Brookings: Experts - Donald Kohn

Comments on “The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter”

Donald Kohn — Sat, 05 Jan 2013 00:00:00 -0500

Editor's Note: These comments on the paper "The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn't Matter" (PDF) by Christina D. Romer and David H. Romer were presented at the American Economic Association Annual Meeting on January 5, 2013.

This is a very interesting and thought-provoking paper. I recommend it highly, not only to all who are interested in Federal Reserve history, but also to those seeking an interesting perspective on recent monetary policy.

The Romers ascribe lack of forceful enough action in the 1930s and 1970s to excessive policymaker humility about the power of monetary policy to address the most important problem of the time. Another way to characterize the same thing is that the timidity of action reflected policymakers perceptions of the relative effect of policy on output and inflation—and hence on the balance of costs and benefits of policy actions. In the 1930s policymakers saw little benefit for lowering unemployment of further ease and large potential costs in terms of higher inflation. In 1970s they saw little effect on inflation from tighter policy but large potential costs in terms of lost output. We can see in retrospect that these assessments were incorrect and based on misunderstandings of underlying economics—of how much slack there was in the economy, the relationship of slack to inflation, the effect on slack of policy actions, and the importance of expectations in shaping the response of the economy to policy actions.

The Romers raise the question of whether recent monetary policy has also been influenced by insufficient confidence in the power of policy actions to deliver net benefits in terms of reducing unemployment. They are concerned that the Federal Reserve has not acted as forcefully as it could have or should have over the past few years because of misperceptions about the relative costs and benefits of actions. An important handicap in making such a judgment is that we are in uncharted waters---both in the behavior of the economy and the nature of the monetary policy response. We don’t have the luxury of 20-20 hindsight to determine what misunderstandings might have been unnecessarily holding back policies. We are in the middle of the situation now and are highly uncertain about what forces are holding back economic growth. That uncertainty is compounded by the use of new policy tools. We have little or no empirical basis for making judgments about the effects—costs or benefits—of large scale asset purchases, huge increases in the FR balance sheet, and increasingly detailed interest rate guidance.

My comments are framed around the following points: We need to be humble about what we know as economists under any circumstance—but especially now; but policymakers can’t let that humility freeze them into inaction, and we need to think about techniques to move forward in such circumstances; then we can examine how the Federal Reserve’s approach to policy has stacked up relative to these techniques for operating under uncertainty.

The last 10 years have highlighted just how little we know about how the economy works. Both policymakers and private agents should have been more humble in the years leading up to the crisis. The so-called “great moderation” led to complacency and overconfidence in both the private and public sectors. There was overconfidence about the self-correcting properties of private markets—how self-interest would limit financial and economic fluctuations. We overestimated the extent to which new financial instruments had led to the diversification of risk across markets and participants. We were overconfident about ability of monetary policy to steer the economy— to avoid major bouts of inflation or deflation and all but the mildest recessions and to counter financial collapses. Especially egregious was tendency to ignore longer-term financial and credit cycles and the intricacies and nonlinearities of the financial sector and its interactions with the real economy. We missed the significance of the buildup of leverage in both the financial and nonfinancial sectors, and their tendency to reinforce each other. And both the private and public sectors paid insufficient attention to tail risk in asset prices and its interaction with leverage and maturity transformation.

Our understanding and the models that embody it not only didn’t see the crisis coming, we didn’t see or fully understand the dynamics of the financial system and its interactions with the economy during the crisis, and we don’t understand why the recovery has been so slow. To gauge our lack of understanding on this last point, I looked at the projections of FOMC participants in June 2010—the last time I contributed to them. All the key relationships were off. We’ve seen much less growth than expected then, despite a more expansionary monetary policy; the unemployment rate is only a little higher than expected, even with the much lower growth, so that relationship was off as well; and inflation has turned out significantly higher than expected, even with less growth and a slightly higher unemployment rate.

