Donald Kohn delivered the following remarks for the workshop, "Implementing Monetary Policy Post Crisis: What have we learned? What do we need to know?" at Columbia SIPA and the Federal Reserve Bank of New York on May 4, 2016.

Before the global financial crisis, the implementation of monetary policy was focused only on one thing--achieving the FOMC’s target for the federal funds rate; and the techniques for doing so relied on very small changes in the supply of excess reserves, which were in minimal demand by banks because they were not remunerated. A number of developments during the crisis and the slow recovery thereafter have substantially altered the approach to this critical objective and opened up new potential objectives and challenges for open market operations and the Federal Reserve’s portfolio.

The workshop dealt with these changes and their possible implications for monetary policy implementation by the Federal Reserve and other central banks. The Fed’s larger portfolio along with the expanded list of counterparties in particular has pointed to potential avenues to combine monetary policy implementation with efforts to reduce or deal with risks of financial instability. The workshop presentations had several important messages: spelling out the objectives of policy implementation carefully, especially where those objectives went beyond the traditional goal of achieving the FOMC’s policy rate objective; explaining those objectives and the use of the portfolio to the public and the Congress; dealing with governance--delineating clearly who is responsible for achieving a policy objective and how they will be held accountable; and assessing the costs and benefits of using the Fed’s portfolio as a tool to achieve a policy objective relative to other tools.

Download Kohn's full remarks »

Downloads

• Download Kohn's full remarks

      

 

 

Editor’s note: Donald Kohn delivered the remarks below at the 18th Geneva Conference on the World Economy, titled "The Liquidity Trap: What to do about it," held in Geneva from May 26–27.

This paper couldn’t be more timely or important. One of the narratives that has taken hold and contributed to roiling global markets in the early part of 2016 is that central banks were running out of room to use even unconventional policies to boost growth, dooming the global economy to a prolonged period of resource underutilization and inflation rates well below central bank targets.

This paper is a very helpful and comprehensive guide to monetary policy in a liquidity trap—at the zero lower bound for policy rates. It aggregates and evaluates the many studies of the effects of unconventional polices undertaken in the past several years, marshals new evidence on the effects of negative policy rates, and uses those results to make concrete suggestions for policy at the ZLB, which it tests in a number of counterfactual exercises

The authors arrive at several conclusions: 1. The zero lower bound and liquidity trap are far more likely to be issues in the future than in the past, given the decline on the equilibrium short-term interest rate; 2. Just about everything central banks tried in terms of low/negative interest rates and asset purchases/QE worked to ease financial conditions and by extension to bolster growth and prevent even worse outcomes, and the negative side effects if any have been small and far outweighed by the benefits of these policies; 3. So to escape the liquidity traps today and in the future, the advice to central banks is to just do more—lower more, buy more, buy over a wider array of assets; 4. And while they are at it, central banks should drive inflation rates to new higher targets of say, 4 percent to elevate nominal rates and make episodes at the ZLB less frequent.

My comment is of the character “yes, but”. I broadly agree with many of the conclusions reached by the authors, but I think there are nuances, costs, and complications they could examine more carefully and that central banks need to consider when making policy in a liquidity trap or raising their inflation targets.

I agree that central banks are likely to find themselves dealing with liquidity traps more in the future than in the past. Sluggish growth in potential GDP reflecting slower technological change, weak capital investment, and the demographics of aging populations has contributed to a prolonged decline in r*. But I would caution that future episodes in the liquidity trap may be less serious than one might infer from recent history and this different character could have implications for policies at the ZLB. That’s because of the very substantial beefing up of the regulation of the financial sector in the wake of the global financial crisis. Standards for bank capital, liquidity, and risk management have been raised quite substantially; plans for bank resolution that minimize risks to financial stability are being made; and some nonbank markets that contributed to financial instability in 2008 have been made more transparent and safer, say through the use of central counterparties for clearing.

This regulation probably has contributed to the decline in r* by making intermediation more expensive. But it also means that the amplification of real economy shocks by the financial sector is considerably less likely and when it occurs should be less serious. Well-capitalized and highly liquid banks will be much less subject to runs with forced fire sales of assets; interconnections in derivative markets will be more transparent and the risk easier to manage; credit should keep flowing to the real economy following an adverse development. Of course business and financial cycles will persist fueled by waves of greed and fear and miscalculations by private and public sectors, but the resulting recessions are more likely to be of the garden variety type, with implications for time spent in a liquidity trap and perhaps for the appropriate type of response.

I agree that unconventional monetary policies have been effective at easing financial conditions and boosting the economy. The paper concentrates a lot on the policy of quantitative easing—large-scale asset purchases in Fed jargon. The authors identify three channels through which such purchases should work. First, a market-calming channel in which central bank purchases help to restore market liquidity when trading conditions are disrupted. Second, purchases can reinforce the signals that the central bank is sending about its intention to keep interest rates at unusually low levels for unusually long periods. Third is the portfolio balance channel in which central bank purchase of longer-term or risker assets reduces term or risk premiums directly and which is transmitted more widely as the previous holders of these assets rebalance their portfolios.

But, I wonder whether the paper’s conclusions about the effectiveness of QE derived from recent experience will be applicable to future episodes of liquidity traps and if they are not, what that says about the efficacy and ordering of unconventional policy tools. Without a doubt, the Fed’s first QE in a dysfunctional MBS market was highly effective. But, as I noted, financial disruption is likely to be much milder in future episodes, reducing any impact from the market-calming channel.

With regard to signaling future policy intentions, central banks have developed various means of forward guidance for policy interest rates over this episode of policy at the ZLB. Guidance has become more sophisticated and more economy based, as, in my view, it should be. The Fed and other central banks have seen forward guidance as a key element and a separate tool from purchases in unconventional policy, and it will come into play in a more developed state in the next episode, reducing the need for and impact of the signaling channel for QE.

Trimming expected future short-term rates is a powerful tool for convincing households and businesses to bring future spending forward to the present, as it emphasizes that yields on holding liquid assets into the future are going to present a poor alternative use of funds to spending today. The paper barely touches on the experience of central banks with forward guidance and its efficacy in promoting spending; greater attention to this tool would enhance the utility of this paper for researchers and central banks.

That portfolio balance channel will continue to have effects on term and risk premiums—depending on the type and duration of the assets purchased. The question is just how powerful this will be in stimulating spending if purchases have no effect on market functioning and little effect on expected short-term rates, given the use also of forward guidance. QE should remain effective to some extent; for example It will increase incentives to barrow and it will raise asset prices, activating a wealth channel. But with expected rates little affected, the impact of the portfolio balance channel by itself on bringing spending forward could be muted. And that might affect the most effective ordering and mix of unconventional policies in a liquidity trap.

Asset purchases generally also involve the central bank taking some fiscal risk. This is true even when the assets purchased are longer-term government bonds without credit risk, as the Fed has been doing. The expected profits from holding long-term government obligations financed with short-term debt (bank reserves) will be positive because of the term premiums that were prevalent when the central bank undertook its purchases. But the returns on carry trades can vary considerably—that’s why there are term premiums under normal circumstances. And of course purchases of corporate bonds or private mortgage securities or equities entail much more risk as well as decisions about government intervention credit allocation that are normally made by the fiscal authorities.

So my second “yes but” for unconventional policies is to consider the governance and accountability issues of independent central banks engaging in QE. Governments and central banks have found ways to deal with this during the crisis for some of the facilities. For example, the Fed’s TALF facility that lent against private securitizations came with a backstop from the Treasury’s TARP program; and the Bank of England’s corporate bond purchases were made pursuant to a public letter form the Chancellor concerning compensation for any loses. Discomfort at the Federal Reserve with some of these issues was reflected in an “accord” with the Treasury department in the spring of 2009, acknowledging, among other things the temporary allocative implications of intervening in government backed MBS markets. Questions have also been raised about the debt management implications of the Federal Reserve’s purchase of long-term Treasury securities—how should this coordinated in the future with the debt managers at the Treasury department.

In sum, QE raises serious issues of governance and accountability for independent central banks that should at least be acknowledged and discussed if public and legislative support for central bank independence in the conduct of monetary policy is to be maintained. I suspect that one reason some central banks were slower to adopt QE types of policies was their concern about provoking questions about authorities and independence; better these issues be confronted openly in dialogue with legislators.

I agree that a 4 percent inflation target that was achieved and credibly committed to would have substantial benefits because it would materially lower the odds on future liquidity traps and encounters with the ZLB, given the higher average level of nominal interest rates implied by a higher target. Of course there are costs to weigh against these benefits. The report argues convincingly that some of the costs often cited can be reduced over time. One such cost is the greater variability of higher levels of inflation. Another is the concern that raising the inflation target will undermine the credibility of any such target—raising it once will arouse suspicions that it can be changed and make it much harder to build credibility for the new target. Both of these can be overcome by central bank actions—though it may take some time and entail transition costs advocates of higher targets rarely consider. For example building credibility for a 4 percent target is likely to require leaning extra hard against any tendencies for inflation to overshoot this objective for a while. This kind of asymmetrical reaction function implies that embedding 4 is likely to require inflation averaging below 4 for some time.

But more broadly, higher inflation could well have costs that go beyond these last two or the shoe leather, menu, and tax distortion costs the report discusses. Alan Greenspan defined price stability as “best thought of as an environment in which inflation is so low and stable over time that it does not materially enter into the decisions of households and firms.” That definition has resonated with many over the years. It reflects, in my view, recognition that inflation has costs beyond the technical issues already discussed. It complicates decision making and distorts market signals. And higher inflation probably create difficulties for households and businesses with limited financial expertise in particular, and is likely to have disproportionate effects on small businesses who can’t hire that expertise and less-educated households.

This sense of broader costs could be one reason ”price stability” is so deeply entrenched in legislation and treaties that establish central bank mandates. Four percent is not price stability in that the price level would double every 18 years. The benefits could well exceed the costs in a world of r* close to zero. But at a minimum, good governance and accountability would suggest consultation with the legislature o r other authorizing authority so the costs and benefits could be fully aired by elected officials.

Finally I agree that unconventional policies at the zero lower bound have been effective, but what lessons should we draw from the experience of Japan? Japan seems to be a distinct natural experiment in the all-in use of unconventional policies to escape a liquidity trap. Under its current governor, the BoJ has used all the tools advocated by the authors of the paper and used them aggressively, but it has not had the kind of success one might have anticipated from reading this paper. It raised its inflation target (to 2 percent from 1); it has purchased large quantities of both government and private longer-term obligations, including equities in the form of ETFs; it has reduced its target rate into negative territory. Many financial market measures responded, at least initially. Core inflation rose for a while, albeit partly reflecting the rise in the level of import prices after the yen depreciated, and inflation expectations also increased. But progress stopped well short of the two percent target and recent signs are that the higher inflation has not become entrenched in wages and that core is slipping back—though it remains higher than before the program began. Perhaps the BoJ should just do more of everything, as the report implies, but it is troubling that more sustainable success at hitting a higher target has not been achieved; the Japanese experience is worthy of extra study for its implications for what works to overcome a liquidity trap.

      

 

 

Editor’s note: The following speech was prepared for Tsinghua University-St. Louis Fed Monetary Policy and Financial Stability Conference at PBC School of Finance, Beijing on May 21, 2016. Not delivered.

I’m glad to have this opportunity to contribute to another conference organized by PBC School of Finance at Tsinghua University on critical economic challenges facing policymakers around the world. When I participated at the inaugural conference two years ago, I addressed the organization and use of macroprudential policy to protect financial stability—employing regulatory tools to make the financial system safer and more resilient to systemic threats. This year the topic is monetary policy and financial stability.

Financial stability is the common theme, and in my view it is the right focus at the right place at the right time. The global economy is still suffering from the after effects of the financial instability that marked the Global Financial Crisis of 2007-09; many economies are not back to full employment and inflation is almost everywhere running below the targets set by central banks and governments. While much has been done to strengthen financial systems around the world, we are still learning the lessons of the GFC—what went wrong and how to avoid a repeat.

One aspect of the answer has been the macroprudential policy I spoke about two years ago. Of course, microprudential regulation—on an institution by institution basis--was universal before the GFC. And authorities, including central banks, worked at identifying broader financial risks in the years leading up to the crisis, but the assignment of responsibility for identifying and taking actions to address systemic risks—externalities for the economy associated with financial decisions-- was either ambiguous or missing altogether in many jurisdictions, as were the tools to deal with those risks. The development of decision-making bodies for macroprudential policy with tools to address risks identified has been an encouraging and promising response to the GFC.

Importantly for the subject of this conference, however, questions persist about the contribution of monetary policy to the buildup of risks in mid 2000s. In my view that contribution was minor; the conditions leading to the crisis mostly reflected failures by both the public and private sectors to appreciate and manage growing risks, especially in mortgage markets in the US and elsewhere, born out of complacency after years of good growth and low inflation.

Still, the intersection of monetary policy and financial stability merits further research. Among other things, concerns over the possible effects of monetary policy on financial stability have re-emerged since the GFC in the current context of very accommodative monetary policies over prolonged periods that many advanced economy central banks have undertaken to bolster growth. These policies have been in fact designed to encourage borrowing and spending by households and businesses—the opposite of the deleveraging that might make systems safer. They have entailed promises to keep rates very low for long periods to hold back expectations of rate increases and asset purchases that have driven down term premiums on longer term securities.

For China, recent data have also highlighted the potential intersection of monetary policy and financial stability. These data show very strong credit growth in late 2015 and early 2016 reflecting monetary policy efforts to encourage borrowing to support continued solid economic growth. Similar surges in credit in other jurisdictions and at other times have not been consistent with sustaining growth and avoiding financial instability over time.

I understand that China is making a number of difficult economic transitions to increase welfare of its citizens: to a more consumption-based growth model, especially consumption of services; to a more market based financial system backing more efficient and more market based resource allocation in the real economy. The challenges are how to make these transitions without putting financial stability at risk, and how to design a policy system that will be able to sustain financial stability as markets and institutions are deregulated and play an increasing role in the allocation of finance and resources—in the context of the current conference, how much weight to put on using monetary policy for financial stability purposes.

We all have an interest in Chinese success. China is an increasingly key player in the global economy and financial markets. We saw last summer how actions here can resonate around global financial markets, especially when they are not well understood.

Those are the reasons I say the topic is the right focus at the right time and right place. I am not an expert on China. My reflections on monetary and macroprudential policies to protect financial stability are drawn from experience and knowledge of US, UK, and other industrial economies, but I hope they are useful as China decides how to move forward.

To preview my conclusions: Monetary policy can have important effects on financial stability risks, but, for the most part, it is not the right policy to address those risks. I am concerned about burdening monetary policy with too much to do; putting weight on financial stability in monetary policy decisions implies less weight on economic and price stability in the conduct of policy, and that can have substantial costs in terms of economic welfare. Financial stability is a prerequisite for price and economic stability, so we cannot rule out adjusting monetary policy for financial stability purposes under some, hopefully rare, circumstances; but authorities should develop other tools and other decision processes to rely on first—macroprudential policies—and the more fully developed are these alternatives to monetary policy, the less monetary policy itself might need to be used to defend financial stability.

Monetary policy and financial stability

Monetary policy can affect risks to financial stability. Of particular concern in recent years has been the possibility that the prolonged period of very easy policy might be inducing behaviors that raise these risks, or could do so in the future. The very accommodative policies that many central banks have felt compelled to run are designed to discourage saving and encourage households and businesses to bring consumption and investment forward from the future to the present, financed, at least in part, by borrowing—increasing leverage or at least reducing the pace of deleveraging. These policies are intended to offset other forces that temporarily appear to be holding back economic growth—for example tight credit from banking systems repairing balance sheets post crisis, and restrictive fiscal policies from countries worried about long-term debt trajectories.

Low rates may affect the behavior not only of savers and borrowers in the business and household sectors, but also raise risks inside the financial sector. The drop in interest rates raises asset prices, creating capital gains for lenders. But intermediaries can feel market pressures to re-leverage those gains— or not permit them to reduce leverage—in what appears to be a favorable financial environment. The resulting outward shifts in credit supply curves can cause asset prices to overshoot, along with investment in credit-sensitive sectors.

Very low rates over long periods can induce a reach for yield among investors who, who for contractual or behavioral reasons haven’t fully adapted their desired or expected returns to the new low-rate environment. Low short-term rates and upward sloping yield curves encourage increased maturity mismatch—a borrowing short to lend long carry trade—with associated vulnerability to runs and other financial stability risks.

In my view, the period of very low rates has not in fact created the financial stability risks that people worry about—at least not to the extent sometimes claimed-- but the potential causality has led some to advocate making financial stability considerations an integral and persistent factor in monetary policy decision-making. In effect, monetary policy would target the financial cycle alongside the business cycle. When financial stability is undermined, so is economic stability, and the effects of instability can be severe, long lasting, and not easily corrected by easier monetary policy, as we have learned in recent years; it is better in this view to act pre-emptively to avoid financial instability.

Moreover, in this view, regulation—microprudential or macroprudential—could well prove inadequate to maintaining financial stability, especially when the risks are in securities markets and not concentrated in the most regulated financial intermediaries. Monetary policy --actual and expected interest rates—“gets in all the cracks” in Jeremy Stein’s memorable phrase; it’s a pervasive instrument from which few financial decisions can escape. Running a bit tighter policy than otherwise would discourage excessive risk taking across a broad swath of the financial markets.

But what this argument sometimes misses, I believe, is that the costs of such a policy may be considerable and the benefits limited. A blunt and pervasive instrument has its disadvantages as well as its advantages. Higher interest rates than otherwise will affect sectors and transactions that do not threaten financial stability; collateral damage may be substantial and unnecessary. In particular, weighting financial stability in monetary policy implies a temporary steering away from, or delaying of the approach to, the primary monetary policy objectives of price and economic stability.

As compared with a policy path that aims to achieve these goals as expeditiously as possible, output and employment will be lower, as will inflation. Persistent undershooting of the inflation goal can undermine the credibility of that goal and expectations that it will be reached. We are seeing in Japan today the great difficulty of lifting inflation to a two percent goal when expectations have adjusted to a long period of very low inflation or deflation. Low inflation expectations contribute to low nominal interest rates and greater odds of hitting the effective lower bound on interest rates in a policy response to a negative economic shock.

Moreover, to be effective, a monetary policy adjustment might need to be large and could risk being ill-timed. Small adjustments in rates may well have little effect on asset price misalignments or high levels of leverage and maturity mismatch that are driven by a wave of optimism and complacency—so large adjustments in rates and deviations from medium-term goals might be necessary. And rate adjustments could come at just the wrong time—weakening the economy when an imbalance is about to correct anyway, deepening the ensuing recession.

So in my view the use of monetary policy for financial stability purposes has a very demanding cost-benefit hurdle to overcome. That’s not to argue that monetary policy should never be adjusted to take account of financial stability risks. In situations in which regulation is likely to prove ineffective, and the odds on an episode of financial instability are rising, a tightening of monetary policy might well pass the cost-benefit test by heading off a crisis that had far more serious costs than those resulting from the temporary steering away from price and economic stability. But we do need to recognize the costs of using monetary policy in this way—of adding this burden to monetary policy making.

