Some credit markets are showing signs of overheating as investors take larger risks in response to the persistence of low interest rates… Fed Governor Jeremy Stein, highlighted a surge in junk bond issues, the popularity of certain kinds of real estate investment trusts and shifts in bank balance sheets as areas the central bank is watching closely…

Mr. Stein gave no indication that the Fed is contemplating any change in its aggressive efforts to hold down interest rates. Rather, he described the overheating as a trend that might require a response if it intensified over the next 18 months. But the speech nonetheless underscored that the Fed increasingly regards bubbles, rather than inflation, as the most likely negative consequence of its efforts to reduce unemployment by stimulating growth. …

Central bankers historically have been skeptical that asset bubbles can be identified or prevented from popping. Moreover, they tend to regard financial regulation as the appropriate means to prevent excessive speculation and not changes in monetary policy … But the crisis has forced central bankers to reconsider both the importance of financial stability and the role of monetary policy. …

And he closed on a cautionary note. “Decisions will inevitably have to be made in an environment of significant uncertainty,” he said. “Waiting for decisive proof of market overheating may amount to an implicit policy of inaction on this dimension.”

With fiscal policy moving in the wrong direction — deficit reduction rather than employment enhancing stimulus, e.g. infrastructure — if monetary policymakers begin getting skittish, then the unemployed will lose the one institution that seemed to actually care about their struggles. Not good.