could be allowed to fail, unencumbered by any kind of bailout, if they again became insolvent.

Creating such living wills is not an option; it is a requirement of the law. Yet, in a recent speech that reviewed the landscape of financial reform, Fed Vice Chairman Stanley Fischer skipped over the requirement almost completely.

Fischer appears to prefer to rely on the resolution powers of the Federal Deposit Insurance Corporation, which is empowered to takeover failing financial institutions, with the expectation that it will impose losses on creditors in such a way that will not cause global panic. (I am on the FDIC’s systemic resolution advisory committee, but I am not responsible for the agency’s plans or potential actions.)

Unfortunately, as currently constructed, these resolution powers are unlikely to work. They do not apply across borders, there is not enough loss-absorbing capital in large complex financial institutions, and the funding structure of big bank holding companies remains precarious.

Senior Fed officials emphasize that big banks fund themselves with more equity now than they did in the past. But the Global Capital Index constructed by Thomas Hoenig, the FDIC’s vice chairman, indicates that the largest US banks are still 95% debt-financed. With that much leverage, it does not take a lot to create fear of insolvency.

Yet, despite repeated and responsible expressions of concern—including from Senate Democrats—the Fed continues to ignore these profound problems. If anything, in his most recent speech, Fischer seemed to brush aside any such fears – assuring his audience that there is great social value in continuing to have extremely large financial firms that operate with so very little equity capital (and therefore a great deal of leverage).

This is more than disappointing. It is profoundly dangerous to the economy. And it imperils the Fed’s future ability to take action as needed.

In recent interviews, including with The New Yorker, Fed Chair Janet Yellen has indicated at least general concerns about financial-sector behavior and the vulnerability of big banks. But unless the Fed acts on such concerns—including by implementing the requirement that large financial institutions adopt meaningful living wills—its independence will come under even greater pressure.

Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario. 

© 2014 Project Syndicate.

Let me cut to the chase: I am increasingly concerned about the risks of our current monetary policy. In a nutshell, my concerns are as follows:

First, I believe we are experiencing financial excess that is of our own making. When money is dirt cheap and ubiquitous, it is in the nature of financial operators to reach for yield.

There is a lot of talk about “macroprudential supervision” as a way to prevent financial excess from creating financial instability. My view is that it has significant utility but is not a sufficient preventative. Macroprudential supervision is something of a Maginot Line: It can be circumvented. Relying upon it to prevent financial instability provides an artificial sense of confidence.

Second, I believe we are at risk of doing what the Fed has too often done: overstaying our welcome by staying too loose too long. We did a good job in staving off the deflationary and depression risks that were present in the aftermath of the 2007–09 financial crisis. We now risk falling into the trap of fighting the last war rather than the present challenge. The economy is reaching our desired destination faster than we imagined.

Third, should we overstay our welcome, we risk not only doing damage to the economy but also being viewed as politically pliant.

The rub

I was uncomfortable with QE3, the program whereby we committed to a sustained purchase of $85 billion per month of longer-term U.S. Treasury bonds and mortgage-backed securities (MBS). I considered QE3 to be overkill at the time, as our balance sheet had already expanded from $900 billion to $2 trillion by the time we launched it, and financial markets had begun to lift off their bottom. I said so publicly and I argued accordingly in the inner temple of the Fed, the Federal Open Market Committee (FOMC), where we determine monetary policy for the nation.

I lost that argument. My learned colleagues felt the need to buy protection from what they feared was a risk of deflation and a further downturn in the economy. I accepted as a consolation prize the agreement, finally reached last December, to taper in graduated steps our large-scale asset purchases of Treasuries and MBS from $85 billion a month to zero this coming October. I said so publicly at the very beginning of this year in my capacity as a voting member of the FOMC. As we have been proceeding along these lines, I have not felt the compulsion to say much, or cast a dissenting vote.

However, given the rapidly improving employment picture, developments on the inflationary front, and my own background as a banker and investment and hedge fund manager, I am finding myself increasingly at odds with some of my respected colleagues at the policy table of the Federal Reserve as well as with the thinking of many notable economists.