From my limited knowledge, I would think that adding financial stability to the objectives of monetary policy would be especially a concern in China at this time. Monetary policy in China already is trying to accomplish a number of things. Of course, its main task is to encourage solid growth in output and employment and low, stable inflation. It appears to be doing this while simultaneously operating within the constraint of damping sharp and potentially disruptive movements in exchange rates when capital controls are, deliberately, only partly effective and gradually being lifted. And it is adapting its policies and tools to encourage the transition to a more market-based allocation of savings and more efficient allocation of resources.

Now, as I understand it, because the transition to market based finance is incomplete, some monetary policy tools work directly to encourage or restrict lending by banks—operating on the price of lending and borrowing. through quantitative restrictions. So, for a time, the mix of monetary policy tools can be adjusted to take account of financial stability as well as growth; in effect the PBOC has more than one tool to accomplish more than one objective.

In this regard, monetary policy in China today has some similarities to monetary and financial policy in the US in the 1960s, 1970s, and into the early 1980s. Through this period, the Federal Reserve changed its interest rate target frequently to balance demand with potential supply and control inflation. But it also supplemented this usual policy tool in a number of ways: It varied reserve requirements for banks to influence their lending; it changed margin requirements on loans to purchase equities with a view to fighting asset price misalignments; it adjusted ceilings on deposit rates (Regulation Q) to influence credit availability to the housing sector; and in the early 1980s, at the direction of the Carter administration, it imposed limits on some types of credit in order to slow borrowing. These types of actions were aimed at reinforcing the effects of interest rate policy, but they also were aimed at particular aspects of the financial cycle, like bank lending, mortgage availability, and equity prices.

However, it found that these tools became less effective and even counterproductive as markets became more complete and avoidance that much easier. Futures and derivatives enabled highly leveraged positions to be built in equity and other markets; nonbank intermediation replaced some types of bank credit; money market funds grew in response to controls on deposits rates; etc. So the Federal Reserve gradually reduced its reliance on price and quantity restrictions and evolved to rely only on its federal funds rate target for monetary policy.

But without these tools to manipulate, and with the success of monetary policy over the 1980s and 1990s and decades of the great moderation, the Federal Reserve perhaps reduced its focus on financial stability risks. Even if it had been more focused on such risks, it didn’t have the right tools to deal with them in the evolving financial system.

An important lesson of the GFC is that the transition to more market-based allocation of savings must be accompanied by consideration of the implications for financial stability and by a new set of structures and tools to preserve that stability—to build resilience against risks. Good design of such a system in China will itself facilitate the transition to more reliance on market prices to allocate credit because it will build in the guard rails as the system is evolving and it will give the authorities greater confidence that stability will not be sacrificed as allocative efficiency is improved. And, importantly for the topic of this conference, it will reduce the pressure for monetary policy to be deflected to protecting financial stability.

Structures to protect financial stability

The key to allowing monetary policy maximum scope to focus on the business cycle is to have well-developed structures in terms of decision-making, tools, and accountability for micro-and macroprudential policy. I am going to focus on macroprudential policy, because that is the area of my activity on the Financial Policy Committee at the Bank of England and the aspect of regulation that had fallen into disuse in advanced economies until the GFC and is now getting renewed attention.

Protecting financial stability efficiently and effectively requires a different focus and set of tools than monetary policy does. Attention is most often centered on tail risks, rather than on the most likely outcomes that are often at the heart of monetary policy decisions. It’s those tail risks—the unlikely event not fully priced into the market—that can have the most severe implications for financial stability. Macroprudential policy action is called for when those tail events are expected to have externalities—ramifications for the whole economy and not just for the parties involved in the transactions. Those ramifications often play out through the response of highly leveraged lenders or borrowers to the unexpected event—or the actions of the counterparties to these lenders or borrowers, as they fear for the safety of the lending or funding they have supplied.

The instruments utilized in macroprudential policy are often the microprudential tools of capital or liquidity requirements for financial institutions, or constraints on terms of lending—like limits on LTV or LTIs for residential real estate loans. The calibration of those tools has a “macroprudential finish” on them to take account of systemic risks.

Having a variety of tools is important to better focus on the source of the risk; the more the remedy can be targeted to the problem, the less likely are unintended consequences and the better the anticipated cost-benefit calculus. So, sectoral capital requirements for say real estate lending should be in the tool kit, as should the ability to set limits on the degree to which the terms of particular types of lending can be eased when the extra supply of credit can threaten stability. Real estate lending is often the force behind episodes of financial instability and the ability to limit risky practices in these credits would seem to be essential. In addition, the US authorities have been concerned about rising leverage and easier covenants in some kinds of business loans, and, judging from commentary like the IMF’s Global Financial Stability Report, some types of business loans in China may be growing as a threat to stability; perhaps an ability to directly constrain risky practices in that area would also be useful.

The macroprudential authorities need processes and procedures for spotting and addressing possible problems outside already highly regulated sectors should new technology or regulatory arbitrage contribute to risk migration. And they should have the willingness and ability to use their tools countercyclically in order to push back the frontier where monetary policy action would be called for to protect financial stability.

Because macroprudential policy requires somewhat different expertise and focus than does monetary policy, I believe it should be carried out in a separate committee from those responsible for microprudential and for monetary policies. Such a committee should be clearly tasked with using its analytic and information gathering powers to identify risks to financial stability and with utilizing the tools it has been given to build resilience in the financial system so that if those risks materialize they would not impair the critical functions of the system to intermediate savings and investment and allow users of that system to manage risk.

The macroprudential authorities will need to take a long view of risks to financial stability, tightening policies when times are good and risks are building and loosening them when the cycle turns and maintaining the supply of credit will contribute to economic stability. Those forward-looking policies will require a good deal of clear communication about their intended effects and their contribution to economic welfare. And their effective implementation is also likely to require a degree of independence from short-term political pressures, especially those that might be brought to bear by lenders and borrowers whose actions are being constrained.

Good macroprudential decision-making will require a major role for the central bank. Central banks bring expertise in financial markets and in the intersection of those markets with the real economy. Their macroeconomic responsibilities give them a broader focus and expertise than the microprudential authorities, which focus on individual institutions.

As I did two years ago, I would suggest that the UK model for implementing macroprudential, microprudential, and monetary policies is quite likely to prove more successful than that prevailing in the US. The US is working with a fragmented regulatory system in which agency responsibilities often overlap or intersect. This system requires considerable coordination across many agencies, each operating with a different focus and mandate. Such cooperation takes considerable time, making many types of countercyclical policies largely impractical.

Although the formation of the Financial Stability Oversight Council in the Dodd-Frank legislation was a step forward, coordination remains difficult and time consuming, and responsibility and accountability for financial stability is not clearly spelled out or aligned with the available tools. And the tool kit itself does not seem adequate; in particular it lacks the authority to limit cyclical deterioration in the terms of residential real estate lending, the source of several episode of financial instability in the past.

In the UK macroprudential policy is made by a committee in the Bank of England. There are separate committees for microprudential and monetary policies, also in the Bank, and these are represented on the macroprudential policy committee through overlapping membership facilitating mutual understanding and collaboration. The committee also includes four external members who are appointed for up to two three year terms. The head of the financial conduct regulator is also automatically a member of the committee and provides another external perspective by being independent to the Bank of England. These external members bring specialized knowledge and perspective from the financial sector and help challenge potential groupthink. The macroprudential committee has a clear financial stability objective, under the Bank’s financial stability mandate, and is held accountable for its actions to further achieving its objective by the UK Parliament. It has a variety of tools at its disposal and has spelled out in public documents how it intends to use them.

To be sure, the UK system, as the US system, is only a few years old, and success at protecting financial stability ultimately must be assessed over decades, not years. But, if the Chinese authorities are looking to foreign experience to guide their own efforts, I see the UK set up as considerably more promising in many dimensions than that of the US.

Conclusion

It is my understanding that China is indeed working on its framework for macroprudential regulation. I applaud this effort. The thrust of my presentation is that its favorable execution will yield payoffs, not only in preserving financial stability, but also in freeing up monetary policy to pursue its goals for growth and price stability consistently and aggressively. The global economy has a stake in its success.

      

 

 

Bernie Sanders was in Puerto Rico on Monday and Tuesday of this week to campaign ahead of the June 5 Democratic caucus (Puerto Rican residents won’t vote in the November election, but can participate in presidential primaries. The 2016 Republican primary occurred in Puerto Rico on March 6).

Speaking at a rally on Monday night, Sanders addressed the issue of Puerto Rico’s $70 billion in public debt, saying:

“Today, I am calling on the Fed to use its emergency authority under Section 13(3) of the Federal Reserve Act to pave the way for an orderly restructuring of Puerto Rico’s public debt. Under current law, the Federal Reserve has the authority, “in unusual and exigent circumstances,” to lend to “individuals, partnerships, and corporations” outside the banking system that are “unable to secure adequate credit accommodations from other banking institutions.

Washington bailed out Goldman Sachs and Wall Street from its bankruptcy.  The people of Puerto Rico are more important than them.  We must act now. During the 2008 financial crisis, the Federal Reserve used this authority to provide emergency loans to AIG and Bear Stearns. It should now use this authority to help the people of Puerto Rico.”

Following the comments, many have wondered if such debt restricting is really within the Fed’s authority. We asked two Brookings experts, former presidential advisor Barry Bosworth and former Vice Chair of the Federal Reserve Board of Governors Don Kohn. Here’s what they said: 

Don Kohn

“I’m not an attorney, but my read is that the type of assistance Senator Sanders is asking the Fed to provide would not be legally possible under the revised section 13-3 of the FRA, and not what the Congress intended.

Among other things, that section requires that any facility be broadly based and not intended for a particular troubled borrower; and that it be for the purpose of providing liquidity to the financial system. For example: ‘Such policies and procedures shall be designed to ensure that any emergency lending program or facility is for the purpose of providing liquidity to the financial system, and not to aid a failing financial company…’ And later, ‘The Board shall establish procedures to prohibit borrowing from programs and facilities by borrowers that are insolvent.’

From a policy perspective, I believe this is a matter appropriately dealt with by the Congress, the administration, and Puerto Rico. It is not directly related to the national macroeconomic goals the Congress has given the Fed nor to its bank supervision or financial stability responsibilities.”

Barry Bosworth:

“First, it is not going to happen.  Puerto Rico's debt situation is not that unusual. Cities like Detroit are caught in the same situation and the Congress is concerned about setting a precedent for states and other cities who are also following dangerous fiscal policies with unsustainable debt accumulation (Chicago's pension fund is but one example on the horizon).

Like Detroit, Puerto Rico needs to restructure its debt in the equivalent of a bankruptcy process. What does bailout mean? All the hedge funds that bought up the debt at discount prices would get 100% of face value? A bankruptcy court is the usual means of resolving these issues. Puerto Rico does not need another loan; it has too many already.  Excessive borrowing created the financial problem, it cannot solve it.

Second, Puerto Rico's fundamental problem is one of a stagnant or declining economy with no job opportunities. What would Sanders do to create economic opportunities on the island going forward? There needs to be incentives for new investment, particularly in infrastructure, and an economic strategy that could make the island an attractive place to do business and create jobs. The greatest challenge facing Puerto Rico is the lack of jobs and economic activity; not access to more credit.”

      

 

 

Don Kohn delivered the following conference keynote at the European Central Bank on April 27, 2016.

I appreciate the opportunity to attend and address this first annual ECB macroprudential policy conference. Calling something the “first annual” is a commitment strategy that will tie the hands of successors, but in a positive, productive way. Macroprudential policy has been around for a long time in many different forms, but the global financial crisis led to a revival, and we are just now getting experience with it in highly developed, deregulated, globally integrated markets.

My keynote is labeled implementation and effectiveness, but I’m going to concentrate on implementation. Surely the macro and micro prudential changes that have been made since the crisis have been effective at making the system less crisis prone than it was in 2007-08, and very much less likely to require taxpayer support to maintain financial stability. Higher levels of good quality capital and minimum liquidity requirements at banks, less opaque instruments and interconnections in markets have made the financial sector more resilient to unexpected developments and less likely to behave procyclically with spillovers to the real economy. And, as we are seeing at this conference, there’s a growing literature on effectiveness.

But we are still in the early stages of learning how effective macroprudential policy will be in highly developed, globally integrated markets. One of the challenges of macro prudential policy is the absence of clear metrics on how well we are doing; we can measure risk and resilience in the financial sector but direct feedback on the degree of safety, the decline of procyclicality and amplification, must be inferred—unlike the inflation, output and unemployment metrics we get monthly for how effective monetary policy has been.

I’m going to reflect on some aspects of implementing macroprudential policy drawn mostly from my experience on the Financial Policy Committee at the Bank of England, hoping these reflections will give you a flavor of the types of issues we have been dealing with and where research might have the largest payoffs in terms of effective macroprudential policy. These are my own views and do not necessarily reflect the views of my colleagues on the FPC.

The legislative remit of the FPC reads: “The responsibility of the Committee in relation to the achievement by the Bank of the Financial Stability Objective relates primarily to the identification of, monitoring of, and taking of action to remove or reduce, systemic risks with a view to protecting and enhancing the resilience of the UK financial system.” I’m going to look at some of the challenges we uncovered as we approached a number of items on this list.

I’ve put them in four broad categories, which I recognize overlap and interact in a number of ways. They are first “the identification and monitoring of risks”. Second, the determination of the systemic aspects of risks that are identified—the externalities that call for macroprudential action. Third, the design of policies to “remove or reduce the risks” and “enhance the resilience of the UK financial system”, including the role of cost-benefit analysis in evaluating policy options. When exercising its functions under the Bank of England Act, the FPC is required by law to be sure “a burden or restriction which is imposed on a person, or on the carrying on of an activity, should be proportionate to the benefits;” and our explanation of any action “must include an estimate of the costs and an estimate of the benefits that would arise from compliance with the direction or recommendation in question, unless in the opinion of the Committee it is not reasonably practicable to include such an estimate.” And my fourth topic will touch on the communication of policies and their rationale.

Risk identification is the foundation for macroprudential action, but it presents a number of challenges.

We are looking mostly for tail risks—unlikely events not fully reflected in market prices that might have systemic effects—events the financial system and its customers might not be fully prepared for. The FPC has identified some particular events that fit easily into the risk category— for example, euro area problems in 2011 and 2012; the June 23 referendum on EU membership. Risk identification can also focus on particular markets where terms and conditions of lending have eased or might do so in the future, sufficiently to threaten financial stability: in the UK we have paid a lot of attention to residential real estate; in the US leveraged lending has been a focus. But tail risks could be broader and more general, stemming from the general state of the financial cycle across a range of markets. Complicating the risk assessment is that interest in tail risk implies the need for information about the entire distribution of risks associated with a particular indicator, not just its mean and current value.

The FPC has a set of indicators to help it identify risks, but it is a work in progress and revising the list is a priority of the FPC in which we will be drawing on the work of you and other researchers. Among other things, we need to be careful not to let data availability drive the list; we should envision what we need and then try to reshape the data collection if necessary.

Judgments about the position of elements in the financial system relative to the distribution of possible outcomes, including the size of the tails, are necessarily based on historic experience. But the structure of financial markets, the behavior of asset prices, and the implications of a given level of, say, leverage have changed considerably over past decades reflecting deregulation, globalization of finance and economic activity, and technical change, raising questions about the weight of history in evaluating sustainable equilibrium values and the distributions around them.

For example, the FPC has viewed the credit gap as of very limited utility when assessing risk because it is based on the extension of a trend in credit growth that itself was greatly influenced by nonrepeating developments, like deregulation. Also, judgments about sustainable levels of bond, equity and other asset prices are greatly affected by estimates of equilibrium interest rates and term premiums going forward—matters of substantial uncertainty.

Still, for all the caveats, the indicators are valuable starting places for assessments of risks; they should anchor policymaker judgments in facts and make those judgments as systematic as possible. Moreover, they are an important input into the political oversight and accountability of the macroprudential authorities; members of parliament have quizzed FPC policymakers on our published indicators and their implications. All authorities will benefit as research helps to develop better leading indicators of financial stability risks.

Importantly, the assessment of risk indicators is as much or more about their levels as about rates of change. Of course, the growth in credit relative to income is critical in our considerations, but in judging things like leverage or asset prices the question is where the measure is relative to its sustainable level. Once adverse events occur, there is a tendency to extend the recent adverse developments and declare that particular risk to be elevated. To be sure, how risks materialize may give us new information about the shape of the distribution and the size of the tail. But what we are likely to be observing as well is the crystallization of previously identified risks—moving along the distribution of risks. It takes discipline to focus on levels and differentiate the crystallization of existing risks from the discovery of new risks.

Much of the FPC’s energy and activity around risk assessment has fed into the concurrent stress test scenarios and the setting of the countercyclical capital buffer (CCyB).

In the stress test process we have collaborated closely with the PRA, the microprudential authority. We have attempted to tell a coherent, if unlikely, story with our scenarios. In 2014 and 2015 the scenarios embodied particular risks interacting with the general state of the financial system. In 2014 we focused on UK domestic risks including a sharp rise in interest rates and its effect on the property markets. In 2015, a softening in global growth and increase in global risk aversion set off the scenario.

In 2016, we are undertaking our first Annual Cyclical Scenario (ACS), which is based on readings from a broad set of indicators and judgments about where in their distributions these variables lie and therefore how much they would move to get them deep into their tails in a severe stress scenario. Based on these indicators and other information, our broad judgment in March was that foreign risks remain elevated—despite having crystallized some in 2015--and domestic risks were in the “standard” range—that is were no longer in the subdued post-crisis state but in general were not elevated, especially in light of still-subdued credit growth. These judgments were embodied in the set of stresses across a wide array of variables included in the stress test. If and as domestic credit growth picks up, borrowers and lenders become more leveraged, and asset prices rise relative to fundamentals, the stresses will become larger; our stress tests will be countercyclical.

The results of the ACS will be one element in our consideration of the appropriate CCyB. Given our assessment of the general risk environment, we have already set the CCyB at .5% of risk-weighted assets. We expect it will end up in “the region of one percent” when risks in general are neither subdued nor elevated.

Every other year, the ACS will be accompanied by an exploratory scenario keyed off a specific set of risks that policymakers consider important for assessing the financial system’s resilience.

Identifying externalities is an essential step between identifying risks and taking action. Macroprudential action to remove or reduce risk or build resilience should require a finding that materialization of the risk would be systemic—that it is a risk to the ability of the financial system or a significant part of it to exercise its critical functions and its materialization therefore would have important adverse effects beyond the parties directly involved. We must ask what is the externality that macroprudential policy should require the private market to internalize—to incorporate into prices? Why are we constraining the actions of a willing borrower and willing lender?