A major complexity in understanding recent developments is the interaction of the shortfall in demand with needed structural shifts and realignments of demand and production and the recovery of balance sheets—the layering of a shorter-term business cycle on top of longer-term structural shifts. We have only limited guidance from history about how this is going to play out in context of the current US financial system and the widespread adjustments in the global economy.

And to this relatively mysterious economic structure, the Federal Reserve is applying unprecedented policy actions. Efforts to drive down longer-term interest rates with unconventional policy actions are natural extensions of the short-term rate policy adjustments of more normal times and should work through the same policy channels, but the new actions are naturally very hard to calibrate. What effects are purchases or interest rate guidance having on financial conditions? What effect are changes in financial conditions having on spending and inflation? To what extent does it matter whether long-term rates are reduced by a change in expectations because of guidance versus a change in the term premium because of purchases? Will there be costs, especially down the road on exit? There is very little history to use to judge the costs and benefits of these actions.

But uncertainty about the economy doesn’t necessarily have to imply caution or paralysis in policy. For example, one could simply adjust policy to make the desired outcome the most likely—even if the distribution of possible outcomes was relatively flat and not well understood. But as the Romers highlight, the natural human tendency is to hold back when uncertain about the system and the effects of policy action—about the balance of costs and benefits to bolder action. How can policymakers counter such an impulse? We can draw on past experience with policymaking for a few suggestions.

The first technique is to use “risk management”. Weigh the costs and benefits of missing to one side or the other of your inflation and output objectives; identify the most important problem relative to those objectives—the one that would reduce public welfare the most if policy were overly cautious; and take some chances to deal with that problem. This approach is especially attractive if the likelihood and cost of missing other objective is seen as relatively small. So, this would imply extra effort to deal with unemployment in the 1930s relative to inflation and with inflation in the 1970s relative to unemployment. Of late, high unemployment or low output would appear to embody a greater cost and risk to public welfare than rising inflation, given the evident slack in the economy and low inflation; of course, this could change in the future.

Second, learn and revise as you go. Policymakers need to be ready to update their understanding as they gain experience with the prevailing economic situation and the effects of policy, which should help gradually clarify the costs and benefits of their policy choices. This implies flexible policy implementation and a willingness to revise the policy setting and the plan going forward. In my view, a time of great uncertainty about underlying economic structures is not well suited to policy rules, especially rules based on recent economic data. The implications of incoming data for future economic performance—when changes in policy will have their effect-- will need to be updated frequently, and lessons learned about the effects of policy settings on the economy. These circumstances would seem to embody the classic case for gradualism in policy implementation—for slowly altering the stance of policy as you learn about its effects. It is critical under these circumstances to make the framework for actions and revisions very clear to the public so agents and markets understand how the central bank is processing information and can anticipate its actions as well as possible, increasing the odds that spending and pricing decisions will reinforce central bank action.

How do we evaluate recent monetary policy experience in the context of heightened uncertainty and the possible techniques to deal with it? The Romers have three issues with the language of Federal Open Market Committee participants that they fear may be indicative that the Committee is not being as bold as it should be. First is the argument made by the FOMC that the benefits of added easing are limited and declining—and relatedly that monetary policy is “no panacea” for the problems of the economy. Second, they highlight the argument that there are potential costs to unconventional policies that may be significant and rising. And third, they cite the gradual evolution toward more aggressive policies as proof that the Federal Reserve should have been more aggressive to begin with.

In my view the FOMC has in fact followed the prescriptions for overcoming inertia and excessive caution. With respect to risk management it has clearly identified long-term unemployment as its major concern—so long as inflation is not likely to stray very far from its objective. Especially in the criteria it has put forth for considering when to begin tightening policy, it has shown a willingness to take risks on the inflation side to make progress on unemployment. Partly this reflects the level of unemployment and inflation relative to objectives, but part of the reasoning surely is that we know more about how to control inflation than how to boost employment with monetary policy, so if inflation overshoots persistently the FOMC can be confident it has the tools to bring it back down. Notably, the quotes the paper views favorably from former chairmen about taking bold actions are about controlling inflation—not about raising output.