Here is the rub as I see it: The Fed as the nation’s monetary authority has been running a hyper-accommodative monetary policy in order to lift the economy out of the doldrums and counteract a possible deflationary spiral. Starting six years ago, we embarked on a path to make money costless and abundantly available. We did so in several stages that are by now well known, culminating by shifting into high gear with the aforementioned QE3 program whereby we have since more than doubled the Fed’s balance sheet to $4.5 trillion.

Previously, we influenced financial markets and the economy by managing the federal funds rate, the overnight rate that anchors the yield curve. Presently, 75% of Federal Reserve-held loans and securities have remaining maturities in excess of five years, and we own roughly 40% of the stock of U.S. Treasury bonds and a similar proportion of MBS. This is an unprecedented profile for the portfolio of the keeper of the watch for the global financial system.

When we buy a Treasury note or bond or an MBS, we pay for it with reserves we create. This injects liquidity into the economy. This liquidity can be used by financial intermediaries to lend to businesses to invest in job-creating capital expansion or by investors to finance the repairing of balance sheets at cheaper cost or on better terms, or for myriad other uses, including feeding speculative flows into financial markets.

Much of what we have paid out to purchase Treasuries and MBS has been put back to the Fed in the form of excess reserves deposited at the Federal Reserve Banks, such as the Dallas Fed. As of July 9, $2.517 trillion of excess reserves were parked on the 12 Fed Banks’ balance sheets, while depository institutions wait to find eager and worthy borrowers to lend to.

But with low interest rates and abundant availability of credit in the non-depository market, the bond markets and other trading markets have spawned an abundance of speculative activity. There is no greater gift to a financial market operator—or anyone, for that matter—than free and abundant money. It reduces the cost of taking risk. But it also burns a hole in the proverbial pocket. It enhances the appeal of things that might not otherwise look so comely.

I have likened the effect to that of strapping on what students here at USC and campuses elsewhere call “beer goggles.” This phenomenon occurs when alcohol renders alluring what might otherwise appear less clever or attractive. And this is, indeed, what has happened to stocks and bonds and other financial investments as a result of the free-flowing liquidity we at the Fed have poured down the throat of the economy.

Lessons from Swift and Irwin

At the Fed, as with any great university like USC, there is a culture of citing serious academic studies to document one’s thesis (especially if you are the lead or coauthor of the study!). You needn’t be an academic economist, however, to understand the danger of too much money. A student of literature can cite Jonathan Swift and his “Poems,” written in 1735:

Money, the life-blood of the nation,

Corrupts and stagnates in the veins,

Unless a proper circulation
Its motion and its heat maintains.

As evidenced by the buildup in excess bank reserves, the money we have printed has not been as properly circulated as we had hoped. Too much of it has gone toward corrupting or, more appropriately stated, corrosive speculation.

To get a sense of some of the effects of excess liquidity, you need look no further than Neil Irwin’s front-page, above-the-fold article in the July 8 issue of the New York Times, titled “From Stocks to Farmland, All’s Booming, or Bubbling.” “Welcome to … the Everything Bubble,” it reads. “Around the world, nearly every asset class is expensive by historical standards. Stocks and bonds; emerging markets and advanced economies; urban office towers and Iowa farmland; you name it, and it is trading at prices that are high by historical standards relative to fundamentals.” Irwin’s comments bear heeding, although it may be difficult to disentangle how much these lofty valuations are distorted by the historically low “risk-free” interest rate that underpins all financial asset valuations that we at the Fed have engineered.

I spoke of this early in January, referencing various indicia of the effects on financial markets of “the intoxicating brew we (at the Fed) have been pouring.” In another speech, in March, I said that “market distortions and acting on bad incentives are becoming more pervasive” and noted that “we must monitor these indicators very carefully so as to ensure that the ghost of ‘irrational exuberance’ does not haunt us again.” Then again in April, in a speech in Hong Kong, I listed the following as possible signs of exuberance getting wilder still:

• The price-to-earnings, or P/E, ratio for stocks was among the highest decile of reported values since 1881;
• The market capitalization of U.S. stocks as a fraction of our economic output was at its highest since the record set in 2000;
• Margin debt was setting historic highs;
• Junk-bond yields were nearing record lows, and the spread between them and investment-grade yields, which were also near record low nominal levels, were ultra- narrow;
• Covenant-lite lending was enjoying a dramatic renaissance;
• The price of collectibles, always a sign of too much money chasing too few good investments, was arching skyward.