These questions are relatively easy to answer when realization of the risk would directly impair the ability of the financial sector to perform its functions of intermediating, supplying credit to the real economy and distributing risk. Recognizing the externalities of financial failure, governments created or empowered central banks to provide liquidity insurance to financial firms. And, during the last crisis they even provided capital to some institutions. This doesn’t absolve macroprudential authorities from weighing costs and benefits of an action such as raising capital requirements, but it does get over the hurdle of whether there is a public benefit worth weighing against costs.

We found ourselves in a more interesting discussion about externalities when we were considering recommendations that would affect the terms and conditions under which households could borrow in the mortgage market. We got into the discussion because we saw a pickup in house prices nationwide and the MPC expected future house price increases to exceed increases in the general price level and in the growth of nominal incomes. Those projections were against the background of already high debt to income ratios in the household sector. We were not so worried about the effect on bank resiliency of a further buildup of debt as house prices rose relative to income, in large part because, unlike in the US, households cannot walk away from their mortgage loans in the UK, and in fact defaults had remained reasonably low even under the very adverse circumstances of the recession. Rather we focused on household borrowers and the response of the heavily indebted households to an unexpected rise in interest rates or drop in income.

In the UK as in the US heavily indebted households cut back disproportionately on spending in the recession. This effect is probably more pronounced in the UK, despite floating rate mortgages being more common, because of the responsibility of borrowers for their debts. The externality we focused on was the business cycle effect of the behavior of heavily indebted households, not the vulnerability of lenders.

To address this potential externality, to reduce the odds on possible declines in the resilience of some household borrowers, we limited high debt to income lending and required lenders to test loan affordability against an appreciably sharper increase in interest rates than built into the yield curve. Notably, we intended our actions as insurance against deterioration in lending standards; we didn’t anticipate much if any effect on current lending terms but were acting pre-emptively before we saw widespread problems.

Policy design is the next step once risks have been identified as systemic. What do we need to do to reduce or remove the risks and build resilience—and what policy best satisfies the criterion that the benefits exceed the costs?

In general, having a wide choice of instruments will help in finding a policy that addresses the issues with benefits exceeding costs. Being able to target a specific risk or identified shortfall in resilience is more likely to minimize costs relative to benefits. If the source is very specific—say residential real estate lending—policy operating directly on the terms and conditions of the lending that are potentially concerning is more likely to be effective and less likely to have adverse side effects or unintended costs.

The FPC has always been able to make recommendations to any one on anything. But our stronger powers of direction—the power to change regulation more quickly and directly—have evolved over time and in particular have come to encompass terms of lending for some specific types of credits. In 2015, amid public and policymaker concern over the implications of the rise in house prices, we received powers over loan to value and debt to income measures for owner-occupied mortgages. We have asked for comparable authority for buy-to-let residential mortgages, importantly because of the potential for house purchases for rental to contribute to tail risk in the overall residential housing market, and look forward to getting those powers this year.

Having a variety of instruments including targeted choices is important for interactions of macroprudential with monetary policy. Using broader instruments, such as overall capital requirements, to deal with sectoral risks probably would have greater effects on overall intermediation costs and on the equilibrium or neutral interest rate, r*, requiring larger monetary offsets to achieve employment or price stability objectives. And the more instruments the macroprudential authority has to deploy, the greater the confidence that it will be effective and the lower the odds that monetary policy will be called on to deal with financial stability risks.

In my view, public welfare is enhanced when monetary policy can concentrate on business cycle goals while macro and micro prudential policies concern themselves with the financial cycle and financial stability. But if building risks to financial and economic stability can’t be addressed by macroprudential policy, they may need to be by monetary policy. The US is a concern in this regard because the authorities there appear to have paid little attention to many of the macroprudential aspects of real estate lending and to developing instruments to deal with the real estate cycles that have been so prominent in financial cycles in the US.

Cost-benefit evaluation is a critical mindset and discipline for regulators and one that the FPC is required to use if practicable as we design our policies. We do, but have found a number of challenges.

The main benefit of macroprudential policy will be the avoidance of output loses stemming from a crisis or from the amplification of shocks by the financial sector, and we are seeing that losses following a crisis can be quite large and extended. But the expected gains in terms of reduced odds on a crisis as a consequence of a particular macroprudential action are hard to estimate and depend on interpretations of past crises and on the models used to project the consequences of the past into the probability of a new crisis. Among other things, the marginal benefit of a particular policy choice and the calibration of that policy in light of the costs depend on the effects of and interactions with other policies. This is especially challenging given the number and complexity of the policy changes that have been undertaken since the global financial crisis.

The cost side is also difficult to estimate with confidence. There are the direct costs imposed on the institutions implementing the new policy. In addition, the potential side effects of new regulation, such as the possible impacts of leverage ratios on market liquidity that have received so much attention of late, are hard to identify and anticipate; indeed these collateral and often unintended costs may be visible only after a policy has been in effect for some time, raising questions about how and whether regulations might need to be re-examined and adjusted once their benefits and costs become more evident after implementation.

It is also important to estimate the possible macroeconomic costs, as well as benefits, of macroprudential regulation, which tends to raise the cost of intermediation and credit as it internalizes externalities. Those higher costs can affect longer-term growth by shifting the composition of output, say from capital spending to net exports as monetary policy eases to offset the effects of macroprudential policy on hitting the inflation target. These types of costs are likely to be second order.

But output costs could be much higher for a time if monetary policy has limited scope to ease, say near the effective lower bound for interest rates. In these circumstances, the macroprudential authorities might have to look for ways to structure their policies that reduces the adverse consequences for the economy. In the early years of the FPC we were focused on the need to rebuild the resilience of the UK banking system and restore confidence in it by raising capital requirements. We also were conscious that, depending on how they were implemented, higher capital requirements could act to counter the MPC’s attempts to bolster growth and be inconsistent with achieving our secondary objective for supporting the government’s policies for economic growth and employment. We viewed the higher capital as supportive of growth over time because it was a necessary condition for easing bank credit restraint. But to ease transition effects we also emphasized that plans to raise capital ratios should rest on increasing levels of capital in the numerator of these ratios rather than reducing lending in the denominator.

My fourth and final topic is the communication and explanation of macroprudential policy. Once the risk and its externality are identified and the policy decided upon, public communication of the decision, its rationale, and its expected effects is both difficult and necessary.

The FPC does a lot of public communicating. We always explain the reasons for exercising our powers of direction or recommendation. Where we are given powers of direction we publish a statement of the general policy we propose to follow in relation to the exercise of that power, which may include when and why we might activate our authority, and also the channels through which we expect the effects to run. We publish twice yearly Financial Stability Reports (FSRs), which include among other things an assessment of risks and resilience, an explanation of any new policies adopted, and an update on the progress made on past policy actions. On the off quarters we publish FPC statements that have evolved into something like executive summaries of FSRs—assessments of risks and resilience and explanations of policies. And we publish a record of our meetings in which we have attempted to capture the scope of the discussion leading up to our decisions, which to date have been made by consensus.

We reach out to the press, to the financial sector, to academics, and most importantly we have considerable interaction with the parliament through testimonies and exchanges of letters between the Governor and the Chair of the Treasury Committee. And members of the FPC make regional visits and meet with businesses as well as local press.

Nonetheless, I’d guess most people do not know or understand what the FPC is trying to do. Among other issues, the language of all this verbiage is often highly technical and specialized, and its effect on the daily decisions of most people is quite indirect, much more indirect than the interest rate they get on their deposit or pay on their mortgage as a consequence of the actions of the MPC. And the lack of knowledge and understanding of macroprudential policy is even more deeply embedded in the US—including among our Congress and judiciary.

But political and public support will be critical. Effective countercyclical macroprudential policy will be pre-emptive—taking away the credit punch bowl as the party gets going and making sure it is full when the party dies down. Experience in the US leading up to the crisis was that even small attempts to tighten supervision and raise questions about risk management in the boom were met with fierce industry and political resistance. And releasing buffers when the financial sector is under stress as risks crystallize may also be difficult for the public to understand and support. The absence of public support invites political interference.

I was pleasantly surprised at the lack of adverse public reaction to FPC’s recommendations on owner-occupied mortgages. Two aspects contributed. First, communication ahead of time: we built the case well in advance of action in speeches and in our publications that house prices were rising rapidly and not just in London, and that the consequences of this could be serious under some circumstances; and we explained carefully our thinking after we acted. Second, the nature of our actions: they were not intended to tighten existing lending standards materially but instead mainly to constrain possible future developments.

When I’ve described this experience to US observers they are highly skeptical of a similar muted reaction to comparable steps in the US. They fear that consumer groups and banks and their political supporters would find common ground in opposing actions that might constrain mortgage credit availability. But there is a history of damaging real estate cycles in the US that everyone remembers. I’m not arguing that there is a problem right now; but no one is talking about the potential for future problems and the apparent lack of tools to deal with them. Surely a stock-taking of instruments available if credit conditions deteriorate would be helpful and might set the stage for action before those conditions actually came about. Lars Svensson told us about the annual report on mortgage markets of the Swedish FSA—a good example of pre-emptive communication setting the stage for any pre-emptive policy that might become necessary.

Downloads

• Macroprudential policy: Implementation and effectiveness

      

 

 

Event Information

Neel Kashkari, the new president of the Federal Reserve Bank of Minneapolis, delivered his first public speech at the Hutchins Center on Fiscal & Monetary Policy at Brookings on February 16. President Kashkari, who was the assistant Treasury secretary overseeing the Troubled Asset Relief Program, assessed the post-crisis legislative and regulatory arrangements for preventing financial crises.

Following the remarks, there was a panel discussion moderated by David Wessel, director of the Hutchins Center. After the session, panelists took audience questions.

Video

• Neel Kashkari: Lessons from the financial crisis

Audio

• Neel Kashkari: Lessons from the financial crisis

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• KashkariBrookings2162016
• 20160216_kashkari_financial_crisis_transcript

      

 

 

Editor's note: This post was coauthored with Don Kohn

At Janet Yellen’s recent hearing before the House Financial Services Committee, a few representatives expressed concern that the Federal Reserve is making interest payments to banks. Specifically, the Fed uses authority granted by Congress in 2008 to pay interest on the reserves that banks hold with it. Total payments to banks last year were about $7 billion. Why is the Fed paying such sums to banks? Are they “giveaways” to the financial sector, as some have implied? We’ll argue in this post that the interest payments the Fed is making are well-justified. In particular, they are essential to prudent monetary policy in current circumstances and do not unduly subsidize banks.

Why is the Fed paying interest on bank reserves?

Reserves are deposits banks have at the Federal Reserve; some are required by law to be held against checking deposits, but banks also hold reserves at the Fed in excess of requirements. Importantly, the amount of Fed deposits held by the banking system as a whole is determined by Federal Reserve open market operations, not by the banks themselves.

Before the Fed paid interest on reserves, banks engaged in wasteful and inefficient efforts to avoid holding non-interest-bearing reserves instead of interest-bearing assets, such as loans. For example, many banks set up mechanisms for moving funds at the end of the business day from accounts which bore higher reserve requirements to accounts which had lower or no reserve requirements. By paying interest on reserves, the Fed made such efforts unnecessary.

More importantly, in recent years the Fed’s ability to pay interest on reserves has become essential to the smooth implementation of monetary policy. The Fed influences the economy by raising and lowering its target for the federal funds rate, the interest rate at which banks lend reserves to each other overnight. Changes in the federal funds rate in turn influence other interest rates and asset prices. In the past, the Fed achieved the desired level of the federal funds rate through market operations that affected the amount of bank reserves in the system. By making bank reserves more scarce, the Fed pushed up the price of reserves—the federal funds rate. By making reserves more plentiful, it pushed down the funds rate.

However, as a consequence of the large-scale asset purchases that the Fed undertook between 2008 and 2014 to help support the US recovery—purchases that were financed by the creation of bank reserves—the quantity of reserves in the system is now very large. Because banks are essentially satiated with reserves, modest changes in the supply of reserves will no longer have much influence on the federal funds rate. Rather than varying the supply of reserves, the Fed now manages the federal funds rate by changing the rate of interest it pays on reserves (as well as the interest rate it offers in so-called reverse repo transactions with money market funds and other private-sector institutions). These changes influence the federal funds rate and other short-term funding rates, and thus financial conditions more generally. As part of its decision to increase rates in December, the Fed increased the interest rate paid on reserves from one-quarter to one-half percent; short-term interest rates in financial markets rose in parallel as expected.

This basic approach, moving the interest rate paid on bank reserves to influence short-term market rates, is used by the European Central Bank, the Bank of England, the Bank of Japan, and many other central banks. In current circumstances, without the ability to pay interest to banks and other private counterparties, the Fed would likely have to implement any tightening of monetary policy by rapidly selling assets it holds. This would have difficult-to-predict effects and would likely prove highly disruptive to financial markets, to say the least.

Where does the money come from to pay the interest on reserves?

To answer this question, keep in mind both sides of the Fed’s balance sheet. The reserves in the banking system (which are liabilities of the Fed) were created when the Fed made large-scale purchases of interest-bearing securities (the corresponding Fed assets). The interest received by the Fed has thus far been much greater than the interest it has paid out. The difference between interest received by the Fed and the interest paid to banks—over $550 billion since 2009—is turned over to the US Treasury.

Does paying interest on reserves prevent banks from lending?

This claim, made even by some good economists, is puzzling. Before December, the Fed paid banks one-quarter of one percent on their reserves. If the Fed had not paid interest, the return to reserves would have been zero. Accordingly, the only potential loans that would have been affected by the Fed’s payment of interest are those with risk-adjusted short-term returns between precisely zero and one-quarter percent—surely a tiny fraction of the total. In fact, over the last four years bank lending has increased at about a 5 percent annual pace (including around a 7 percent annual rate the past two years), with only residential mortgage lending lagging in the aftermath of the housing bust.

Does paying interest on reserves subsidize banks?

Reserves are an asset on banks’ balance sheets, and, like any bank asset, they must be funded by corresponding liabilities. The federal funds rate, which is what banks pay to borrow from other banks, is one reasonable measure of the marginal cost of funds to banks. Since the Fed’s action to raise rates in December, the funds rate has generally fluctuated around 37 basis points (a basis point is .01 percentage points). Consequently, we can safely say that the subsidy to banks implicit in the Fed’s interest payments can be no greater than the difference between the 50 basis points (one-half percentage point) the Fed now pays on reserves and the 37 basis points or so that banks must pay to finance their reserve holdings—that is, about 13 basis points (13/100 of one percent).

From an economic point of view, however, even 13 basis points is probably an overstatement of any subsidy. Here’s why: If the full marginal cost to banks of adding reserves was simply the funding cost, then a bank could borrow in the market at the fed funds rate, deposit that money at the Fed, and earn the higher rate of interest on reserves while taking no risk. In principle, this activity should lead the market-determined federal funds rate to be very close to the interest rate paid on reserves—indeed, that’s what many at the Fed expected to happen when Congress authorized payments of interest. The fact that there is a persistent differential between banks’ funding costs and the interest rate they receive on reserves suggests that there may be additional costs to banks of holding reserves, above the explicit marginal cost of funding.

It is not difficult to identify such costs. For example, banks are required to hold capital against even very safe assets, including reserves at the Fed, because of the so-called leverage ratio. Because equity capital is relatively more expensive for banks, these requirements increase the effective marginal cost of funding reserves. Similarly, the premiums charged banks by the Federal Deposit Insurance Corporation for insuring deposits are tied to the level of bank assets, including reserves; the extra premiums are another cost of increased reserve holdings. In short, the absence of bank efforts to obtain additional reserves at current interest rates suggests that much of the difference between the interest rate banks receive on reserves and their explicit marginal cost of funds is eaten up by other costs tied to holding reserves.

Doesn’t the Fed’s writing checks to bank create a perception problem?

Yes, unfortunately. Although the payment of interest on reserves provides no meaningful subsidy, the Fed does face an appearance problem from the fact that it is writing checks to banks. This problem will likely get worse if the Fed raises short-term interest rates further, because that would require raising the interest rate it pays on bank reserves as well. Of course, misplaced criticism is no reason not to do the right thing with monetary policy. But the Fed will need to make good economic arguments to explain why paying interest to banks is necessary.

A couple of factors may reduce the appearance problem over time. First, the Fed has already announced that, at some point, it will stop reinvesting the proceeds from maturing securities, thereby allowing its balance sheet to shrink to something approximating its pre-crisis size. As the balance sheet shrinks, so will the quantity of outstanding bank reserves. The Fed could therefore emphasize that it expects that the need to make substantial interest payments to banks is temporary, and that those payments will shrink as the balance sheet normalizes and the Fed returns to its more traditional approaches to managing interest rates. Moreover, at that point, the interest rate on reserves is likely to be at or below market interest rates and thus at best a wash for banks.

Second, the Fed is currently targeting a 25-basis-point range for the federal funds rate, with the interest rate on reserves at the top end of that range. With experience, the Fed should be able to shrink its target range, with the effect that the federal funds rate will draw even closer to the interest rate paid on reserves. It should then be easier to explain why banks are not receiving a subsidy from the Fed, as it will be evident that they are earning about the same on their reserves as they could receive in the open market.

Of course, while its communications challenges are real, the Fed’s first priority must always be to put in place the right monetary policy for our economy.

      

 

 

For the Federal Reserve, 2015 marked a milestone: the end of seven years of holding its key interest near zero where it had been pinned since the financial crisis and recession deepened in late 2008.

In 2014, the Fed already had begun to step back from the unconventional policies by ending its purchases of Treasury bonds and mortgage-backed securities. And it had laid out the criteria for the next step—raising rates—when it had seen some further improvement in labor markets and was reasonably confident that inflation would rise to its 2 percent target over the medium term. In the view of the Federal Open Market Committee, those criteria were met by its December meeting, and the FOMC announced a quarter-percentage point basis point increase in the target range for the benchmark federal funds rate, raising it from 0-0.25 percent to 0.25-.50 percent.

Why raise rates now?

The timing and fact of any rate increase were controversial. Some skeptical observers focused on reasonably modest growth, persistent very low inflation, and globally weak growth and disinflationary pressures. They wondered: Why raise rates at all? They noted that the Federal Reserve had been consistently over-predicting growth and inflation, and they argued that waiting to confirm the emergence of rising inflation would allow the labor market to tighten further, giving greater opportunities to the unemployed and underemployed. Those pushing for an increase emphasized the rapid improvement in labor markets and low level of the unemployment rate, worrying about the risks of eventually overshooting of the inflation target and the possible distortions in financial markets of keeping rates near zero. Some of them had argued the Fed should have raised rates earlier in the year.

It was improvement in the labor market—actual and expected—and its implications for inflation down the road that led the Fed to begin the process of reducing the extraordinary degree of accommodation in monetary policy in December. Employment had been increasing at an average of around 200,000 per month in 2015, more than twice as fast as consistent with stable unemployment in the steady state, and it had shown no real sign of slowing in the fourth quarter. The unsustainable pace of job increases indicated that interest rates would need to rise at some point to prevent inflation pressures from building and threatening an overshoot of the Fed’s 2 percent target.