I would judge that the actions of the FOMC evidence a learning process as well. Policy has evolved as the FOMC learned about the evolution of the economy—just how sluggish the recovery would be; and as it has learned about inflation—just how little inflation and inflation expectations have been affected by unconventional policies and increases in the Federal Reserve’s balance sheet, an oft stated worry of those opposed to bold action. Consequently, it has become more willing to use its unconventional tools over time, even when its forecast has only changed marginally, consistent with gradualism in the face of uncertainty. Moreover, it has increasingly spelled out its policy approach in public. Some of the added discussion has been tactical—using dates of possible first tightening to guide rate expectations down—but some has helped to elaborate the strategy better, including the January 2012 document about the framework for policy and the added information in December about the economic conditions that would guide its consideration of first tightening.

Moreover, I don’t think you can dismiss the possibility that as the operations scale up, the benefits of added unconventional measures are limited and declining, or that the costs are increasing, as reflected in the comments of FOMC officials. On the benefit side, the marginal effect of lower longer-term interest rates in bringing increasing amounts of consumption and investment from the future to the present may well decline the deeper into the pile of possible future projects you dig. And the income effect of lower rates damping the spending of savers may gather force relative to the substitution effect inducing greater saving the longer rates are expected to be quite low. On the cost side, the greater the purchases the higher the risk that market functioning may be impaired or that the eventual unwinding of the portfolio will have adverse consequences for financial stability. And the larger the portfolio, the more questions are raised about the fiscal risk the Federal Reserve is taking and about complications when it’s time to exit—to raise rates and roll back the portfolio.

Importantly, these concerns have not stopped the Federal Reserve from taking increasingly bold actions over time. But in this context, warnings from the Federal Reserve that monetary policy is “no panacea” for what ails the economy are understandable and justified. Can monetary policy restore full employment before the benefit and cost lines cross? And even if it can, wouldn’t the return to full employment be faster and more certain if other government policies were working in the same direction?

Finally, people point to the Volcker disinflationary episode as an example of how humility about what we know about the economy doesn’t have to imply timidity in action, and how forceful action can overcome pessimism about the effectiveness of policy. Monetary policy under Volcker’s leadership was decisive, bold, and effective at promoting the longer-run welfare of the US economy. For sure, Paul Volcker didn’t believe we knew much about how the economy and inflation worked—for example he largely ignored staff forecasts in light of their poor track record over the 1960s and 1970s. But he knew inflation had been very costly and could be reduced with monetary policy, with a one-time cost in output of unknown dimensions, but long-run gains. And he was willing to innovate in the conduct of policy in order to get that done.

It’s important to recall, however, that, his action followed years of failed efforts to tame inflation with policy gradualism and nonmonetary policies. Like the current Federal Reserve, he talked a lot about other governmental policies that he thought might make his efforts more difficult; he worried and spoke out forcefully on the risks he saw from the fiscal and current account deficits of that time; he’s not present to speak for himself, but I suspect he would be comfortable with the “no panacea” language the current Federal Reserve uses. And he was willing to back off in the fall of 1982 with inflation still above his objective but recession deepening and financial stability threatened. That is, he was willing to update his cost/benefit calculation as circumstances changed.

In the current situation the FOMC has said unemployment is very costly; it has signaled it is willingness to take risks on inflation to boost resource utilization; it has innovated in numerous ways; but it can’t and shouldn’t ignore its calculation of costs and benefits and adjust policy as needed. In sum, I’m not sure it’s justifiable to argue that the FOMC has missed its “Volcker moment” or has been less forceful than warranted in real time policymaking.

Authors

Donald Kohn

Publication: American Economic Association Annual Meeting

Image Source: © Larry Downing / Reuters

Federal Reserve Independence in the Aftermath of the Financial Crisis: Should We Be Worried?