I concluded then that “the former funds manager in me sees these as yellow lights. The central banker in me is reminded of the mandate to safeguard financial stability.” Since then, the valuation of a broad swath of financial assets has become even richer, or perhaps more accurately stated, more careless. It is worrisome, for example, that covenant-lite lending has continued its meteoric revival and has even surpassed its 2007 highs.

Macroprudential supervision: A Maginot Line?

There are some who believe that “macroprudential supervision” will safeguard us from financial instability. I am more skeptical. Such supervision entails the vigilant monitoring of capital and liquidity ratios, tighter restrictions on bank practices and subjecting banks to stress tests.

Although these macroprudential disciplines are important steps in reducing systemic risk, I also think it is important to remember that this is not your grandparents’ financial system. The Federal Reserve and the banking supervisory authorities used to oversee the majority of the credit system by regulating depository institutions; now, depository institutions account for no more than 20% of the credit markets. So, yes, we have appropriately tightened the screws on the depository institutions. But there is a legitimate question as to whether these safeguards represent no more than a financial Maginot Line, providing us with an artificial sense of confidence.

If you look up “Maginot Line” in Wikipedia—the source of most of the world’s conventional wisdom—it notes that “… experts extolled the Maginot line as a work of genius.” It did prevent Germany from leading a direct attack on France during World War II. But it was ultimately ineffective as the Germans outflanked it through neighboring Belgium. “Genius” proved insufficient to thwart a determined force. Thus, the term “Maginot Line” is commonly used to connote a strategy that clever people hoped would prove effective, but instead fails to do the job.

With this in mind, and given that our direct supervisory authority covers roughly only a fifth of the credit system, the Dodd–Frank legislation called for the creation of the Financial Stability Oversight Council (FSOC). This committee composed of members from the Fed and other regulatory authorities is tasked with identifying and monitoring risks posed by so-called systemically important financial institutions.

These financial institutions—banks and nonbanks alike—are better known as “SIFIs,” an acronym that appropriately sounds like something youmight get from wanton behavior. Just last week, Fed Vice Chair Stan Fischer spoke of the need to fortify the FSOC process. I agree with him that this is a sensible thing to do.

And yet one has to consider the root cause of the “Everything Boom.” I believe the root cause is the hyper-accommodative monetary policy of the Federal Reserve and other central banks. This was recently written about and documented at length in the annual report of the Bank for International Settlements, a report I highly recommend to you. The Fed and other central banks have been the catalysts for a search for yield. Markets discount risk liberally if they are under the spell of a presumed central bank “put” that will diminish the risk of loss. They will continually seek a financial Belgium or some other venue to bypass the protective wall that macro-financial supervision and oversight bodies such as the FSOC are believed to represent, however fortified.

An adjustment to the stance of monetary policy

I am not alone in worrying about this. In her recent lecture at the International Monetary Fund, Fed Chair Janet Yellen said, “I am also mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk, and of the limits of macroprudential measures to address these and other financial stability concerns,” adding that “[a]ccordingly, there may be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risks to financial stability.”

Here is the message: At some point you cross the line from reviving markets to becoming the bellows fanning the flames of the “Booming and Bubbling” that Neil Irwin writes about. I believe we have crossed that line. I believe we need an adjustment to the stance of monetary policy.

Our duty as the nation’s central bank is not to engineer a “put” to the markets. Our duty is mandated by Congress and the amendments it made under the Federal Reserve Act in 1977.

Specifically, the amended act states: “The Board of Governors of the Federal Reserve System and the FOMC shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

Take it from Shakespeare’s Portia

In my opinion, we have certainly taken liberty with the definition of “moderate interest rates.” The Oxford English Dictionary defines “moderate” as “avoiding extremes.” And, aptly, it cites among the first uses of the adjective “moderate” Portia’s monologue in Shakespeare’s Merchant of Venice: “O love be moderate, allay thy ecstasy. In measure rain thy joy. Scant this excess. I feel too much thy blessing. Make it less. For fear I surfeit.”