The level of the unemployment rate was one factor that suggested December was the time to move. Job growth had dropped the unemployment rate from 5 ¾ percent in the fourth quarter of 2014 to 5 percent in the fourth quarter of 2015. The 5 percent rate is close to the level the FOMC and many economists think is consistent with stable inflation; other measures, for example of discouraged workers and those working part time for economic reasons, suggested some slack persisted in labor markets, but those measures also had been declining appreciably over the year.

The improvement in the labor market was achieved with very moderate economic growth averaging just above 2 percent in the first three quarters of 2015. But productivity growth had been very slow—around ½ percent at an annual rate—and that, together with the effect of retiring baby boomers on labor force participation, meant that this pace of expansion in economic activity was enough to absorb new entrants into the labor force and put people back to work. This growth of GDP had been a product of good increases in demand by U.S. households and businesses, netted against a drag from international trade as increases in the foreign exchange value of the dollar and weak growth abroad dampened exports. This pattern was expected to persist in 2016, but again the net would likely be enough growth to erode the remaining slack in labor markets and cause inflation to rise toward the Fed’s 2 percent target.

Inflation was very low in 2015—barely positive—dragged down by declining energy and import prices. Core inflation measures showed a more mixed picture: the price index the Fed tracks most closely, the personal consumption expenditures (PCE) price index (excluding volatile food and energy prices), was stable at 1 ¼ percent, but the Consumer Price Index, excluding food and energy, edged higher in 2015. Measures of wage pressures also were mixed. Most of them suggested little if any acceleration, despite the low unemployment rate. But unit labor costs—a measure that combines productivity and wages—did accelerate, and rose by 3 percent from the third quarter of 2014 to the third quarter of 2015. The Fed expected inflation to pick up as energy prices stopped declining, the dollar leveled out, and as the expected tightening in the labor market pushed up costs and prices more quickly. The FOMC knows that there’s a lag between its interest-rate actions and the effects on the economy. It realizes that rates will be still quite low even after they are tightened a notch. So, in the FOMC’s judgement, waiting longer to raise rates would raise unacceptable risks that the economy would need a much steeper and disruptive set of rates increases later.

What's next?

The Federal Reserve has been emphasizing that it’s not the first hike that’s important for the interest rates and asset prices that matter for spending and inflation, but rather its market expectations for the whole future path of rates. In that regard, Chair Yellen and many other members of the FOMC have emphasized that subsequent rate increases will depend on the implications of incoming information for the outlook for inflation and activity. But they have also noted that their projections for the economy imply that rate increases will be very gradual and come to rest at a much lower level than has been the case in past tightening cycles.

Gradual rate increases are justified in part by the low level of inflation—it is quite far from the Fed’s 2 percent target, hasn’t yet begun to increase, and when it does, is expected to rise slowly. Gradual increases are also consistent with special caution when interest rates will be near zero even after lift-off. In those circumstances, too-rapid increases that weakened the economy, or sent it back into recession, would be hard to counter with easier monetary policy; on the other hand, an unexpectedly rapid build-up in inflation pressures could be controlled with a steeper path of rate hikes.

The anticipated shallow path of rate increases also reflects expectations that the ultimate level of rates will probably be considerably lower than suggested by historical experience. This inference derives importantly from the observation that the economy hasn’t responded very strongly to near-zero nominal rates and deeply negative real rates over the past seven years. Several research studies have taken from this that at least for a while the real “neutral” rate—the rate that is consistent with the economy holding at full employment and inflation remaining stable—is around zero, or 2 percent in nominal terms. To be sure, that rate could rise over time, say as the global economy strengthens, or as potential GDP growth picks up, but that remains to be seen.

The Federal Reserve’s decision to raise rates is good news: it signals that the economy has recovered from the Great Recession and is expected to continue to grow at a moderate pace over coming years, even as rates rise slowly from the extraordinarily low level they have been since the fall of 2008. Considerable drama has surrounded the initial decision to raise rates, but drama, speculation, and uncertainty won’t be going away in 2016; it will now shift toward the next and subsequent rate increases. Stay tuned.

      

 

 

Donald Kohn, Robert S. Kerr Senior Fellow in Economic Studies at the Brookings Institution, and External Member of the Financial Policy Committee of the Bank of England, delivered remarks to the Federal Reserve Board's Boston Conference on October 2, 2015. Note: This paper represents the author's own views and not necessarily those of the Bank of England or his colleagues on the Financial Policy Committee.

Policy makers around the world have learned a number of lessons from the global financial crisis (GFC) about requirements for a policy tool kit that will prevent the next financial crisis –or at a minimum considerably lessen the pain of financial cycles for the real economy. We have learned that medium-term price and economic stability is not enough to guarantee financial stability and that the absence of financial stability can cause substantial and prolonged deviations from inflation targets and full employment.

Moreover, monetary policy has not been powerful enough to restore price and economic stability quickly once they have been disturbed by a major financial crisis. Clearly more is needed to prevent such crises from occurring in the first place. Improvements in institution-by-institution risk management and capital and liquidity buffers would help, but viewing each institution separately is not sufficient to preserve financial stability. Externalities to the behavior of individual institutions means that the authorities need to look at the whole system, devising and administering regulations to take account of the interactions and spillovers and to damp the procyclicality that seems naturally to be built into financial markets and their feedback on the economy.

Macroprudential policy—the extra regulatory perspective that does take account of systemic effects—had been a feature of policy in the US and many other industrial economies in the 1950s, 60s, and 70s, and it has remained a key aspect of the regulatory approaches in many emerging market economies in the 2000s. But it fell out of favor in most economies with open and highly developed financial markets, because markets were perceived as having gotten better at distributing and diversifying risks and because markets were undermining the effectiveness of regulation by providing more avenues for regulatory arbitrage.

Now, in the wake of the GFC, macroprudential regulation has been reborn in advanced economies, mostly as a “macroprudential finish” to standard microprudential tools, like capital and liquidity requirements applied to a wider range of institutions that are judged to be systemically important -–but also with changes in market structures, for example the central clearing of derivatives.

But that gives us two types of financial policies with a macro focus—macroprudential and monetary policies. They share a common ultimate objective: preserving economic stability in the interests of maximizing sustained long-term growth. Moreover these two types of policies interact in a number of important ways. That has raised questions about when and how each set of policy tools should be used, who should have their hands on the macroprudential levers and, if they are a different set of hands, how the two authorities should interact. What each set of tools concentrates on is important to my conclusion about governance, so I’ll touch on that, but I will concentrate on the structure of governance, with particular reference to the US and to the Federal Reserve. Should the FOMC or the Board of Governors have authority over macroprudential policy? I will draw some lessons about how policymaking might be structured from the UK, where I am an external member of the macroprudential authority—the Financial Policy Committee. And I’ll point to deficiencies I see in the structure for macroprudential policy in the US beyond the Federal Reserve.

Macroprudential and monetary policies

Macroprudential and monetary policies interact in complex ways as they seek to contribute to sustained growth—both working through their effects on financial conditions.

Monetary policy operates mostly by affecting the actual and expected level of short-term interest rates, and in the case of securities purchases, influencing term premiums at longer maturities. Changes in expected interest rates feed through to asset prices and foreign exchange rates. Monetary policy contributes to sustained growth mostly by keeping average price levels reasonably stable over time and by returning the economy to its sustainable level of production as quickly as possible consistent the longer-term imperative of price stability when there are trade-offs.

Macroprudential policy is used primarily to build the resilience of the financial system, the ability of both borrowers and lenders to withstand shocks. This resilience reduces the odds that the effects on the economy of a downswing in asset prices or a rise in credit problems are amplified by a failure of intermediation. Macroprudential policy may also affect asset prices themselves, damping the upswing and cushioning the downswing. The tools it uses for this purpose--adjustments in capital and liquidity requirements, changes in the structure of some markets, and, in some countries, alterations in permissible terms of lending--affect the cost of intermediation and the availability of credit.

Because both can affect the cost of credit, the instruments used by each policy can have important effects on the appropriate instrument settings the other policy must adopt to reach its objectives. For example, added risk taking and increased credit availability is an important channel for easy monetary policy to return the economy to potential and achieve inflation targets. But highly accommodative monetary policy can increase risks to financial stability by encouraging leverage and maturity mismatch that may prove dangerous when rates rise and capital gains reverse or by inducing a “search for yield” in which lenders and investors do not give adequate consideration of potential defaults when rates eventually increase and the economy slows. Macroprudential policy must act to ensure that the financial sector is resilient to the impact of these positions and prices unwinding—that the sector can continue to provide its essential services of intermediation, risk management, and payments.

Analogously, the effects of macroprudential policy on intermediation costs can affect incentives to borrow and spend, and therefore the level of aggregate demand relative to potential supply and prospects for inflation, which must be taken account of by monetary policy. For example, the tightening of financial regulation after the GFC to rebuild protections for financial stability and reduce procyclicality from the financial sector has probably contributed to the further decline in equilibrium interest rates. And that in turn has meant that monetary policy has had to remain unusually accommodative for longer in order to promote a return to maximum employment and 2 percent inflation targets.

The two-committee approach

Despite the close interactions and relationships between monetary and macroprudential polices, a number of arguments favor putting primary responsibility for each in two separate committees. In brief, although they share a common very long-term goal of sustained growth at potential, they try to get there in very different ways through very different instruments and very different “intermediate” targets.            

Macroprudential policy tries to identify tail risks and externalities that are not appropriately priced by markets and that can lead to contagion and spillovers, posing greater risk to the financial system and greater cost to the economy than to individual market participants. The focus of macroprudential policy will be on the financial cycle, which may have a different periodicity than the business cycle. Financial risks can build up over much longer periods, through several business cycles. The complacency of private market participants and their regulators that led to the underestimation of the risk to financial stability in the years leading up to 2007 accumulated over the several decades of the “great moderation”. The macroprudential policy actions that internalize these externalities and put extra weight on tail risks impose greater intermediation costs. The actions can be and are often concentrated on particular intermediaries or market segments where the financial stability risks seem to originate--for example, by increasing capital and liquidity buffers for banks, imposing through-the-cycle margining for securities transactions, or restrictions on intermediary activities or on credit terms for particular types of lending.

Monetary policy, by contrast, is focused on economic and price stability primarily at the business cycle frequency. It is concerned primarily with the most likely outcomes for the economy and prices; though “risk management” can play a role when certain outcomes are seen as disproportionately costly, it’s the risk of broad macroeconomic results that is taken into account, rather than the tail risk in particular financial markets. Its tools –actual and expected interest rates and the central bank balance sheet – generally work very broadly through financial markets to the economy.

To be sure, monetary policy could be used to “lean against” emerging threats to financial stability, as some have urged it should^[1]. In this view, monetary policy should regularly consider whether it needs to steer away from, or delay the return to, medium term objectives for inflation and employment in order to safeguard longer-term stability, and many of these analysts would expect the financial stability argument not infrequently would have a significant effect on monetary policy. Only in this way can the authorities be adequately assured of avoiding financial instabilities that would deflect the economy from sustained growth and inflation near target over the longer-run.

This argument rests on two premises. One, that monetary policy settings can have major effects on financial cycles—by creating bubbles and imbalances when policy is easy, and by preventing such risks from developing, whatever their origin, if policy is tighter. Second, that microprudential and macroprudential policies are not themselves sufficiently robust to contain or prevent the buildup of risks or to prevent disruptive financial crises. In particular, macroprudential and microprudential policies can make banks and other heavily regulated intermediaries more resilient, but will be weak in tackling bubbles and imbalances in securities markets and at less-regulated entities. By altering risk-taking incentives quite broadly, changing interest rates is effective in preserving financial stability, in part because it “gets in all the cracks”.^[2]

But monetary policy is a blunt instrument, operating through multiple channels while many risks to financial stability are focused in particular markets and types of borrowing and lending (the residential real estate market and mortgage credit would be a prime example). Moreover, the effects of changes in monetary policy settings on risks to financial stability arising from mispricing of assets, leverage, and maturity mismatches are unclear and could be quite small. As a consequence, using monetary policy to deal with threats to financial stability could well involve major costs; the monetary authority might need to steer considerably away from or delay return to its medium term objectives for output and prices to deal with financial stability risks, and the collateral damage to employment and inflation, even the credibility of its inflation target might well be substantial.^[3]

Overall, protecting financial stability efficiently and effectively requires a different focus and different set of tools than does achieving an inflation target. And it seems that, given the tools available to each type of policy, cost-benefit calculus would keep monetary policy focused on aggregate demand relative to supply and overall inflation, while macroprudential policy would focus on reducing the odds that disturbances in the financial sector that could have major and disruptive feedbacks on longer-term growth prospects, with monetary policy a “last line of defense” on protecting financial stability.^[4]

In my view, these differences in focus, in instruments, in proximate objectives and the effectiveness and efficiency with which they can be reached by each set of instruments, all argue for these two functions being carried out in separate committees. The public interest and macroeconomic stability will be best served by each committee concentrating on how to use its particular tools to meet its primary objective—price stability and sustained full employment for the monetary policy makers, and financial stability for the macroprudential policymakers. And accountability will be more readily applied when elected representatives can focus their review of monetary policy on the medium-term legislated mandates for that policy, and their review of macroprudential policy on actions to protect financial stability.

Of course, given the interactions and interdependencies of these policies, members of each committee will need to be exceptionally well informed about the policies of the other one. This will require a deep understanding of the strategies and intentions of the other, their rationale and expected effects. This degree of understanding can be accomplished through communication between the committees and through overlapping membership.

The need for formal cooperative agreements or understandings between the two committees will be rare. In general macroprudential policy probably works more slowly and with longer lags than monetary policy. Even countercyclical macroprudential policies, like changes in the countercyclical capital buffer, can take effect after some months (12 months for the CCB in the absence of exceptional circumstances^[5]), though market expectations and the preparatory actions of affected institutions may bring some of the effect forward. By contrast, actual or expected changes in monetary policy settings are likely to have more immediate effects on financial conditions. And consideration of macroprudential policy actions is likely to occur less frequently than the monthly or 8 times per year schedule for monetary policy in most jurisdictions.

Monetary policy should be able to adjust to actual and expected changes in macroprudential policy—for example by lowering the path for its policy rate to the extent that tighter macroprudential policy is expected to raise intermediation costs appreciably enough to affect the balance of aggregate demand and potential supply. In this sense it would treat macroprudential policy analogously to the way monetary policy takes account of the likely evolution of fiscal policy. Similarly, macroprudential policy should be able to take account of how the expected path of monetary policy might affect financial stability risks.

Applied to the Federal Reserve

In the Federal Reserve, committee separation implies that the Board of Governors should remain in control of macroprudential policy as the FOMC runs monetary policy. Of course the Board is (supposed to be) a majority of the FOMC, but when they meet as a Board they should find it easier to maintain the separate focus I believe required. Overlapping membership and communication by Board members with other FOMC members, who, as reserve bank presidents, already have extensive interest and knowledge of the financial sector and regulatory matters, should take care of mutual understanding.

The rationale for keeping macroprudential policy in the Board and separated from the FOMC is reinforced for the Federal Reserve by the governance structure of the reserve banks. In large measure, macroprudential policy involves the use of microprudential tools, like bank capital requirements, to internalize externalities and protect against downside risks. These policies can have substantial effects on the business models and profitability of banks and other financial intermediaries. The reserve banks are owned by the banks in their district, which elect 6 of the 9 members of the boards of directors, three of whom are bankers; the other six are not bankers, but may have ties to other parts of the financial system. Having the presidents vote on an aspect of setting of regulations could well entail a change in law. Right now, the Federal Reserve Act places the over-riding authority for supervision and regulation of banks in the Board of Governors, though the reserve banks do the hands-on supervision of banks and the New Yok Fed has an important role in overseeing financial markets through its responsibility to keep markets functioning well as it to executes monetary policy for the FOMC.

Strict rules prohibit directors’ involvement in supervision and regulation and tightly govern conflicts of interest, and those rules could be extended to macroprudential regulation as well. Still, the nonbank directors select the president, who reports to the entire board on the functioning of the bank. And one of the duties of the directors under the Act to is to give input to monetary policy decisions. They report on conditions in the economy to inform the reserve bank president’s analysis of the economy and policy, and they vote on discount rate recommendations to the Board of Governors. Especially if monetary and macroprudential polices became intertwined in one committee—the FOMC—it would be very difficult to avoid regulation becoming an important discussion point at directors’ meetings. At a minimum the optics would be terrible given this governance structure, and concerns about the influence of bankers and interested private parties on regulation would be accentuated, understandably in my view.

An FOMC decision to use its balance sheet tools for macroprudential purposes as well as for monetary policy, could complicate the operation of a two-committee structure, but would not undercut its basic rationale and efficacy. The FOMC has announced its intention to return policy implementation to the norms and techniques used before the crisis and before the adoption of unconventional policy measures. This includes ultimately allowing the balance sheet to shrink to the minimum necessary to control the federal funds rate—that is reducing assets enough to bring excess reserves back to frictional levels. This lower level of assets would limit the scope for using the size and composition of the Federal Reserve’s assets for other purposes.

Some observers, however, have suggested that the Committee retain a large balance sheet and use it at least in part to foster financial stability.^[6] Most prominently, they would have the Federal Reserve retain enough assets that it could also engage in a potentially large volume of short-term reverse RPs with the nonbank private sector. In effect, the Fed would be supplying safe and liquid assets—loans to the Fed secured by Treasury securities—to money funds, GSEs, dealers, and perhaps some other private sector investors. In the years leading up to the crisis, the demand for safe liquid assets had induced the private sector itself to produce them—assets that turned out to be not so safe, not so liquid, and a source of financial instability when the realization of their vulnerability hit home. In this view, having the government—in this case the Federal Reserve—issue such assets would crowd out private sector issuance and enhance financial stability.^[7] Other possible uses of the Federal Reserve balance sheet for financial stability purposes might include using MBS purchases and sales to affect mortgage rate spreads and adjusting the maturity of the portfolio to influence the spread between short-term and long-term rates. Where any of these techniques adopted, the Federal Reserve’s portfolio would be employed in the interests of financial stability alongside the macroprudential tools that relied mostly on adjustments to microprudential tools.

As noted, at present the FOMC apparently does not intend to engage in any of these activities. The FOMC has been reluctant to remain as large a part of the intermediation process as would be implied by the large portfolio/RRP combination and worried about how its involvement would play out in a crisis; resistant to re-involve itself in credit allocation as implied by MBS purchases and sales; and seems to have become more comfortable using forward guidance to influence long-term rates than using twist or QE type operations to affect term premiums.