Donald Kohn — Fri, 04 Jan 2013 00:00:00 -0500

Editor's Note: The following comments were delivered on a panel of the National Association for Business Economics at the American Economic Association Annual Meetings on January 4, 2013.

We are going through extraordinary period in business cycles and central banking. The too-calm, too-confident, veneer of the so-called Great Moderation was shattered by the worst financial crisis in 80 years. The Federal Reserve, indeed central banks all over the industrial world, have taken extraordinary actions in response to make sure this crisis not followed by an economic result like that of the 1930s.

The Federal Reserve expanded access to the discount window for banks, and it opened credit facilities to nonbanks for the first time since the 1930s, including in a few cases to help stabilize or facilitate the takeover of systemically important institutions at risk of failure that would have further destabilized the financial system. The Federal Reserve aggressively reduced short-term rates to zero and then, to spur growth, has worked to reduce intermediate- and long-term rates even further by greatly expanding its balance sheet with purchases of long-term securities and by issuing guidance about the future path of short-term rates. And it has addressed perceived clogs in the transmission of monetary policy by intervening directly in government guaranteed mortgage market—taking a hand in credit allocation where markets are not functioning well. Other central banks in industrial countries that have been hit by crisis in recent years have taken comparable, unconventional, steps to stabilize markets and encourage growth. We are in uncharted territory—both in our understanding of economic developments and of the policy response.

Naturally, understandably, and appropriately, these circumstances have increased the scrutiny of central banks, including the Federal Reserve, raising questions about the goals, governance and accountability of these institutions. This panel has been asked whether we should we be worried that this scrutiny will result in an erosion of independence. To foreshadow my answer: these actions should not and need not lead to a loss of monetary policy independence, but we need to be vigilant because risk factors have increased.

When discussing central bank independence, it’s important to draw two key distinctions about what we mean. The first distinction concerns functions performed by the central bank. With regard to independence, our main focus has been on the setting of monetary policy, not regulatory policy. In this regard, the Federal Reserve has always lived with a bifurcated regime. The Regulatory functions of the Federal Reserve have involved a very high degree of cooperation and coordination with other agencies. Major decisions are arrived at jointly by several agencies. And those decisions are subject to examination and oversight by the General Accountability Office of the Congress.

The cooperative character of bank regulation is made necessary by the balkanized US regulatory system, with many different agencies having a hand in regulation and supervision of the financial system. It also reflects the nature of the actions taken. Regulation is necessary to offset the moral hazard created by the safety net and deal with externalities. But it involves elements of credit allocation, it constrains private decisions, and it affects the relative positions of individual firms. And it can have consequences for the public purse if regulation and supervision are not effective enough at constraining risk. Some degree of independence from political pressure is helpful in carrying out these tasks, but they may not lend themselves to the same arms-length relationship to elected representatives as does monetary policy.

The conduct of monetary policy has enjoyed considerably more, but still limited, independence. Within monetary policy, it is useful to distinguish goal from instrument independence. Goals for policy are and should be set in the democratic process by elected representatives. But independence is critical in the setting of the instruments to achieve these goals. Central banks should be held accountable for outcomes, not inputs. Instrument independence is necessary to overcome the short-term perspective of politicians, who are more interested in boosting growth for the next election and less focused on the longer-term inflationary consequences of such actions; across time and countries there is plenty of evidence that less independence is correlated with higher inflation.

Even instrument independence not absolute. Instrument settings will always be subject to political pressure and discussion. Moreover, some control is exercised through the appointments process, which for the Chairman occurs every four years. But an independent central bank—one that has been insulated from these pressures--doesn’t need to follow the politicians’ instructions; it should resist where those desires are inconsistent with its own views of how to achieve the objectives it has been given.

