Economics rarely has the benefit of a crystal ball. But in this case, we are seeing the future now and have the opportunity to prepare for the challenges related to persistently low natural real rates of interest. Thoroughly reviewing the key aspects of inflation targeting is certainly necessary, and could go a long way towards mitigating the obstructions posed by low r-star. But that is where monetary policy meets the boundaries of its influence. We’ve come to the point on the path where central banks must share responsibilities. There are limits to what monetary policy can and, indeed, should do. The burden must also fall on fiscal and other policies to do their part to help create conditions conducive to economic stability.
Now imagine a potential bubble that only the Fed sees. Imagine if Chairman Greenspan declared war on housing prices in 2004, when many Americans were enjoying homeownership for the first time. I suspect many Americans, members of Congress, homebuilders, realtors, banks (and many others) would have been outraged that the Fed was depriving people of participating in the American dream for a problem that they didn’t believe was real. Imagine if the Fed decided to raise rates to prevent housing prices from climbing. Given how painful the Great Recession was, this may have in fact been a better choice than what the Fed actually did, which was basically nothing. But I have doubts about whether the Fed could have maintained the policy long enough for it to have the desired effect before the American people rejected it. 1 At a minimum, the Fed would have had to work very hard to try to convince the public that the housing bubble was real and a danger. It can be very hard for a sole regulator to stand up against a national belief that home prices only go up and say: “We know better than all of you.” But that doesn’t mean we shouldn’t try.