Were a future FOMC to shift to more active portfolio management to promote financial stability, it wouldn’t undermine the basic reasons for a two committee structure with the Board retaining the macroprudential use of microprudential tools: the importance of keeping the FOMC primarily focused on monetary policy in the context of the business cycle and being held accountable for achieving its dual mandate, while separate authority is held primarily accountable for financial stability; and the optics of keeping the reserve banks away from setting regulatory policy that might affect their bank owners. To be sure, active use by the FOMC of its portfolio for financial stability purposes would put extra pressure on coordination and knowledge exchange between the Board and the FOMC—coordination that will occur in any event given the overlapping membership and involvement of the presidents in supervision.

Implemented in the UK

The UK is implementing the two committee structure for monetary and macroprudential policy. Monetary policy is in the control of the Monetary Policy Committee in the Bank of England. In the wake of the global financial crisis, the structure of supervision and regulation was overhauled. Three new entities were established: the Prudential Regulation Authority was set up under the Bank to do microprudential regulation of banks, insurance companies, and a few other entities; the Financial Conduct Authority over sees conduct in the financial markets, including interactions of intermediaries with consumers as well as conduct within the market; the Financial Policy Committee was created in the Bank to take responsibility for using macroprudential policy to protect the stability of the UK financial system, working within a broad remit of the Bank “to protect and enhance the stability of the financial system of the UK”.

I am one of four external members (that is, not an official of the Bank) of the FPC. In addition we have 5 internal members—three overlap with the MPC and three with the PRA; the head of the FCA; and a nonvoting member from the Treasury.^[8] The primary objective of the FPC is to “identify, monitor, and take action to remove or reduce systemic risks with a view to enhancing and protecting the stability of the UK financial system”. Subject to that we are to support the economic policy of the government, including its objectives for growth and employment—our secondary objective.

The primary objective of the MPC is stable prices, defined by the government as 2 percent inflation; and subject to that to support the economic policy of the government, including for growth and employment. So the two committees are responsible and held accountable for separate primary objectives, with the same secondary objective.

Information sharing between the committees is effected by the overlapping membership, with the Governor of the Bank chairing both committees. The FPC uses the macroeconomic forecasts of the MPC in considering the effects of the macroeconomic environment on financial stability; that was important in the housing market, as I’ll return to below. The two committees are occasionally briefed together on common interests, like housing.

The FPC can make recommendations to anyone, and we have powers of direction over a number a number of macroprudential tools, including several that can be used in a countercyclical manner: the countercyclical capital buffers on risk-weighted and leverage bases; sectorial capital requirements in the real estate area; and LTVs and LTIs on mortgages for owner occupied housing.

The two committees have had a couple of interesting interactions, which illustrate how the two-committee system can work. Early on, when the FPC and the Bank were implementing higher capital and liquidity standards while the MPC was pushing to speed the recovery, the FPC was careful to ensure as best possible that its actions to build resilience did not reduce the availability of credit for UK households and businesses. It emphasized in its communications with the banks and microprudential authorities that we expected higher capital requirement ratios to be attained by increasing capital in the numerator and not by decreasing assets in the denominator. In addition, the FPC recommended that new liquidity requirements be phased in gradually and the Bank of England gave banks liquidity credit for a portion of their collateral prepositioned at the Bank discount window so they didn’t shift from lending to liquid assets.

When the MPC first engaged in forward guidance about holding asset portfolios and interest rates at extraordinary levels at least until certain macroeconomic thresholds were reached, they gave the FPC a “knockout” of that guidance.^[9] That is they said the guidance would cease to hold if the “FPC judges that the stance of monetary policy poses a significant threat to financial stability that cannot be contained by the substantial range of mitigating policy actions available to the FPC, the PRA, and the FCA in a way consistent with their objectives.” As expected, the knockout was never triggered (and it is no longer in effect as the unemployment rate has breached its threshold), but it meant the FPC had to consider the stability risks of low-for-long interest rates very explicitly and concretely and communicate its findings to the MPC on a regular basis; these communications were published soon after the MPC meeting. It was a good discipline and a nice illustration of how judgments and actions on financial stability could rest primarily with the macroprudential authority, while monetary policy could still be invoked as a “last line of defense”.

Finally, we worked with the MPC to consider developments in the UK housing markets in 2013/14. House prices in the UK did not fall that far in the financial crisis and remained elevated relative to some standard metrics. In 2013, house price inflation picked up again throughout the UK, not just in London and the southeast. Moreover, projections made by the MPC, which we on the FPC were able to discuss with them, were for prices to continue to rise nationally more rapidly than general inflation and nominal incomes, when household debt to income ratios were already high. As the FPC, we wanted to protect against deterioration in credit quality and buildup of debt in heavily indebted households that could amplify the effects of an unexpected increase in interest rates or weakening of income growth. So in 2014, we worked through the FCA to required lenders to apply a stress of an increase in interest rates of three percentage points when assessing the borrowers’ ability to repay floating rate loans; and we worked through the PRA to limit high LTI loans by banks and building societies—specifically, no more than 15 percent of their new loans could be at LTIs of 4-1/2 or above. As a consequence, the MPC has been able to continue to concentrate on achieving its medium-term inflation target without needing to steer away to take account of growing longer-term risks in residential mortgage markets.

The UK system is new; it is a promising beginning, but its success can only be judged over decades. Moreover, with London a large and extremely important global financial center, the UK is very open to shocks emanating from elsewhere. We are acutely aware that financial stability in the UK depends in part on the successful implementation of micro- and macro-prudential policies around the globe—and nowhere is more important in that regard than the United States.

Structural deficiencies in the US organization for macroprudential policy

The organization of macroprudential and monetary policies within the Federal Reserve seems about right to me at this time: The Board of Governors in charge of regulation and the FOMC of monetary policy. But broader and deeper structural deficiencies exist in the US regulatory system for macroprudential regulation. The more effective is macroprudential policy, the less frequently the “last line defense” of monetary policy will need to be activated, and the medium-term objectives of price stability and maximum employment compromised for a time; deficiencies in US macroprudential organization and policy could mean that the last line of defense is closer to the battle line in the US than it needs to be.

Nothing speaks more clearly to these deficiencies than the ambiguity about who is in charge and the misalignment between perceptions of responsibility and authority. The widespread perception is that the Federal Reserve is responsible for financial stability. To be sure the Federal Reserve has considerable powers to make the financial system resilient to shocks, some of which it acquired in Dodd-Frank. But these are centered in banks and bank holding companies and a few systemically important nonbank intermediaries. And, in its oversight of the banking system, the Federal Reserve must work with two other agencies, though it retains considerable authority, especially for holding companies. Beyond the banking system, the Fed can play a leadership role, for example in addressing issues in shadow banking and the securities markets, but it must work with and through other agencies. This is increasingly important as activity migrates outside the banking system in response to technology and to the costs of building resilience in the banking system.

In the US, protecting financial stability, and especially protecting it through macroprudential policies that take account of spillovers, contagion across markets and institutions, and other externalities, depends on coordination across a fragmented, Balkanized, regulatory system beset by gaps and overlaps. It is a system in which many of the agencies lack a macrofinancial or macroeconomic perspective and are without financial stability mandates. They are, understandably, and properly in a democracy, focused on their explicit legislated mandates—for example for protecting investors or consumers. They concentrate their attention on the markets, market participants, and behaviors they have traditionally overseen, and less on how those markets and behaviors interact with the entire system. Their constrained perspective is reinforced by the knowledge of and relationships they build with the players in their scope and by Congressional oversight that is dispersed among several committees.

The creation of the Financial Stability Oversight Council has been helpful in bringing forward analysis of risks to financial stability and stimulating and coordinating actions to deal with those risks across agencies. But FSOC by itself cannot remedy the underlying flaws of financial regulation in the US. FSOC itself has no real powers beyond SIFI designation and making recommendations. Moreover, there are too many agencies protecting too much turf and some turf—like most insurance regulation-- is outside any federal oversight. The membership of FSOC is vested in the agency heads—not the agencies themselves—limiting the chances for buy in to measures to protect financial stability by other members of boards or commissions.

Finally, there is likely to be value in having macroprudential policy vested in a body with some independence from short-term political pressures. Effective macroprudential policy could well affect the level and distribution of private sector profits, and it will require constraining the actions of private parties when things are going well and the requirements to protect the system—to build resilience—are not self-evident. But FSOC is chaired by the secretary of the Treasury, and the required degree of independence is greater than is likely to be consistently embodied in Treasury secretaries, especially as elections draw near. And having the secretary as chair would greatly complicate coming to any understanding about the appropriate division of labor between macroprudential and monetary policies.

Deficiencies in the tools available for macroprudential regulation

Perhaps reflecting the deficiencies in governance and structure, the US has been engaged mainly in structural macroprudential actions—mostly building permanent buffers and protections in systemically important institutions—rather than in countercyclical tools and actions. Structural policies can be very helpful in protecting stability and increasing the scope for monetary policy to concentrate on achieving price stability and maximum employment as rapidly as possible. But there are limits. To the extent structural policies concentrate on already regulated institutions, like bank holding companies, they will give incentives for intermediation to move to less-regulated areas of the financial markets, where coordination across agencies is at a premium and the efficacy of tools to mitigate risks is more open to question. A little less reliance on structural and more on countercyclical would reduce those incentives to shift and leave more intermediation subject to the occasional use of countercyclical tools. And, appropriately designed and implemented, countercyclical requirements can be released in a downturn. Some types of countercyclical tools might be targeted at specific terms and conditions of lending, wherever it occurred.

So far, the only explicitly countercyclical tool in the US kit is the countercyclical capital buffer under Basel 3. In addition, the stress tests are designed with an important countercyclical dimension, and the results can be used to spot shifting interdependencies and correlated positions, as well as the vulnerabilities of individual institutions.

But I am particularly struck by the lack of countercyclical tools for real estate credit. Real estate cycles have been the major drivers of financial cycles in the US in the 1980s and 2000s and elsewhere around the world. The ability to increase sectoral capital requirements for real estate would help to build resilience in the next upswing. And a body with macroprudential authority needs to be able to impose limits on LTVs and LTIs, not only on the loans on the books of depositories but also on loans held elsewhere, say through securitization. I don’t know whether the authorities would have utilized such tools in the mid-2000s when they would have been so helpful in retrospect, and I’m sure if they were used political opposition would have been fierce, but having them and having an expectation that they would be used counter-cyclically would have forced a conversation. In the next housing boom, and one will come, the lack of these tools will force monetary policy to respond to the upswing more than it otherwise would, at the cost of jobs and at the risk of the credibility of its inflation target.

What is to be done?

First best of course would be legislation—to consolidate agencies and make financial stability an integral part of their remit and to create a macroprudential regulator with authority that matched its responsibility. Such a regulator should have a heavy Federal Reserve presence, but it need not be housed in the Fed. Paul Volcker had some interesting ideas along these lines.^[10] But history suggests that thorough regulatory overhaul in the US is unlikely.

Still I suspect steps could be taken within the current framework to strengthen our ability to protect financial stability, including by being more countercyclical. We need a stock take: relative to past and likely future threats to financial stability, what tools do we have and what are the impediments to using them most effectively? FSOC and the Office of Financial Research identify risks, but usually those are risks that agencies are already taking some steps to address—and they are more structural than countercyclical. What we need is an assessment of where the holes are in coverage and how they might be filled. What can be done under current legislation? Do all relevant agencies/authorities have enough flexibility in their mandates to consider financial stability? As implied by the previous discussion, the stock take should include tools to deal with cycles in real estate lending, both commercial and residential. It should also deal with securities markets, especially where they involve leverage, maturity or liquidity transformation, as the system evolves in this direction.

The exercise should involve all the relevant agencies—it can’t be just a Federal Reserve effort. An agreement for greater data sharing among the agencies would be a concrete first step toward working together for financial stability.

I understand that similar exercises are underway for securities markets, securities financing transactions and other aspects of “shadow banking” in the US and at the FSB. But these discussions need more of a public face and need to be put in context. The public and political discussion in the US about financial stability focusses almost exclusively on SIFIs: should the big banks be broken up? Should Glass-Steagall be restored? What are the criteria for becoming and remaining a nonbank SIFI? Publication of a stock take, most especially one that pointed out holes and deficiencies, would broaden the public conversation and promote a better understanding of the requirements for good macroprudential regulation. Among other things it should foster understanding that such regulations should tighten in the good times and ease in bad, and that such actions would enable the monetary policymakers on the FOMC to concentrate on achieving their maximum employment and stable price objectives as rapidly as possible.

Downloads

• Download the full text of the speech

      

 

 

Event Information

On September 17, the Center on the United States and Europe (CUSE) at Brookings hosted Henri de Castries, head of the Institut Montaigne and AXA, for the 12th annual Raymond Aron Lecture. In his remarks, de Castries explored the challenges facing Europe and the transatlantic economy and offered perspectives on how Europe can restore economic and monetary leadership amid global volatility. As the head of one of the world’s largest insurance companies and chair of several public policy research institutions, de Castries applied his business experience to consider strategies for European leaders to emerge from the Greek crisis and the broader institutional turmoil within the eurozone. Following de Castries’s address, Brookings Senior Fellow and former Federal Reserve Vice Chair Donald Kohn offered remarks in response.

Henri de Castries has been the chairman and chief executive officer at AXA Group since 2010. Previously, he served in various senior executive positions within AXA after joining the company in 1989. He was elected chairman of the Paris-based think-tank Institut Montaigne in June 2015. Donald Kohn is a senior fellow in Economic Studies at Brookings and was vice chairman of the Board of Governors of the Federal Reserve from 2006 to 2010.

Brookings President Strobe Talbott and Brookings Trustee Antoine van Agtmael provided welcoming remarks. Jim Hoagland, contributing editor of The Washington Post, introduced the session and moderate the discussion.

The Raymond Aron lecture series, named after the renowned scholar of post-war France, annually features leading French and American personalities speaking on current issues affecting the transatlantic relationship.

Join the conversation on Twitter using #EuroLeadership

Video

• Restoring European economic leadership

Audio

• Restoring European economic leadership

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• 20150917_aron_europe_economy_transcript

      

 

 

Event Information

The Federal Reserve, which has been holding interest rates near zero since late 2008, is poised to raise them sometime this year, perhaps in September, perhaps in December. What happens when the Fed finally makes its move—to the U.S. economy, to bond and stock markets, to the rest of the world? What should the Fed’s strategy be going forward for raising interest rates? Should it be predictable? Or dependent on data? Should it stick to its vow to move gradually? And what should the Fed do with its $4 trillion bond portfolio? Allow it to shrink gradually? Sell off bonds? Maintain a portfolio bigger than pre-2008 levels? 

On September 3, the Hutchins Center on Fiscal and Monetary Policy at Brookings discussed all these questions and more with four experts: Brookings’ Donald Kohn, a former Fed vice chairman; Peterson Institute’s Joseph Gagnon, a former top Fed staffer, Johns Hopkins’s Jon Faust, and Julia Coronado of Graham Capital. David Wessel moderated the discussion. 

 You can tweet questions from the public at #FedRates.

Video

• What happens when the Fed raises interest rates?
• Will the Fed Raise Rates in September?
• Does the Timing of the First Interest Rate Increase Matter?
• It’s the Interest Rate Path Over Time that Makes a Difference
• The Timing of the First Interest Rate Rise Matters a Lot

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• 20150903_fed_interest_rates_transcript

     

 

 

Mr. Chairman and Members of the subcommittee:

You have before you a long list of proposed legislative changes applying to the Federal Reserve, some of which would make important changes in the character of the institution, its policy processes, and its authorities. At the same time you are also considering the formation of a commission to examine whether indeed the Federal Reserve should be altered to make it a more effective institution. The basic premise of both of these strands is that something has been seriously amiss with the way the Federal Reserve has carried out the responsibilities Congress has given it.

I do not agree with that premise. In my view, the actions of the Federal Reserve in the crisis and slow recovery were necessary and appropriate. Its conduct of monetary policy has been as systematic as possible under unprecedented and constantly evolving circumstances, and it has been especially transparent about how those monetary policy actions were expected to foster achievement of its legislated mandate and what it would be looking at in the future to gauge the need for future actions. The Federal Reserve, working in part under the guidance of the Congress in Dodd Frank, has greatly toughened and improved its regulation and supervision of the institutions for which it is responsible, and the financial system is safer than it has been for many years.

No institution is perfect. Circumstances change, lessons are learned, and all policy institutions must adapt if they are to continue to serve the public interest as well as possible. You are right to be asking tough questions about whether further improvements in the Federal Reserve’s performance as well as your oversight and the Fed’s accountability are possible, and the extent to which new legislation is needed to make those changes. In my view, however, the suggestions in the proposed legislation, as I weigh their costs and benefits, are not likely to improve the Federal Reserve’s performance and enhance the public interest, and could very well harm it.

Congress has established goals for monetary policy, given the experts at the Federal Reserve insulation from short-term political pressures to set their policy instruments to meet those goals, and then held the Federal Reserve accountable for the outcomes. The Senate, in its role in appointments to the Federal Reserve Board, has a critical say in making sure the right experts are in place to carry out this responsibility. You have recognized that this model of independent but accountable central banking has proven to work better in the public interest than one in which political pressures can be brought more forcefully to bear on the central bank instrument settings. I urge you to keep the current balance in place.

Let me address just a few of the proposals.

Policy Rules and GAO audits. Being as systematic, predictable, and transparent as possible about what the Federal Reserve is doing increases the effectiveness of monetary policy because it helps private market participants accurately anticipate Federal Reserve actions. It also enhances your ability to assess the policy strategies of the FOMC. The Federal Reserve should explain why it has chosen the instrument settings it has, how those settings are expected to foster achievement of their responsibilities, and on what basis they might evolve in the future. The FOMC has taken a number of steps to increase the predictability and transparency of its actions, especially over the past 10 years.

But “as possible” is the key phrase in that first sentence of the previous paragraph. The Federal Reserve, the Congress, and private market participants must recognize the limits of our knowledge of economic relationships, including the relationship between changes in policy instrument settings and progress toward the Federal Reserve’s legislated objectives. The U.S. economy is a complex and ever-changing system that cannot be comprehensively summarized in a few variables and empirical relationships. Not only are the relationships imperfectly understood and evolving, but unexpected developments here and around the world can affect the U.S. economy.

The result is that the Federal Reserve must use all available information that might shed light on evolving economic relationships and the effects of policy, and use it in a flexible manner. Statistical economic models relating future inflation, economic activity, and labor market slack to incoming information about the economy and to financial variables have proven especially unreliable over the past eight years of financial market disruption; history has been a poor guide to the future in these unprecedented circumstances. Models and policy rules can be useful inputs for policy, but they are only inputs and cannot be relied on as hard guides to policy settings to achieve the Federal Reserve’s objectives.

To be sure, policy has taken unexpected steps over the past seven years, but this was in response to unexpected developments. Moreover, the recovery from the financial crisis was disappointingly slow. But it would have been even slower had the FOMC not undertaken unconventional and sometimes unexpected policy actions. The pricing of actual and expected volatility in financial markets has not suggested an unusual amount of uncertainty about the path of interest rates or the Federal Reserve’s portfolio holdings going forward.