In considering whether Federal Reserve independence is likely to be threatened by the nature and aggressive character of its recent actions it’s important to keep in mind that there is no necessary connection between recent actions and future loss of independence. This is a decision for Congress to make legislatively, and it needs to understand the costs and benefits from any erosion of independence. Moreover, concern about a potential mistake by Congress in this regard is not a reason for the Federal Reserve to hold back on using the tools Congress has given it to accomplish the objectives Congress has set. The Federal Reserve needs to keep explaining why it considers its actions to have been consistent with furthering its objectives, and that that any fiscal risk incurred or credit allocation affected by its actions has been necessary to achieve its legislated objectives and has been a temporary function of an extraordinary situation. We can see from what is going on in Japan right now that perceptions of timidity and caution also have the potential to threaten independence.

But a number of risk factors suggest extra vigilance will be called for over coming years to preserve the appropriate degree of Federal Reserve independence. First, an era of polarization of political discourse has not proven conducive to a reasoned discussion of monetary policy and the pros and cons of independence. Exhibit one in this regard would be the debates in the Republican primaries with candidates competing as to how rapidly they would “fire” Ben Bernanke, with one characterizing a policy disagreement as “almost treasonable”. Also discouraging was the unprecedented letter from Republican congressional leaders to the Federal Reserve in September 2011 trying to dictate an instrument setting—the management of its portfolio. And, as I’ll underline in a second, we haven’t yet heard from the forces that might eventually be aroused by exit from these policies.

Second, the Federal Reserve has had some powers trimmed in Dodd-Frank, suggesting an erosion of trust and deference by lawmakers. The restrictions apply to its authority to lend to non-bank institutions under 13-3 of the Federal Reserve Act, and include an obligation to get the approval of the Secretary of the Treasury even for widely available facilities. In addition, against the recommendation of the Federal Reserve, the Congress mandated the publication of the names of all borrowers at the discount window—bank and nonbank-- no later than two years after they borrow. So far, the instrument independence of the Federal Reserve in monetary policy per se has not been abridged in any way, but it may be that the Federal Reserve’s views carry less weight than they did before the crisis.

Third, although in recent years the political blowback mainly has come from those who say they are worried about inflation, the major challenge to independence is likely to come from those concerned about unemployment as the Federal Reserve exits from unconventional policies. At some point the Federal Reserve will need to tighten policy to keep inflation from rising persistently above its price stability target. It will need to raise rates and begin returning its portfolio towards its prior plain vanilla size and composition. The turn toward tightening is always a difficult decision—and subject to second-guessing in the political sphere—but it will be even tougher after long period of weak growth and unprecedented policy actions.

It will be a complex exit involving many steps—with lots of opportunity for kibitzing and objecting over a long period. It will ultimately involve a sharp correction in long-term rates—a reversal of a negative term premium as well as upward adjustment in expected short-term rates. It will entail withdrawal of special support for the mortgage market. As long-term rates rise the Federal Reserve will have mark to market loses on its balance sheet. These loses are not a threat to the Federal Reserve’s ability to tighten or its independence so long as cash flow is positive, but the loses could be used as a political weapon. The main tightening tool will be increases in the interest rate paid to banks on their deposits at the Federal Reserve, further damping Federal Reserve profits; this is a tool well known in other jurisdictions, but is new for the US. The size of the portfolio shouldn’t impede ability to tighten, given this new tool, but a huge volume of reserves could make control over the federal funds rate less precise than it has been in the past. Finally, in light of the apparent inability of the Congress and administration to deal with longer-term budget issues, the rise in rates could be occurring in context of still-unsustainable path for budget and debt, and higher rates will underline that issue and make it worse. This will be another source of unhappiness in political sphere.