“Joy,” “ecstasy,” “excess,” “surfeit,” “too much”: These words are certainly descriptive of the current status of the credit, equity and other trading markets that have felt the blessing of near-zero cost of funds and the abundant rain of money made possible by the Fed and other central banks that have followed in our footsteps.

Some are willing to tolerate the consequences of the blessings that the Fed poured upon the financial markets because, in their view, we have yet to close in on the other parts of our mandate, to wit: “promot[ing] effectively the goals of maximum employment and stable prices.” So where do we stand on those two fronts? Answer: closer than many think.

I will be arguing at the upcoming FOMC meetings that while it is difficult to define “maximum employment,” labor-market conditions are improving smartly, quicker than the principals of the FOMC expected. The commonly cited household survey unemployment rate has arrived at 6.1% a full six months ahead of the schedule predicted only four weeks ago by the central tendency of the forecasts of FOMC participants.

The most recent data indicate that nonfarm employment surprised to the upside, increasing by 288,000 in June, and prior months’ increases were revised upward. The U.S. Bureau of Labor Statistics’ so-called JOLTS (Job Openings and Labor Turnover Survey) data indicate that job openings are trending sharply higher, while “quits” as a percentage of total separations continue to trend upward—a sign that workers are confident of finding new and better opportunities if they leave their current positions.

And there are areas where jobs are going unfilled. If you had opened the July 8 edition of the Wall Street Journal to page A2, you would have seen an eye-catching headline: “Help Wanted: In Truck Cabs.” This article noted that not only are we presently short 30,000 long-distance truck drivers who earn an average annual pay of $49,540, but also that “[b]usinesses with openings across the pay and education spectrum are struggling to hire house cleaners, registered nurses, engineers, software developers and other workers.”

Both statistically and anecdotally, we are now getting a consistent message from a variety of sources that the labor market, broadly considered—and not just in booming regional economies like Texas’—is tightening. The employment gap is closing faster than most forecasters foresaw.

It should come as no surprise that wages are beginning to lift. For example, median usual weekly earnings collected as part of the Current Population Survey are now growing at a rate of 3%, roughly their pre-crisis average. The latest survey of the National Federation of Independent Business, released last week, shows the net percentage of small firms planning to raise wages is up sharply over the past year.

In short, the key variable of the price of labor, which the FOMC feared was stagnant, appears to have taken on life and is beginning to turn upward. It is not doing so dramatically. But the relationship between the unemployment rate and wage growth is nonlinear, so that as the unemployment rate falls, the incremental impact on wage growth accelerates. And wage growth is an important driver of inflation.

The FOMC has a medium-term inflation target of 2% as measured by the personal consumption expenditures (PCE) price index. It is noteworthy that the 12-month consumer price index (CPI), the Cleveland Fed’s median CPI, and the so-called sticky CPI calculated by the Atlanta Fed have all crossed 2%, and the Dallas Fed’s Trimmed Mean PCE inflation rate has headline inflation averaging 1.7% on a 12-month basis, up from 1.3% only a few months ago. PCE inflation is clearly rising toward our 2% goal more quickly than the FOMC imagined.

I want to be clear on this: I do not believe there is reason to panic on the price front. Just as I did not worry when price increases were running below 2%, I am willing to tolerate temporarily overshooting the 2% level in the case of supply shocks, as long as inflation expectations are firmly anchored. But given that the inflation rate has been accelerating organically, I don’t believe there is room for complacency.

Lessons from duck hunting

One has to bear in mind that monetary policy has to lead economic developments. Monetary policy is a bit like duck hunting. If you want to bag a mallard, you don’t aim where the bird is at present, you aim ahead of its flight pattern. To me, the flight pattern of the economy is clearly toward increasing employment and inflation that will sooner than expected pierce through the tolerance level of 2%.

Some economists have argued that we should accept overshooting our 2% inflation target if it results in a lower unemployment rate. Or a more fulsome one as measured by participation in the employment pool or the duration of unemployment. They submit that we can always tighten policy ex post to bring down inflation once this has occurred.