Requiring the Federal Reserve to send you a rule that includes “a function that comprehensively models the interactive relationship between intermediate policy inputs” and “the coefficients of the directive policy rule that generate the current policy instrument target” would be at best a useless exercise for you, the Federal Reserve, and the American public and could well prove counterproductive for achieving goals and understanding strategies. If it is adhered to it will produce inferior results; if it is not, as I would hope and expect, it would be misleading.

If the Federal Reserve were to frequently alter and deviate from policy rules you would require it to publish under the proposal, as I expect it would, then the GAO would be frequently second guessing FOMC decisions. Indeed, under another section of the proposed legislation the exemption for monetary policy from GAO audit would be repealed.

Congress was wise to differentiate monetary policy from other functions of the Federal Reserve in 1978 when it authorized GAO audits of those other functions. It recognized that the GAO audits could become an avenue for bringing political pressure on the FOMC’s decisions on the setting of its policy instruments. Around the same time, Congress clarified the objectives for policy and it established reports and hearings to hold the Federal Reserve accountable for achieving those objectives. It also recognized that over time and across countries, experience suggested that when monetary policy is subject to short-term political pressures, outcomes are inferior; in particular inflation tends to be higher and more variable.

In that context, the extra pressure of GAO audits of policy decisions moves the needle in the wrong direction. At some point, and I hope before too long, the labor market will be strong enough and the prospects for inflation to rise will be good enough that the Federal Reserve will begin to tighten policy to avoid overshooting its two percent inflation target. That will not be popular with some political observers. The Congress made a good decision in 1978 and I urge you to stick with it and find other ways to inform your oversight of monetary policy.

Changes to emergency lending powers for nonbanks. Supplying liquidity to financial institutions by lending against possibly illiquid collateral is a key function of central banks. Indeed, having an institution to do this in the U.S. was a major impetus behind Congress establishing the Federal Reserve in 1913. When confidence in financial institutions erodes and uncertainty about whether they can repay the funds they borrowed increases, they experience runs—those supplying funds to banks and other intermediaries stop. Without a backup source of funding, lenders are forced to stop making loans and to sell assets in the market at any price. The resulting drying up of credit and fire sale of assets severely harms the ability of households and businesses to borrow and spend and can result in deep recessions with high unemployment. Borrowing from a central bank under such circumstances helps lenders continue to meet the credit needs of households and businesses; it is an essential way for the central bank to cushion Main Street from the loss of confidence in the financial sector.

For most of the twentieth century the Federal Reserve could perform that function adequately by lending to commercial banks and other depositories. But in the past few decades, intermediation in the U.S. has shifted from banks to securities and securitization markets. In 2008, the Federal Reserve found that lending to nonbanks—to investment banks, money market funds, buyers of securitizations—was required to stem the panic and limit the damage to Main Street. Some of what we did, however necessary, was uncomfortable—in particular lending to support individual troubled institutions, like AIG, or to support of the acquisition of Bear Stearns. The Federal Reserve supported giving the FDIC an alternative method of dealing with troubled financial institutions and limiting the use of the discount window for nonbanks to facilities that would be widely available to institutions caught up in the panic.

Congress made those changes on lending to nonbanks in Dodd-Frank and added a few more on reporting, collateral, and approval by the secretary of the Treasury. I would not go further; in fact I’m concerned that some of what you have already done might limit the effectiveness of the Federal Reserve’s lender of last resort function for a twenty-first century financial market—make panics even harder to stop and raise the risk that households and businesses would lose access to credit. The restrictions you have already placed on 13-3 lending, the resolution authority you have given to the FDIC, and the higher capital requirements on systemically important institutions are in the process of eliminating the moral hazard of any remaining perceived benefit from nonbank access to lender of last resort.

We need to keep in mind that difficult judgments are required in such a situation—especially about solvency and collateral valuations. The nature of a financial crisis is that the line between liquidity problems and solvency problems is not clear—institutions that might be insolvent if their assets were sold at fire sale prices might be comfortably solvent when the panic subsides; collateral whose value has dropped sharply in the panic will recover as the panic subsides. Central banks need to be able to make such judgment calls quickly—and explain them to the public—and they need to be sure not to add to market problems by chasing collateral values down or judging otherwise sound institutions as insolvent.

The Monetary Commission. As I said at the beginning of my testimony, no institution is perfect; all need to learn lessons and adapt. The Federal Reserve has been adapting its monetary policy strategy and communications. The Federal Reserve, the other regulators, and the Congress have addressed many of the deficiencies in regulation and supervision that allowed the circumstances that led to the crisis to build.

As I also noted, I do not believe that major changes have been identified that would make the Federal Reserve a significantly more effective public policy institution. But I recognize that the geographical structure of the System was set in 1914; some of the relationships among its constituent parts, including the make-up of the monetary policy committee, in the 1930s; and its monetary policy goals and reporting in the late 1970s. I cannot rule out that a group of thoughtful policy experts might be able to suggest some further improvements to goals, structure, and decision-making processes.

But the proposal before us has a panel rooted in partisan politics, not expertise, and its make-up is strongly tilted to one side. It has in effect pre-judged one aspect of the conclusions by mandating that a reserve bank president be included, but not a member of the board of governors. Shifting authority from the Board to the presidents is a general theme of many of the proposals before us and as a citizen I find it troubling. The reserve banks and their presidents make valuable contributions to the policy process; in particular they bring a greater diversity of views than is often found on the board of governors. But they are selected by private boards of directors, to be sure with the approval of the board of governors, and giving them greater authority would in my view threaten the perceived democratic legitimacy of the Federal Reserve over time.

The Congress has given the Federal Reserve Board, with its members appointed by the president and approved by the senate, a clear majority on the FOMC, even when there might be a vacancy on the Board. And it has given the Board authority over discount window lending by the reserve banks as well as their operations. I believe that public support for the Federal Reserve in our democratic society requires that the authority of the Board not be eroded.

Downloads

• Download the testimony
• Media summary

     

 

 

Event Information

 Follow @BrookingsChina to join the conversation.

Audio

• China's transition at home and abroad (English)
• China's transition at home and abroad (Chinese)

Transcript

• Transcript (.pdf)

Event Materials

• 20150721_china_transition_transcript

     

 

 

Event Information

The financial sector has undergone major changes in response to the Great Recession and post-crisis regulatory reform, as a result of the Dodd-Frank Act and Basel III. These changes have created serious questions about the sector’s role in supporting economic growth and how it affects financial and overall economic stability.

On June 8, the Initiative on Business and Public Policy at Brookings explored the intersection of the financial system and economic growth with the goal of informing the public policy debate. The event featured a keynote address by Richard Berner, director of the Office of Financial Research and other participants with a wide range of views from a variety of backgrounds. Among other issues, the experts considered the changing landscape of the financial sector; growth-promoting allocation and investment decisions; credit availability for low- and moderate-income households; the ideal balance between growth and stability; and the impact of the 2014 midterm elections on regulatory reform.

 Follow the conversation at @BrookingsEcon or #Finance.

Video

• Keynote remarks by Richard Berner
• The financial sector: How has it changed?
• The view from the trenches
• The future of the U.S. financial sector

Audio

• Can the financial sector promote growth and stability?

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• Aaron Kleins presentation
• 20150608 BAER slides
• 20150608 MEHTA slides
• 20150608_financial_sector_stability_transcript

     

 

 

Event Information

A widely heard criticism of the Federal Reserve’s purchases of trillions of dollars in bonds, or quantitative easing, is that the Fed increased inequality by pushing up prices of stocks, bonds, and other assets already in the hands of the wealthy. Did it? What role does monetary policy play in influencing the distribution of income and wealth?  Would alternative policies have had different distributional effects?

On June 1, the Hutchins Center on Fiscal and Monetary Policy presented three new papers that explore these questions. Josh Bivens of the Economic Policy Institute looked at the channels through which conventional and unconventional monetary policies influence inequality. Matthias Doepke and Veronika Selezneva of Northwestern analyzed the impact of monetary policy on the distribution of wealth across households. Finally, Martin Beraja, Erik Hurst and Joe Vavra of the University of Chicago, and Andreas Fuster of the New York Federal Reserve examined whether regional differences should figure into monetary policy decisions that may affect inequality.

Responding to the papers and discussion was Brookings Robert S. Kerr Senior Fellow Donald Kohn, Kevin Warsh of the Hoover Institution, McKinsey’s Susan Lund, Mark Zandi of Moody’s Analytics, and Jean Boivin of BlackRock.

 Follow the discussion @BrookingsEcon or #Inequality.

Video

• Inequality and monetary policy, conventional and unconventional
• Distributional effects of monetary policy
• Regional heterogeneity and monetary policy
• Panel Discussion

Audio

• Did the Fed's quantitative easing make inequality worse?

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• 20150601_quantitative_easing_inequality_transcript

     

 

 

Donald Kohn, Robert S. Kerr Senior Fellow in Economic Studies at the Brookings Institution, and External Member of the Financial Policy Committee of the Bank of England, delivered remarks to the Society of Business Economists in London on May 14, 2015.

It is a pleasure to be able to speak to the Society of Business Economists. Your Chairman suggested I reflect on my years on the Financial Policy Committee, and I will do that, but I will spend most of my time looking forward—giving my views on some broad priorities for the FPC in coming years.

I have been a member of the Committee since its inception as the interim FPC in the spring of 2011. In that time I believe we have accomplished much to make the UK financial system safer and put in place the foundations for continuing that work in the future.

We have worked with the Prudential Regulation Authority (PRA) to build the resilience of the UK banking system—especially to build its capital cushion against future shocks—so that it can continue to deliver financial services to the real economy in the face of adverse economic and financial developments, and without requiring further taxpayer support. To this end, we phased in the Basel 3 capital risk-weighted capital requirements as quickly as possible for UK banks and instituted a minimum leverage ratio; there is still some work to be done, but major UK banks are now comfortably ahead of the Basel 3 transition timetable. Greater capital supports growth not only by making crises less likely and less severe, but also because well-capitalized banks have been shown to be more willing to lend.

Last year the FPC and the PRA initiated concurrent capital stress tests across large UK banks and are making these tests a regular part of the capital framework. This was a major innovation and strengthens our ability to be explicit about what we see as the important risks to financial stability in the UK and to test the banks’ resilience to those risks. Last year we tested banks’ resilience against the effects of a substantial rise in UK interest rates and a fall in property prices; this year our stress scenario originates in a major shortfall in growth in the rest of the world. The horizontal comparisons across banks from these tests can be particularly revealing about the relative capital positions, modelling characteristics, and risk management capabilities of each major UK bank.

These tests also importantly increase transparency to the public about the FPC’s view of risks to financial stability, the individual bank’s ability to withstand those risks, and the actions the FPC and PRA are taking in response to the results. In that regard the stress tests are an important new element in the accountability of the FPC and the PRA. I expect the stress test to play a major role in our execution of macroprudential policy in the future and I expect us to continue to develop our ability to use the information we collect to identify threats to financial stability, such as procyclicality of bank risk models, interconnections among banks that may not be evident on the surface, and crowded and correlated positions that make the system vulnerable to particular asset price movements.

The FPC has also identified various risks to financial stability beyond those posed by potential bank credit losses and made recommendations to deal with them. For example, we highlighted the dangers of cyber attack, and the potential for rising house prices to cause borrowers to become so indebted for the purchase of houses such that they would need to cut back sharply on spending should interest rates spike unexpectedly or income be temporarily depressed. In both cases we made recommendations that were implemented to counter the perceived risks. And we worked with the banks to enhance their disclosures and thereby strengthen the ability of their private sector counterparties to monitor and price the riskiness of banks through greater bank transparency—especially around capital risk calculations.

Finally we have put in place much of the basic framework required to operate macroprudential policy on an ongoing basis. We worked with HM Treasury and Parliament to get authority for the tools we need—including powers of direction over capital, leverage and key terms of lending against residential real estate. And we issued policy statements outlining how we might use these powers of direction to sustain financial stability.

As a Committee, we have established good working relationships with the PRA, the Financial Conduct Authority (FCA) and the Monetary Policy Committee (MPC). Macroprudential policy is implemented mostly through the PRA and FCA and they and we need to have a good understanding of what each authority is trying to accomplish and how our actions affect the objectives of the others. The chief executives of the PRA and FCA are both members of the FPC and have provided guidance on how to shape our recommendations to accomplish our objectives. Both macroprudential and monetary policy seek to accomplish their separate objectives by affecting aspects of financial conditions, so it is critical that each committee understand what and how the other intends to operate and can weigh the implications for meeting its objectives. The FPC has been asked to provide an independent voice on financial stability—by the MPC and by Treasury (in help-to-buy) to assets the financial stability implications of their policies.

We are not completely finished with establishing the macroprudential framework: we need to complete the capital framework; we have requested powers of direction for buy-to-let lending; and the FPC will always need to be alert to the possibility that preserving financial stability in an evolving financial landscape could require new tools in new areas. But I believe the basic structure is largely in place. Going forward we will be placing more emphasis on how we use the structure; it is a time of transition for the FPC.

Having just begun a new three-year term with the FPC, I would like to use this occasion to look forward, to reflect now on what I hope we can accomplish in the next three years, building on the approach already in place. I will concentrate on two broad challenges: first, how the FPC can continue to build a systematic and disciplined approach to macroprudential policy—to identifying risks and using our powers of direction and recommendation to address them; and second, how the FPC can contribute to fostering safe and resilient market alternatives to bank finance in the UK.

Systematic and disciplined approach to macroprudential policy

A good deal of uncertainty about macroprudential policy is inevitable: policy will need to respond to threats from unexpected developments—possibly from abroad in globally linked markets—interacting in unexpected ways with complex and only imperfectly understood financial systems. But within that inherently uncertain environment, the FPC can work to make macroprudential policy more systematic and predictable. This will help market participants to plan and to anticipate our policy actions, and those anticipatory actions should help stabilize the system under many circumstances. Systematic and transparent policy-making also facilitates public accountability: for how we intend to identify risks that embody externalities with macroeconomic and financial stability implications; for how we will determine appropriate responses that are targeted and proportionate to the risks and consistent across time and circumstances; and for how we weigh our secondary objective for growth and employment alongside our primary objective for financial stability.

We do need to recognize that there are likely to be some limitations on systematic, predictable, macroprudential policy—say, as compared to monetary policy. Most obviously, we have no ready continuing measure of how we are doing relative to our financial stability objective that is comparable to inflation readings for monetary policy. Financial instability is mostly obvious after it has occurred. Moreover there are multiple kinds and degrees of instability with varying implications for the financial sector and the real economy; for example asset price overshooting with limited leverage like dot-com equities, versus housing price overshooting in the presence of highly leveraged lenders and borrowers. Both can have adverse effects on the economy, but the disruptions to the financial sector in the second case proved a much more potent downward force on employment and economic activity. As I will discuss below, we have developed a set of indicators for financial stability, but refining and testing those indicators is an ongoing challenge.

In addition, we have little experience with using macroprudential tools in a countercyclical way in a highly developed, globally integrated economy like that of UK. These types of tools were more common in the UK and US several decades ago, when markets were less developed and arbitrage opportunities more limited, and they have been more widely used in emerging market economies in recent times. But for the UK today, we have limited information to use to draw inferences in order to gauge calibration and effectiveness.

Nonetheless, I believe we can and should be able to make further progress toward systematic and disciplined macroprudential policy. I see two broad areas for such progress.

First, we can continue to develop a more systematic approach to identifying risks and deciding which tools to use to address them. This should be aided as much as possible through monitoring a set of indicators we and you can have confidence in. Identification of risks and indicators of risks is challenging. We are looking for systemic risks, which generally involve market failures that are not embodied in market prices or captured by institution-by-institution microprudential oversight. Examples would include asset mispricing owing to widespread complacency or over confidence; complex and opaque interconnections among key financial market institutions; crowded trades that might reverse with widespread consequences; broad increases in lender leverage or maturity mismatches that look relatively benign on an individual institution basis; substantial increases in borrower leverage; or a buildup of macroeconomic or macrofinancial imbalances that might hold the potential for sharp changes in asset prices or credit availability when they correct.

In addition, systemic risks often involve the tails of distributions—vulnerabilities to unexpected developments. Financial institutions, investors, households, businesses, do not plan on being unable to meet their obligations, or to have difficulty trading out of a position, or to take a loss that impairs their ability to spend or hire. But they could be vulnerable to unexpected shocks that subject them to extreme events against which they are not adequately prepared. Our job is to identify tail events to which they are vulnerable and that could pose an unacceptable risk to financial stability.

Of course we already look at indicators of the sorts of imbalances and distortions that have preceded past crises. These include the build-up of leverage and maturity mismatch in banks and other intermediaries; the rapid growth of credit to households and businesses relative to income; current account imbalances that might imply a build-up of indebtedness and greater vulnerability to developments elsewhere; and asset pricing, for example for houses or risky bonds, that looks extreme relative to standard metrics.

But the threats next time might well come from a different direction, and problems could be amplified by newer characteristics of financial markets. Among other things, activity and risks are likely to migrate to different parts of the financial system and the consequences of tail events change shape as market participants adapt to the shifting regulatory landscape after the global financial crisis. Identifying indicators for newer types of vulnerabilities—the next problem—is even harder than for the issues we have experience with, but is absolutely necessary.

The FPC has a set of indicators we publish and use as a first step toward deeper analysis of possible emerging threats to stability. I expect us to refine these over coming years. The reactions and inputs of business economists and others knowledgeable about financial markets would be most helpful in this regard. Do you find the FPC indicators helpful? What indicators do you use? What new information would you like to have as you assess vulnerabilities in the financial landscape? The Bank consults regularly with a wide array of business and financial market participants and I reach out regularly myself to help identify risks and assess the effect of our actions.

The analysis of risk in turn should point toward the most appropriate tool to address the risk. Where is the market failure that threatens financial stability? What is the most efficient and effective way to reduce that risk?

A broad increase in credit through the banking sector might be addressed by an increase in the countercyclical capital buffer for banks which would better assure their resilience to a reversal of the cycle to a turn in asset prices whose upward movement had been fueled by credit or an increase in debt servicing problems among borrowers should interest rates rise and growth slacken. An increase in capital requirements, which, if binding, would raise the effective cost of funding loans a little, might help to damp the buildup in credit itself, though I suspect that effect will be quite limited in the face of optimistic expectations fueling strong demand and ample supply of credit; but a rise in capital will unambiguously bolster resilience.

Imbalances and risks that appeared to emanate from particular sectors might call for tools focused on that sector, that could be aimed at reducing exposure/leverage from either the lender or borrower side—or some combination. Higher sectoral capital requirements, for example for bank real estate lending, would make that lending a little less profitable and by potentially increasing bank capital would make banks extending such loans less vulnerable to risk from that lending—help them weather a turn in the market and pick up in defaults. If the market failure arose from households becoming too exposed to certain types of mortgage loans that left them particularly vulnerable to changing economic circumstances, the most effective restrictions might be ones that place limits on the terms of the lending—for example the interest rate stress test and LTI restrictions the FPC recommended for residential real estate lending last June. Experience in other jurisdictions implies that these sorts of product restrictions can be effective at damping credit and price cycles, perhaps more so than actions on bank capital.