Fourth, the Federal Reserve, like many other central banks, has been given added responsibilities in regulation and supervision. These responsibilities include a key role in macroprudential regulation, with responsibility for protecting the overall stability of the financial system. Carrying out this regulation already involves a differential impact on some organizations—those identified as systemically important. It could also entail tightening up when credit is growing too fast and imbalances are seen to be developing—another form of taking away the punch bowl as the party gets going—for example through raising the countercyclical capital buffer under Basel III. This will not be popular with those drinking the punch. In the years leading up to the crisis we saw considerable political resistance to even mild forms of tighter policy, for example with respect to commercial real estate lending. The risk is that greater scrutiny and criticism of this aspect of Federal Reserve activity could spillover to monetary policy. It is important to retain the bifurcation—the differences in governance and accountability for regulation and monetary policy.

But macroprudential policy could also protect monetary policy independence. It reduces the need for the Federal Reserve to use monetary policy to deal with bubbles, imbalances, or a build up of leverage. It now has another tool to apply to these. Monetary policy can be focused on price stability and maximum employment and more readily held accountable for those less diffuse goals than for “financial Stability”. More focused goals and accountability should support retaining monetary policy independence.

The most immediate threat to appropriate independence now would seem to be the proposal to allow GAO to audit of monetary policy—to remove the exemption for monetary policy that has existed since the 1970s. The expanded GAO audit authority would be another avenue to bring pressure on the Federal Reserve’s monetary policy—perhaps trying to delay actions pending a GAO study. Of course, such pressure can and should be ignored when the Federal Reserve is convinced it is doing the right thing to accomplish its legislated objectives. But extending the GAO audit moves the needle, however slightly, in the wrong direction when it will be important to protect the Federal Reserve’s instrument independence for exit. And it erodes that distinction between the governance of regulatory and monetary policy functions that seems so useful to make.

Federal Reserve monetary policy independence will be critical to preserve over next few years. There’s just too much history behind the concern that less independence leads to higher inflation over time. I hope all economists can agree on this—whatever they think of the actual policy actions that have been undertaken. The views of economists could be important in any discussion of this subject that might occur.

Authors

Donald Kohn

Publication: American Economic Association Annual Meeting

Image Source: © Jason Reed / Reuters

Monetary Policy in 2012: Further Disappointments in Growth; Further Innovations in Monetary Policy

Donald Kohn — Thu, 20 Dec 2012 14:09:00 -0500

Economic growth again disappointed in 2012. Around this time in 2011, the policymakers at the Federal Reserve were predicting the economy would grow in 2012 around 3 percent or a bit above; it now appears that economic growth this year will be 2 percent or a bit below. Nonetheless, the unemployment rate did fall a little more than Fed policymakers were predicting—from 8.5 to 7.7 percent—but this was not as good news as it seems because the drop was due to disappointing productivity growth and people dropping out of the labor force, in part as they grew discouraged looking for work.

Headline inflation numbers reflected the rise and fall of energy and other commodity prices in 2012, but considerable slack in the labor market and the economy more generally kept a lid on price increases. Wage and compensation growth remained very sluggish—real wages and unit labor costs for businesses were about unchanged over the year—reflecting the intense competition for jobs. Inflation actually slowed over the year, falling from 2.4 to 1.7 percent overall on the Fed’s preferred PCE chain price index (through October, latest data available) and from 1.9 to 1.6 percent for the core measure that abstracts from volatile food and energy prices.

With inflation subdued and showing no signs of picking up, unemployment still well above the Federal Reserve’s estimate of its long-term sustainable value, and concerns intensifying that cyclical unemployment could turn into structural unemployment permanently reducing the economic potential of the U.S. economy, the Federal Reserve kept its policy focus firmly on what it could do to boost growth to improve labor market conditions more quickly. In the past, under conditions like these, it would have lowered its target federal funds rate, and that action would have reduced intermediate and longer-term borrowing costs, raised asset prices and weakened the dollar, all three channels inducing businesses and households to buy more U.S. produced goods and services. But short-term interest rates are already at zero, so the Federal Reserve must operate more directly on intermediate and longer-term rates, which in turn should feed through to asset prices and the dollar as well as lowering borrowing costs. It has developed two techniques to do this: buying longer-term securities; and stretching out the time that market participants expect short-term rates to be near zero by giving guidance on how long the Fed itself expects short-term rates to remain at these extraordinarily low levels.