I would remind them that June’s unemployment rate of 6.1% was not a result of a fall in the participation rate and that the median duration of unemployment has been declining. I would remind them, also, that monetary policy is unable to erase structural unemployment caused by skills mismatches or educational shortfalls. More critically, I would remind them of the asymmetry of the economic risks around full employment. The notion that “we can always tighten” if it turns out that the economy is stronger than we thought it would be or that we’ve overshot full employment is dangerous. Tightening monetary policy once we have pushed past sustainable capacity limits has almost always resulted in recession, the last thing we need in the aftermath of the crisis we have just suffered.

Diluting the punch from 108 proof

So, what to do?

One might posit that by tapering our large-scale asset purchases with an eye to eliminating them in October, we have begun advance targeting with an eye to living up to our congressional mandate. My sense is that ending our large-scale asset purchases this fall, however, will not be enough.

Many financial pundits protest that weaning the markets of über-accommodation, however gradually, risks wreaking havoc, so dependent on central bank largess have the markets become. As a former market operator, I am well aware of this risk. As I have said repeatedly, a bourbon addict doesn’t go from Wild Turkey to cold turkey overnight. But even if we stop adding to the potency of the financial punchbowl by finally ending our large-scale asset purchases in October, the punch is still 108 proof. It remains intoxicating stuff.

I believe the time to dilute the punch is close upon us. The FOMC could take two steps to accomplish this after ending our large-scale asset purchases.

First, in October, we could begin tapering our reinvestment of maturing securities and begin incrementally shrinking our portfolio. I do not think this would have significant impact on the economy. Some might worry that paring our reinvestment in MBS might hurt the housing market. But I believe the demand for housing is sufficiently robust to continue improving despite a small rise in mortgage rates. The economy is improving. An acceleration of income growth that will result will likely buttress a recovery in housing and compensate for the loss of momentum that occurred during the winter freeze. (As a sidebar, I note that according to the National Association of Realtors, overseas buyers and new immigrants accounted for $92 billion, or 7 percent, worth of home purchases in the U.S. in the 12 months ended in March, with one-fourth of those purchases coming from Chinese buyers. As Californians, you might find it of interest that Los Angeles was the top destination for real estate searches from China on realtor.com; San Francisco was second; Irvine was third.)

Importantly, I think that reducing our reinvestment of proceeds from maturing securities would be a good first step for the markets to more gently begin discounting the inevitable second step: that early next year, or potentially sooner depending on the pace of economic improvement, the FOMC may well begin to raise interest rates in gradual increments, finally beginning the process of policy normalization.

Protecting the Fed as a political nuisance

I mentioned at the onset that I think it imperative that the Fed be wary of giving rise to concerns that we will be politically pliant. I’ll conclude with some comments on this, especially since congressional hearings are currently underway to consider structural changes that might be called for on the occasion of the Fed’s 100th anniversary.

A little history helps put current events in perspective. When the German Reichsbank was formed in 1871, German Chancellor Otto von Bismarck was reportedly taken aside by his most trusted adviser, Gerson Bleichröder, and warned “… that there would be occasions when political considerations would have to override purely economic judgments and at such times too [politically] independent a central bank would be a nuisance.”

It is no small wonder that the political considerations of the First World War and the impulse to override what might have been the purely economic judgments of Germany’s central bank led to the hyperinflation of the Weimar Republic and the utter destruction of the German economy.

At great personal risk, former Fed Chair Paul Volcker made clear that the Federal Reserve would not bequeath a similar destiny to the United States. Those of us who are the current trustees of the Fed’s reputation—the FOMC—must be especially careful that nothing we do appears to be politically motivated.

In nourishing growth of the economy and employment, we must avoid erring on the side of coddling inflation to compensate for the inability of fiscal and regulatory policymakers in the legislative and executive branches to do their job. We must not flinch from insisting that our work is best done in a deliberate manner and never, ever for the sake of satisfying the voyeurism of the media or politicians. We must all, Federal Reserve principals and staff, and ordinary citizens alike, continue to protect the independence of the Fed and its ability to be a political nuisance.

Richard K. Fisher is President and CEO of the Federal Reserve Bank of Dallas.