Second, we should be able to improve and make more systematic the calibration of our tools by making progress on analysis of the impact—that is the costs and benefits—from changing regulations. As noted, we have limited experience to analyse this in the UK, but the FPC is required to act proportionately and to do a cost-benefit analysis where possible. To some extent, costs may be more obvious, immediate, and easier to quantify than benefits—in terms of raising the price or restricting the availability of credit and imposing compliance costs on institutions. The benefits of reducing the odds on future instability are longer–term and harder to specify. Still, those benefits are considerable, as we have learned so painfully over the past few years.

Refining impact analysis can help us with: policy design and calibration—selecting the tool or combination of tools best suited to address the problem, and the calibration most likely to produce a positive balance of benefits over costs; communication and public accountability—explaining our choice, the reasons for it, and the outcome we anticipate from its use; and evaluating those outcomes relative to expectations.

None of this will come easily and quantification of costs and especially benefits will be subject to considerable uncertainty. But it is important that the FPC’s framework and approach to policy weigh what we can determine about the costs and benefits of our recommendations and directions. We will gain experience over time, and will continue to refine our models and techniques.

By establishing a systematic and disciplined policy making approach, the FPC will be better able to achieve its statutory objectives of protecting financial stability and supporting growth. But it is important to be clear and have common expectations of what macroprudential policy and the FPC can achieve. Asset prices will fluctuate and overshoot long-term sustainable levels from time to time. Financial intermediaries will make poor decisions or be hit with unexpected developments, some of which will be serious enough to undermine viability and cause failure. But if the FPC and other authorities do their jobs right, neither of these will threaten financial stability. The system will continue to intermediate between savers and borrowers, offer risk management services, and deliver payments without interruption and at prices that allow the UK economy to live up to its full potential.

Fostering safe, resilient, efficient market alternatives to bank finance in the UK

The second broad area I expect to make progress on in the next three years is fostering resilient and efficient market alternatives to bank finance in the UK. Developing these alternatives is important for a number of reasons. Intermediation is already shifting to some extent outside banks into securities markets, as evidenced by a large volume of corporate bond issuance in recent years, and we need to identify and address any financial stability concerns resulting from that shift. This shift is partly in response to record low long-term rates resulting from weak economies and the efforts of central banks to stimulate growth and hit inflation targets using unconventional monetary policies. It also reflects some restraint on business lending by banks—as they rebuild balance sheets after the crisis and as their costs reflect tighter regulation and higher capital and liquidity requirements imposed to prevent a repeat of the global financial crisis. So incentives to channel a smaller proportion of intermediation through banks than before the crisis are likely to persist.

At the same time, financial market structures are evolving, partly in response to the increase in the demand from borrowers for market finance, but also reacting to regulatory changes after the global financial crisis and to new technologies, which are changing the nature of risks. Savings have been redirected from banks to funds run by asset managers operating in securities markets. Regulation is moving more derivative transactions onto exchanges and through central counterparties, which increase transparency and clarify interconnections, but also tend to concentrate risk. The spread of “big data” and algorithmic trading may create or at least intensify some feedback loops in asset pricing and have unpredictable effects on market liquidity.

Increased flows through capital markets have the potential to create material benefits for financial stability and for savers and borrowers. Businesses and households (through securitization) will have access to a greater diversity of funding sources. Having financing available through both banks and markets has been characterized as a “spare tyre” approach to intermediation—if one aspect of intermediation is impaired, the other could be available to take up the slack. This possibility helped the US weather a number of financial shocks—until the crisis when both “tyres” were flat, in part because complex and obscure interconnections had developed between them. And a variety of intermediation channels facilitates innovation and competition, reducing costs to household and business borrowers and enhancing returns to lenders.

But there are potential risks to financial stability when market finance is not done right, and the most telling example of that is the US subprime mortgage market in the years leading up to the crisis. In that market, substantial, unwarranted, credit easing was supported by innovations in market-based securitization that entailed a marked increase in leverage and maturity mismatch in securitizations held outside of banks, though often with bank exposure through implicit or explicit back-up facilities—think SIVs and asset-backed commercial paper conduits. Moreover, the instruments created in the securitization and tranching process were opaque and complex, behaving in unanticipated ways under stress and creating uncertainty about the incidence of losses as real estate prices fell and borrowers defaulted, leading to panics and fire sales when confidence eroded. Other, new types of risks may develop as more funds flow through markets where smooth functioning is dependent on market liquidity and market plumbing being in good order.

Doing it right—fostering safe and resilient market-based finance is a medium term priority for the FPC. The FPC is far from the only player involved promoting this objective—for example the steps to create a capital markets union in the EU will be important. But the FPC has a key role to play in the UK.

We need to make sure that markets develop in ways that protect overall financial stability. Identifying risks, market failures, and externalities in the securities and securitization markets and devising approaches to deal with them have their own special set of challenges, however. These new threats to financial stability are likely to occur in structures and institutions outside, or only indirectly related to, the more heavily and directly regulated sectors. This potential highlights the importance of reviewing the regulatory perimeter (the nature and extent of regulation on different sectors and markets) on a regular basis, trying to identify gaps that regulators and, on occasion Parliament, might need to fill. And we will need to continue to work closely with the FCA and PRA to gather information about how the system and risks are evolving and consider responses.

The risks we should be looking for could be quite different from the leverage or maturity mismatch or poor underwriting standards issues that we are used to dealing with in banks. And the materialization of these risks could disrupt intermediation and damage the real economy. For example our current analyses of risks from securities markets have examined the effects on pricing of the “search for yield”; possible increases in herding behaviour as more funds are administered through asset managers; the effects of perceptions of first-mover advantage by investors in these funds if they fear overshooting of asset prices; and the apparent decline in market liquidity, which could exacerbate the resulting asset price volatility.

Moreover, securities and securitization markets are global in character. That facilitates savings flowing to the most productive capital projects. But it also implies an exposure to risks originating around the world when UK action, by itself, may not be sufficient to assure safe and efficient markets, especially with London a key node in the global financial system. The UK will benefit from a global approach to global markets, and, fortunately, the Financial Stability Board has been formulating such an approach.

A critical element in safe and efficient markets is the “plumbing” of those markets—how securities are traded and financed. As noted, central counterparties and data warehouses will make interconnections and risks more transparent—but they also concentrate risk so we need to get oversight right globally. Securities financing transactions proved to be a source of instability in the global financial crisis, and the FSB is leading an effort to take a close look at these and address risks through minimum haircuts and other measures.

The FPC’s approach to its concerns about market liquidity illustrate the kinds of steps we will need to take to analyse the potential financial stability implications of the shift to market finance and then to determine whether a policy response is required. We set out in a box in the December 2014 FSR our thinking on the causes of market illiquidity in order to delineate and deepen the analysis of this issue. Then in March this year, we asked the Bank and the FCA to encourage and contribute to international work to build an understanding of vulnerabilities. We asked them to explore the channels through which UK financial stability could be affected by a decline in market liquidity. We asked to them to gather information from UK asset managers about how they planned to deal with a potential stressed market liquidity situation. And we asked them to assess how and why liquidity in relevant markets might have become more fragile.

In sum, we have initiated work to deepen analysis and understanding of the risks, in particular to the UK; we have encouraged work in international fora; and we are gathering information what market participants are doing about any developing risks from market illiquidity. Once we get this information—now scheduled for Q3 this year—we will decide whether there is anything we should do to address whatever market failures and vulnerabilities are identified—be that acting in the UK alone or by the Bank advocating positions within the global context.

Conclusion

The FPC has accomplished much, but much remains to be done in building a structure to protect financial stability in the UK. Let me be clear: I don't mean to imply that FPC has not been following a systematic and disciplined approach to fulfilling its mandate; we have, but macroprudential regulation is new and we are climbing a learning curve. The UK has a well-designed system for macroprudential regulation and its interaction with microprudential and monetary policies, and I am honored to be a part of it. We need to continue to develop how it is used.

I have outlined an ambitious agenda for the future, but much work is already underway. Interactions—two-way communication—with informed observers like yourselves will be important to our success. We need to work on enhancing public understanding of what we are trying to do. And we need your perspective on how we are doing and what we could do to meet our objectives.

I am grateful for the opportunity to talk to you today. You can invite me back in three years to hold me to account for how well the FPC has met the ambitious agenda I have laid out tonight.

     

 

 

Event Information

Due to tomorrow's expected inclement weather, this program has been cancelled. 

The financial sector has undergone major changes in response to the Great Recession and post-crisis regulatory reform, as a result of the Dodd-Frank Act and Basel III. These changes have created serious questions about the sector’s role in supporting economic growth and how it affects financial and overall economic stability.

On March 5, the Initiative on Business and Public Policy at Brookings will convene a public event exploring the intersection of the financial system and economic growth with the goal of informing the public policy debate. The event will feature a keynote address by Richard Berner, Director of the Office of Financial Research and other participants with a wide range of views from a variety of backgrounds. Among other issues, the experts will consider the changing landscape of the financial sector; growth-promoting allocation and investment decisions; credit availability for low- and moderate-income households; the ideal balance between growth and stability; and the impact of the 2014 midterm elections on regulatory reform. All participants will take questions.

     

 

 

As a small open economy with open capital markets, Singapore is greatly exposed to developments in the global economy. Among the many such influences is monetary policy, especially in large industrial economies that also have open capital markets so that the impulse from those policies shapes global capital flows. And that influence has been particularly marked with policy rates at zero in many countries, with the resulting capital flows eventually finding homes in places like Singapore.

In the spring of 2013, when expectations that the Federal Reserve might soon begin taking its initial steps to exit from its unusual monetary policies of asset purchases and zero interest rates were roiling global markets, Ravi Manon, managing director of the Monetary Authority of Singapore, remarked that “monetary policy has become interesting again.” I dare say it has become even more fascinating in the time since then as the Fed has taken actual steps toward the exit, while the Bank of Japan and European Central Bank have been required to double down on their unconventional policies to fight stagnation and persistent below-target inflation.

In my talk today, I thought it would be useful for me to discuss U.S. monetary policy. I will put it in the context of the outlook for the U.S. economy, but also of global developments—not only as those developments affect U.S. monetary policy, but also as that policy affects global markets. What can we expect? Are there ways to mitigate the risks to the global financial markets from disparate monetary policies in the world’s largest economies?

The U.S. economy and monetary policy

That the Federal Reserve feels comfortable taking steps to exit from unconventional policies of course is very good news. The U.S. economy has made steady progress out of the very deep recession that followed the rolling financial market crisis of 2007-08, albeit much more slowly than had been hoped or anticipated. Economic slack—underutilized labor and capital resources--have been greatly reduced. The unemployment rate has fallen to a little over 5-1/2 percent, just above the upper end of estimates of the long run sustainable unemployment rate in the U.S. economy; and the utilization of industrial capacity is now around its long-run average. The inflation rate, abstracting from the effects of energy price declines, has moved up from very low levels toward the Federal Reserve’s 2 percent target, though its upward movement has stalled out and it still remains well below that level.

At the end of 2013, the Fed was comfortable enough with the progress in putting people back to work and confident enough that progress would continue to announce that it would gradually phase down its purchases of long-term Treasury and mortgage backed securities. Sizeable gains in employment continued in 2014, and the Fed tapered off its purchases, ending them and capping its portfolio last October. Those holdings remain very large, keeping downward pressure on long-term rates, but the Fed no longer feels the need to increase the pressure by adding to its holdings. To be sure, communication about the end of so-called QE hasn’t always been easy--there were some hiccups in the spring and summer of 2013, but in the event, it was executed smoothly with no disturbance to financial markets.

But if one aspect of unconventional monetary policy in the U.S.—asset purchases—has been capped, another remains in place. Policy interest rates remain near zero and the Fed continues to try to steer the bond market by promising to keep them there for a while longer—to be “patient” in deciding when to begin raising rates. That decision is now being tugged in two different directions by actual and prospective developments in the U.S. economy.

On the one hand, economic growth appears to have picked up some and the labor market is strengthening faster. After the first quarter of 2014 when output and employment were reduced by adverse weather, the U.S. economy has grown quite rapidly, by the standards of recent years. And that growth has been accompanied by more rapid increases in employment and substantial reductions in the unemployment rate.

A number of factors lie behind this improved performance: Borrower and lender balance sheets are in much better shape, and credit is flowing easily again to most sectors at very low interest rates; contributing to the improvement in household balance sheets has been an increase in equity and house prices, bouncing back from depressed levels and responding to extraordinarily low interest rates; the overhang of excess houses has been worked off, and as soon as household formation picks up—the kids move out—the uptrend in housing construction will pick up momentum; and increases in employment have fed greater increases in income. Importantly, fiscal policy is no longer constraining growth: In 2012 and 2013 increases in taxes and cuts in government spending at the federal level were a substantial drag on demand; and federal government fiscal restraint was occurring at a time when state and local governments were also cutting back. That restraint from all levels of government ebbed over 2014, and fiscal policy will be neutral to possibly supplying a slight tailwind in 2015.

Prospects going forward are even better. The decline in energy prices is adding to the disposable income of households. Both household and business confidence is on the rise, and we know how important these animal sprits are to growth. Many of those forecasting U.S. growth have revised up their projections; the IMF for example increased its projection of U.S. growth for 2015 to 3-1/2 percent with growth dropping back only to 3-1/4 percent in 2016. Both of these growth rates are substantially in excess of the increase in potential output in the U.S. of around 2 percent or so and if realized would tend to push the unemployment rate well through the levels previously thought consistent with keeping inflation stable. It’s this prospect that has the Federal Reserve and most observers anticipating that it will begin to raise rates sometime this year.

What’s holding them back? Why hasn’t the Fed already begun increasing rates in light of this outlook? In a word, inflation, including questions about whether and how fast it will rise in the U.S., even if growth remains above potential. Headline inflation has come way off, mostly because of the declines in energy prices and the drop in the prices of other imports as the dollar has strengthened. And because those prices have continued to move lower, inflation is likely to remain quite low or even fall further in the months ahead. However, the Fed will look through the direct effects of oil and import prices. By themselves, they are indicative of changes in price levels not of continuing disinflation or dangers of deflation. Energy prices won’t fall and the dollar won’t rise forever; eventually these prices will level out or even reverse a portion of their recent movements. Instead, the focus will be on underlying inflation rates likely to emerge when the adjustment to energy prices and the dollar are finished. And in that regard there are signs that underlying inflation rates have not been moving toward the two percent target, certainly not as quickly as might be expected given the approach of the unemployment rate and capacity utilization toward levels that in the past had been associated with reasonably full employment.

One possibility is that the unemployment rate we usually look at isn’t representative of the true state of the labor market. Workers who have dropped out of the labor force in this long slow recovery or who have taken part time jobs when they wanted full time jobs are available and ready to work and are a potential source of labor supply, even though they don’t count in the usual unemployment rate. In effect, the sustainable unemployment rate might be lower than we thought—at least for a while. The data on wages and labor costs are quite mixed; some measures show the sort of pick up you’d expect as the unemployment rate has dropped to relatively low levels, but others remain very weak. The Fed will be monitoring labor costs carefully to judge just how close to full employment the U.S. is.

Another possibility is that these drops in energy and import prices are—or might—feed through to underlying inflation on a more persistent basis through second-round effects. A key channel for this type of effect would be through inflation expectations—not so much through the expectations of inflation in the near-term, which we know will be held down by energy price declines, but by expectations about inflation once the energy price decline has passed through the system. If people come to expect very low inflation over a long period, they will adjust wages and prices accordingly in a self-fulfilling feedback. The evidence here also is mixed. Surveys—mostly of households and economists—do not show any real slippage in long-term inflation expectations. But those derived from the financial markets, the gap between nominal and real interest rates, have come off considerably. There may be some special reasons for this, but inflation expectations are another factor the Fed is watching carefully.

It will be some months before the Federal Reserve is likely to be able to sort through these influences on inflation, and that’s why most observers don’t expect it to raise rates before midyear, and possibly for several months thereafter. When it does finally raise rates, it will want to be fairly confident it is the right thing to do. Raising rates too early and slowing the economy too much or stopping the rise inflation before it has enough momentum to get to the 2 percent target would be a difficult mistake to correct. Not only would the rate rise need to be reversed, but unconventional policy measures, like asset purchases might have to be restarted, to uncertain effect. We’ve already seen how hard it is to re-energize an economy when interest rates are already extremely low. The Fed will not want to be too late with its rate rise, but that’s an easier mistake to correct. If it appears that by waiting too long to tighten, the Federal Reserve has allowed inflation pressures to build more than is desirable, the Federal Reserve can just raise interest rates faster, which will damp demand and keep the economy and inflation from overshooting.

Global Interconnections

So far, my discussion has referred to global interconnections only in passing, but they are critical to understanding the challenges facing U.S. monetary policy as well as the challenges U.S. monetary policy may pose to the rest of the world. I will start with the effects of global developments on the U.S. economy and monetary policy.

Slower growth outside the U.S. together with a much stronger dollar will take something off U.S. growth this year. Because the U.S. is not a very open economy—exports are less than 15 percent of GDP—the net effect of those factors should not be large, provided reactions are reasonably close to average historic experience. The upward revisions in U.S. growth estimates I referenced earlier have been made following most, though not all, of the recent dollar strength.

Moreover some of the upward movement in the dollar reflects more aggressive monetary policy actions by the ECB and other central banks to counter economic weakness and disinflationary impulses. Those policies should help to bolster global growth, offsetting the effect of the stronger dollar on the U.S. Easier monetary policy for a sluggish economy is not a zero sum game. Monetary policy operates in part through an exchange rate channel to be sure, but other mechanisms are at work, including lower interest rates, higher asset prices, and not least, greater confidence about the future and a willingness to take risks--in capital investment as well as the allocation of savings. Sluggish euro area or Japanese economies and extremely low inflation or deflation there pose greater risks to the global economy than do the exchange rate movements that result from more accommodative monetary policies.

Still, concerns about developments beyond the U.S. borders are probably one factor behind the Fed’s patience in raising rates. Some of the strength in the dollar reflects safe-haven flows into the U.S. in a turbulent economic and political world as well as pessimism about economic prospects elsewhere—perhaps because of doubt about the effectiveness of recent monetary policy actions--and these are negative influences on U.S. expansion. And some of the drop in oil prices reflects weaker global demand in addition to increased supplies. At a minimum, the downside risks to U.S. growth from overseas are sizable, especially when so much of the industrial world seems to be struggling to generate adequate demand while a number of emerging market economies are downshifting or facing problems of their own. Weak global demand has been generating a strong disinflationary impulse, which is only added to by the supply side shock of greater oil production. No wonder the Federal Reserve is looking for greater confidence that inflation in the U.S. will rise toward its 2 percent before it will begin to exit from its zero interest rate policy.