It used both of these techniques in 2012, adding innovative spins late in the year. Importantly it started the year by spelling out a bit more clearly its approach to pursuing its dual legislative objectives of “maximum employment and stable prices.” Two points were critical: First, it explicitly adopted a long-run inflation target of an increase of 2 percent in the PCE chain price index; it was hoping that the target would help to anchor inflation expectations more firmly and thus would enable it to adopt more aggressive policies to boost employment without endangering achievement of its price stability mandate. Second, it enunciated a “balanced approach” to pursuing its two objectives such that if they ever appeared to be in conflict they would give greater weight to the goal they were missing by more, taking more time to achieve the other goal. In the current context the “balanced” approach implies that if inflation is expected to run a little over target while unemployment is still quite high they wouldn’t withdraw policy accommodation right away but would approach the price stability goal slowly while continuing to make faster progress on unemployment.

Through the first nine months of the year, the Federal Reserve extended policies and techniques it had adopted in 2011 to reduce longer-term interest rates. It continued the maturity extension program popularly known as “Operation Twist” in which it sold shorter-term treasury securities and bought longer-term Treasury debt to put downward pressure on long-term rates. And it adjusted its estimate of how long near zero short-term rates would need to be maintained from “at least through mid 2013” to “at least through late 2014.”

Then at its September, October, and December meetings the Federal Reserve became more aggressive and more innovative. It restarted its program to expand reserves and its own balance sheet by buying mortgage backed securities in order to reduce mortgage rates and help the housing market and by converting its “twist” acquisition of Treasury securities into outright purchases financed by reserve creation. And it extended its expected period of near-zero interest rates to “at least mid 2015.” But in addition it innovated by tying the two types of policies—purchases and low interest rates—to evolving economic conditions rather than to a given amount of purchases or a date for raising rates. It will continue its purchases so long as the outlook for the labor market does not improve substantially. And it will not consider raising rates so long as unemployment is above 6.5 percent while projected inflation is below 2.5 percent, though to be sure they left themselves some wiggle room by noting that they will be looking at a variety of indicators of labor market tightness and inflation pressures.

The shift to economic conditions and the particular economic conditions chosen to act as thresholds for considering changing policy have several important implications. They reinforce the primary focus on labor markets—the maximum employment part of the dual mandate in the current and expected circumstances of still-high unemployment and still-low inflation. To that end, they imply continued downward pressure on interest rates through purchases so long as the labor market doesn’t look like it will be approaching a much better place in the future. And they make more explicit the willingness to take inflation risks—indeed to tolerate inflation a little over the new 2 percent target for a time —in order to get that labor market improvement, before raising interest rates. One of the objectives appears to have been to reassure households and businesses that the Federal a Reserve will not tighten prematurely and that they can plan on the Fed continuing to support growth for some time. And the shift to economic conditions implies that markets will be able to adjust interest rates with less explicit guidance from the Fed because market participants should better understand how the Federal Reserve itself will respond to evolving economic conditions.

Although financial market reactions to these late-year announcements were muted—except for a notable decline in mortgage rates-- most observers agree that the actions of the Federal Reserve have been transmitted through the financial markets in the forms of easier financing conditions for a variety of borrowers and of higher asset prices. As such they should help to boost spending at least a little, though the extent of the improvement is not expected to be large. It’s difficult to see their effect on confidence in an environment that is dominated by discussions of fiscal policy and where the difficult negotiations between the administration and Congress appear to have had a negative effect on household and business attitudes.

