In banking legislation passed in 2010, U.S. lawmakers prohibited the Fed from engaging in rescues of individual financial firms, such as it did with Bear Stearns Cos. and American International Group Inc. during the last meltdown.
Harvard University professor Martin Feldstein told the AEA meeting that outside of the banking sector, the Fed doesn’t have the macro-prudential tools needed to restrain too much risk- taking.
He called on the central bank to raise interest rates more rapidly to rein in asset prices that are "already dramatically out of line" with where they should be.
The ratio of U.S. stock prices to earnings is well above its historical average, he said, while the yield on the 10-year Treasury note is about half of what it should be if monetary policy was more normal.
"There are serious risks" that a sudden lurch down in asset prices could lead to widespread financial losses and push the economy into recession, according to Feldstein, who is also president emeritus of the National Bureau of Economic Research. His base case though is for another good year of growth of 2 percent to 2.5 percent, led by household spending.
Not ‘Significant’ Risk
Cleveland Fed President Loretta Mester said the central bank is monitoring the potential dangers of overheating "as best we can."
"Right now, we do not see this as a significant risk," she added at an AEA panel discussion with Feldstein on Sunday.
She argued that the Fed’s decision to increase rates last month for the first time since 2006 puts it in a better position to limit threats to financial stability.
Starting to lift rates "helps to mitigate any potential for building risks to financial stability stemming from excessive leverage or from investors taking on risks they are ill-equipped to manage in a search for yield," she said.