We seem to be in a pattern of global growth in which strength in the U.S. is being counted on as an important element supporting global demand. I find this pattern worrisome. The U.S., especially the U.S. household, was the “demander of last resort” for the global economy in the mid 2000s. The result was a rising current account deficit and a buildup of debt; the normal equilibration mechanism of a fall in the dollar and higher interest rates was damped by capital inflows, partly reflecting demands for safe assets (many of which, like AAA-rated MBS tranches turned out not to be so safe), and partly reflecting the export-led growth models of some countries and their investment of proceeds from intervention to suppress currency appreciation.

As we saw all too vividly, that was not a sustainable situation and it is one we don’t want to repeat. A more sustainable global expansion would rely more on current account surplus countries to boost domestic demand through fiscal or structural policies. That’s happening to some extent, but not quickly enough to strengthen global demand sufficiently and the consequence is the global disinflationary pressure I spoke of earlier.

To counter that pressure and the particular problems besetting their economies, a number of important central banks, including the ECB and BoJ, have intensified their unconventional monetary policies. Meanwhile, as I’ve been discussing, the Fed in the U.S. appears to be getting ready to raise rates. Having monetary policies moving in different directions in various places is not unusual; it’s normal for countries to be in different stages of the business cycle and monetary authorities to be responding to that economic divergence with appropriately calibrated policies. And it is normal—indeed desirable—for divergent monetary policies to be reflected in exchange rate movements.

What is not normal is that this divergence in policies is coming after a period in which the monetary authorities in so many industrial economies have been in synch--running highly accommodative policies trying to stimulate their economies and raise inflation to target at the same time; in which they were doing this with highly unusual policies—zero interest rates and purchases of long-term assets; and, with few interruptions they have been at this for a long time—ever since the fall of 2008. We are in uncharted waters. We don’t know to what extent the resulting capital flows, portfolio choices, and asset price relationships are overextended and likely to reverse quickly and possibly disruptively as some rates rise while others are driven still lower. We can count on considerably more volatility and wider risk spreads as people adjust to the changing financial landscape. But that follows a period in which many worried that low-for-long monetary policies had induced a “search for yield” that had driven risk spreads and volatility lower than is sustainable, with investors taking risks they may not have understood or evaluated correctly.

The global financial authorities have made major strides in making their systems more resilient to unexpected developments, in particular with higher capital and greater liquidity for banks and bank holding companies. In several jurisdictions, banks have been stress tested with scenarios that included rising rates. Moreover, we’ve seen several episodes in which volatility and risk spreads have risen, including the summer of 2013 during the so-called taper tantrum, and in the past few months amid mounting uncertainty about global economic prospects, plunging oil prices, growing political and economic tensions in the euro area, and strong monetary policy responses. Although there’s been some fallout from these financial market developments, none has threatened financial stability.

Still, this could be a testing time for the global financial system as prices and flows adjust to the changing reality. A substantial amount of credit has been flowing into bond markets through mutual funds and ETFs; bond market liquidity appears to have been reduced since the crisis, and when investors in these types of managed funds realize the potential for large price movements in response to redemptions it may fuel an even stronger desire to sell the funds and an associated fire sale. Riskier borrowers, such as below investment grade businesses in the U.S. and emerging market businesses borrowing in dollars, have found credit especially readily available, perhaps as investors looked around for higher yield assets in a low interest rate world. Some rise in dollar interest rates and the dollar exchange rate is to be expected as U.S. monetary policy firms; indeed higher interest and exchange rates are ways tighter policy is transmitted to the economy to restrain incipient inflation pressure. But an unexpectedly sharp rise in rates or increase in volatility could reveal weaknesses and mismatches among these borrowers that have not been anticipated by investors. And the effects could be especially felt in emerging market economies, which had been the recipient of so much of the flows seeking higher yields.

Because the important players among financial intermediaries are so much stronger, we shouldn’t see types of contagion that so often characterize systemic financial crises, like that of 2007-08. But there may well be surprises and strong reactions in prices and flows, with implications for a number of markets and economies. And this possibility raises the question of what might be done—by the Federal Reserve and other central banks—to reduce the odds on nasty surprises as they carry out divergent monetary policies.

Let me start by talking about what won’t be done. The Federal Reserve will of course react to the effects of its actions on markets and economies to the extent those effects feed back on the U.S. in ways that jeopardize its pursuit of stable prices and high employment. And so too will the ECB and the BoJ and other central banks adjust policies as financial and economic conditions evolve. But they are not likely to defer or change their course of action because of potential spillovers to other countries, beyond taking account of the effects of these spillovers back on their own domestic economies. Raghu Rajan, the governor of the Reserve Bank of India, and others have argued that the Fed and other industrial economy central banks should cooperate more in their policies and adjust them to reduce these spillovers on third parties.

But the Federal Reserve’s legislated mandates are for maximum employment and stable prices in the United States. And those are the objectives for which it is held responsible and accountable in a democracy. The Federal Reserve would be, rightly in my view, highly skeptical about agreeing to cooperate explicitly with other countries to adjust policies in ways that take risks with these domestic objectives to reduce spillovers to other countries based on the commitments of other countries to follow particular policies. The potential gains from those sorts of cooperation are likely to be small even under ideal conditions and the commitments on which such solutions might be based would be difficult to enforce and to adapt subsequently in rapidly changing circumstances.

The global economy will be best served by a strong and stable U.S. economy, euro area economy, etc., and fostering that will go a long way toward fostering a strong and stable global economy. If the Federal Reserve had hesitated to ease further through unconventional monetary policy in recent years because of concerns about spillovers, the U.S. economy would have been weaker, deflation a greater threat, and the global economy even less robust. Analogously, hesitating to tighten out of concern about effects on other economies will risk inflation in the U.S. and more forceful and disruptive tightening later.

It would helpful in terms of preparation and market volatility if the Federal Reserve and other central banks could reduce uncertainty through “clear communication and predictable action”. Accidents and instability are most likely to occur when people are surprised. When markets can anticipate central bank actions accurately, they can adjust and work with the central banks to reinforce the intended effects of their actions. Central bank transparency can help to foster both monetary policy and financial stability objectives.

However, both we as observers and the central banks need to recognize the natural limits on predicting monetary policy actions or even specifying monetary policy reaction functions. To be sure, the Fed could have done better in its communications in the summer of 2013. But to some extent, the miscommunication and misinterpretation may have arisen from the Fed trying too hard—trying to be more transparent and predictable than is possible in an uncertain world—and from the rest of us not making allowance for the challenges involved.

We are living in a particularly uncertain economic environment. Except for Japan, until 2008 we had no recent experience with a severe financial crisis followed by a prolonged slump in advanced economies. And this recent experience has vividly demonstrated that our understanding of many basic economic relationships is incomplete at best, including at the intersection of financial markets and the real economy. Neither the central banks nor the private sector have done very well at predicting output, employment and inflation in recent years. Moreover, we are employing monetary policy instruments for which we have no precedent. And there are many policy levers in use at the same time; the Fed and other central banks are using portfolio tools and trying to shape policy expectations in new ways.

So, the Federal Reserve and we need to be especially humble about our predictions for the economy, about the relationships of these predictions to evolving financial conditions, and about how financial conditions might react to policy actions and words. Forecasts are subject not only to the usual types of unanticipated events, but also to substantial uncertainty about the basic structure of the economy, including how inflation might respond to particular unemployment rates. This presents great challenges to “forward guidance” about future interest rates. Unable to adjust policy rates downward, central banks have become increasingly explicit about their plans for adjusting—or not adjusting—policy rates in an effort to reduce longer-term interest rates, or prevent them from moving up prematurely.

Central banks need to strike the right balance between commitment to prevent unwanted increases in long-term rates and flexibility to react as new information about the economy and its structure become available. And we can’t expect more specificity and commitment about future rates than is healthy to give. In this uncertain and ever changing economic environment, we are likely to be surprised by some central bank actions from time to time, but if that surprise occurs in the context of a basic understanding of the goals and strategy of the central bank, it shouldn’t be destabilizing.

Ultimately it will be up to the individual countries and currency areas facing U.S. monetary policy exit to adapt. That will require strong financial systems that are robust to shifting yield curves and currency values. As I noted, much progress has been made in oversight of banking systems, but one lesson from the experience of the U.S. is that nonbank finance also needs to be resilient to unexpected developments.

More generally, oversight of financial systems needs to take account of interconnections and vulnerabilities of the entire system—beyond just looking at individual institutions. Singapore has been in the forefront of implementing this so-called macroprudential policy in response to growing threats from capital inflows, especially as they affect the housing market and credit flows into that market. In the UK, the Financial Policy Committee, of which I am a member, has also acted to guard against the build up of risks in lending against rising house prices. Macroprudential policy in one form or another has been around for some time, but we are just learning how to implement it in globally interconnected markets.

Sustaining growth and stability in the face of increases in volatility and surprises in asset prices will also require ability to control overall financial conditions whatever the Federal Reserve or other industrial economy central banks decide to do. I recognize that Singapore has successfully implemented a crawling peg exchange rate system. But for most countries such control in turn will entail a high degree of exchange rate flexibility, offset if necessary with monetary or fiscal restraint if declining exchange rates threaten overheating. Allowing one-way bets to cumulate behind inflexible but unsustainable exchange rates will risk a larger and more disruptive adjustment later on. To be able to adjust monetary and fiscal policy in a credible way rests in turn on sound and credible longer-run policy frameworks.

Global financial markets and economies have come through a very turbulent period in recent years, and it looks like there may be more bumps to come. I noted at the beginning of my talk it is very good news that the Federal Reserve believes that the U.S. economy is robust enough that economic and price stability will soon require an increase in interest rates. At the same time we should wish every success to the ECB, BoJ, and other central banks using unconventional means to stimulate their economies and avoid deflation. Flexible economies, sound policy frameworks, and robust financial sectors is what we all will need to come through this period and restore global growth and price stability. Singapore has been in the forefront in this regard. I hope my discussion today will help you anticipate and prepare for what might lie ahead.

     

 

 

Speaking with MoneyandBanking.com, a blog by economists Stephen Cecchetti and Kim Schoenholtz, Donald Kohn discusses how the financial crisis has affected views of the central bank policy tool kit, of financial stability and of what's needed to preserve the benefits of global finance.

Has the experience of the crisis changed your view of the central bank policy tool kit?

Donald Kohn: My answer is yes, to some extent. It changed my view on asset purchases. Before the crisis I was skeptical that asset purchases, particularly the possibility of U.S. Treasury bond purchases that we were talking about in the U.S. before the crisis, would have much effect. I thought that the Treasury market was extremely liquid and dominated by expectations about future Federal Reserve policy and other things, so that it would take massive purchases to change interest rates.

Maybe what we’ve had is massive purchases, but I do think QE has been effective in a couple of dimensions regardless. One is the portfolio balance dimension, where I was skeptical. The purchases have been large enough to change term premia; to incent people to look for other assets with duration and risk so that the impact spread through the financial system. I also think the purchases, particularly the initial set, were successful in underlining the determination of the Federal Reserve to do whatever it takes to get out of the recession initially and then to stimulate the economy to get back to full employment—importantly including holding interest rates near zero for quite some time.  That has been a signaling aspect of purchases that I believe has been effective.

And finally, because the initial purchases in Fall 2008 and Spring 2009 included mortgage-backed securities at a time when even the government-guaranteed mortgage-backed security market was not very liquid, I think we had an extra bonus from those purchases at that time by promoting liquidity in that particular market.

The other aspect of unconventional monetary policy is forward guidance: what central banks say about future policy rates. This isn’t a tool that originated in the crisis. For example, the Federal Reserve talked about interest rates in 2003, 2004 and 2005, when we were trying to lean against any tendency for the market to over react to the initial tightening coming out of that recession. Some central banks, like the Reserve Bank of New Zealand and the Swedish Riksbank, have published expected interest rate paths for a number of years. But I do think central banks got into much more detail during the crisis. Certainly the Federal Reserve did with a deliberate effort to steer expectations in response to the fact that the federal funds rate was at the zero lower bound.

I always thought that forward guidance and words would be effective in changing expectations. I also thought it was a complicated thing to balance commitment and flexibility; commitment so people believed that the path of interest rates you were telling them about was one that you really thought you were going to follow, other things equal; but flexibility, so that if other things weren’t equal you could change. That has been as complicated and difficult as I thought it would be.

So on the forward guidance, I think it has been effective. My views haven’t changed notably. It’s hard to deal with, but it’s part of the tool kit.

I think the third aspect here is targets. There’s been a lot of discussion about whether, instead of an inflation target, there ought to be a price level or nominal GDP target. Here my view hasn’t changed. I believe that in the case of the United States, the inflation target coupled with the high employment target is better than a price level, or especially a nominal GDP, target. I think it’s worth continuing to think about these things, but right now I would stick to the 2% inflation target that everyone else, including the United States, is using.              

Where should we be looking now for financial stability risks given this experience?

Kohn: The response of the authorities to the crisis has concentrated on banks, especially large banks, and other systemically important financial institutions, including insurance companies, investment banks, etc. I think those financial institutions that have been the target of the authorities’ attention are in much better shape, and I don’t think they constitute a risk to financial stability today. So I don’t think that what nearly brought the system down before, a Lehman Brothers kind of collapse, is currently a risk.

There could be mispriced bonds. People have pointed to junk bonds and dollar-denominated emerging market bonds and asked whether the risk in those bonds has been accurately valued by the market.  With regard to the consequences of a price adjustment, I would contrast the dot-com boom and bust with the housing boom and bust. The difference was the participation of intermediaries. Most price adjustments are fine. There could be quite a bit of volatility in the market as prices adjust. But I don’t see it having the same kind of risk characteristics that the subprime market had in the United States.

I would look at this price risk and volatility in the last couple of months. We’ve seen an increase in volatility and some widening of risk spreads. So, to the extent that we were worried that people were taking risks for which they weren’t being rewarded, and that those risks weren’t being reflected in the market, we ought to be a little less worried today. On the other hand, markets haven’t proven themselves as liquid as we might hope so there might be some liquidity risk out there. So, it’s the markets and the pricing of risks, including liquidity risks, I would be looking at.

Also, I would look at what remains of the shadow banks. In the tri-party RP [repurchase] markets, the money markets funds and other cases, there have been some fixes. But I do think we need to be careful that – as we put more restrictions on banks and other systemically important institutions – if their activity migrates to other places, it doesn’t do so in a way that has systemic risk associated with it. I don’t see that today, but I think it’s something we have to be careful about in the future.

What do we need to do to preserve the benefits of global finance?

Kohn: To start, let me say that I do see considerable benefits from global finance that are worth preserving. The global economy will be more productive if savings can move to the highest return assets. It will be more productive if the global financial system supports international trade, and if businesses can engage in cross-border financial transactions at the least possible cost. I do think it’s important that business find the cheapest possible finance and have the greatest possible opportunities consistent with financial stability to grow and be productive.

One of the problems that came home to us in the crisis was, as [Bank of England Governor] Mervyn King and many others said, these institutions are global in life and national in death. What’s required to preserve a global financial system that distributes savings efficiently is that authorities have confidence in one another. I have to believe that authorities in other countries are making their institutions that are doing business in my country safe. That they are requiring enough capital and liquidity, as well as appropriate risk management practices, so that those institutions don’t constitute a risk to my economy should they get in trouble. So I think making financial institutions safer and enhancing confidence across borders is important.

The other aspect of this is the death part. So, make them safer in life, but also make it possible to resolve them in death. It is important to do this without threatening financial stability and without inducing some authorities to ring fence whatever assets are in their country and grab them first. I do think that the issue of resolution and the resolution of globally active financial institutions is absolutely key.

Now I think progress has been made across both of these issues. Financial institutions are safer, with better capital and liquidity standards across the board. And progress is being made, maybe a little more slowly, on the resolution side of it. But all of this requires international coordination and cooperation. It’s very hard because all these rules are made in nation states. Or, in the case of the euro zone, some of them are made in the nation states and some of them are made in the center. So I think there’s work to be done to preserve global financial stability. But the program is out there; it just needs to be implemented and those understandings need to be enhanced and the confidence of one authority in the other needs to be rebuilt. 

     

 

 

Janet Yellen and her colleagues at the U.S. Federal Reserve seem to be eyeing June for a long-anticipated rise in the federal funds rate, assuming inflation heads on track to its target, reckons former Vice Chairman Donald Kohn.

Kohn served as vice chairman under Ben Bernanke from 2006 to 2010, capping a 40-year career at the Fed. He is a senior fellow at the Brookings Institution, a U.S. think tank.

Edited excerpts from his recent interview with The Nikkei follow.

Q: What was your impression of Fed Chair Janet Yellen's Dec. 17 press conference? The Federal Open Market Committee added a new phrase, "be patient," to its forward guidance while maintaining that the federal funds rate will likely stay near zero for a "considerable time."

I thought the interesting aspect of the statement in her press conference was about inflation. I think some people in the markets thought that the Fed would have to see inflation close to 2% before it raised rates, but she made it clear that 1) they were going to look through the decline in energy prices, the effects on headline inflation; and 2) even for core inflation, it could be where it is, but they would have to be more confident that it was rising towards their 2% target.

In some sense, I think it showed the Fed more willing to act in a somewhat more pre-emptive way than I think some in the market thought. But, at the same time, they're not going to act precipitously. They are going to be patient.

That's maybe a little more flexible than "considerable time," which people had interpreted maybe as three or four meetings, six months or so. So I think they do have some more flexibility, but it's not complete flexibility.

Q: When do you think the Fed will begin raising rates?

I think it's clear from the dot chart and from a lot of the discussion that, although [Yellen] was very careful to say that every meeting is a [possibility,] that it's more likely to be at a press conference meeting, and June makes more sense. So my guess is they're thinking about June.

Q: Chair Yellen said the Fed probably won't repeat the "measured pace" of rate increases seen in the past.

I think she was trying to get away from the measured-pace language that came to mean 25 [basis points] at every meeting. Now, I don't think that's what we intended, and I was part of the FOMC at the time, when we put those phrases in there, in May, I guess, of 2004, but it certainly came to mean that. The current FOMC is trying to avoid that degree of predictability.

She was trying to caution us that we shouldn't expect the same language. They're not going to commit to doing 25 at every meeting. In fact, the trajectory [of their expectations] looks flatter than that, so at least for a year or for 2015, if they start in June, it's probably about every other meeting they would raise [the rate]. I do think that she was pushing back against the idea that they would be so predictable in their rate increases, and that was reinforced by her emphasis on data dependency.

Q: How do you view the state of the U.S. labor market and economy?

I think the 5% [economic growth] we now know for the third quarter explains a little better why the labor markets seem to be strengthening so much.

I think most of [the fourth-quarter projections] I've seen other folks making are more like 2 1/2 [percent]. So that gives us something like 2 1/2 for the year. That's strong but it's not overwhelming.