As we exit 2012, the growth outlook is highly dependent on the outcome of those fiscal negotiations as well as on developments overseas, where many industrial economies are stagnant or in recession. The Federal Reserve has spent 2012 laying out a framework for monetary policy to respond to evolving economic conditions, whatever the source of change. The consensus economic forecast for 2013 is for another year of moderate growth and only slow progress in lowering the unemployment rate, even with a favorable resolution of the fiscal difficulties that reduces uncertinaty while not front-loading restraint. Under these circumstances we could expect the Federal Reserve to continue buying securities and keeping rates at very low levels for some time. As to whether the fertile brains of Chairman Bernanke and his colleagues will come up with further innovations to speed this process along, we’ll just have to stay tuned.

Authors

Donald Kohn

Image Source: © Brendan McDermid / Reuters

Structuring the Financial Industry to Enhance Economic Growth and Stability

Tue, 04 Dec 2012 08:30:00 -0500

Event Information

December 4, 2012
8:30 AM - 2:30 PM EST

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

In light of the financial crisis and ensuing severe recession, Western governments are in the process of sharply transforming the laws and regulations for banks and other financial institutions. Yet, recent scandals and problems at major banks have given new life to calls for major structural changes beyond Dodd-Frank, Basel III and other banking reforms, including a return to Glass-Steagall’s restrictions on activities at banking groups or breaking up the largest banks. Any such changes would have significant implications for economic growth and stability, given the central role of finance in lubricating the gears of the economy.

On December 4, the Economic Studies program at Brookings held a conference to review the social purposes of finance, the current structure of the financial industry, and various reform proposals. Federal Reserve Board Governor Daniel Tarullo delivered the keynote address, along with presentations by Brookings Senior Fellows Martin Baily and Donald Kohn.

Read a summary of the event by Douglas Elliott »

Video

Transcript

Transcript (.pdf)

Event Materials

Managing Transitions in Northeast Asia, the Global Economy, and Japan-U.S. Relations

Wed, 28 Nov 2012 09:00:00 -0500

Event Information

November 28, 2012
9:00 AM - 3:30 PM EST

Keidanren Conference Hall

Tokyo, Japan

Northeast Asia has seen significant leadership changes in recent months, with the election of Park Geun-hye as president of South Korea, Xi Jinping as leader of China’s ruling Communist Party, and Shinzo Abe as prime minister of Japan. As leaders of world-leading economies, these key players will no doubt bring about dynamic change in the region’s politics and economy, while balancing relations with the United States and its own newly re-elected president.

On November 28, 2012, the Center for Northeast Asian Studies (CNAPS) at Brookings, the Japan Center for Economic Research, and Nikkei held a one-day conference on “Managing Transitions in Northeast Asia, the Global Economy, and Japan-U.S. Relations.” Three panels, featuring Brookings scholars as well leading experts from across Asia, provided their views on issues of profound importance to the Northeast Asian region including leadership transitions, global economy and trade, global governance, and U.S.-Japan relations in the 21st Century.

Farm Credit System Liquidity and Access to a Lender of Last Resort

Donald Kohn and Natalie McGarry — Tue, 06 Nov 2012 10:18:00 -0500

Introduction

This report was researched and written at the behest of the Farm Credit System Insurance Corporation (FCSIC) in order to evaluate the liquidity of the Farm Credit System (FCS), analyze the FCS’s vulnerability in the event of a broad financial market shutdown, and look at the policy aspects of a lender of last resort in such a circumstance. In the following sections the authors detail the structure of the FCS, provide background on how the FCS, other Government Sponsored Enterprises (GSE) and Federal insurance agencies weathered the 2008 crisis, compare these entities’ access to a lender of last resort, and finally provide analysis and recommendations on the state of FCS’s liquidity and options for securing a backstop in the event of a market shutdown.

Background

The FCS is a GSE designed to expand the availability of credit for agriculture and rural America. There are four FCS Banks (Banks)—AgFirst, AgriBank, Farm Credit Bank of Texas (FCB), and CoBank. The Banks are owned by the member associations, which in turn are owned by their agricultural borrowers. CoBank is also owned by eligible retail cooperative borrowers. At yearend 2011, the FCS had combined assets of $230 billion on a capital base of $35.9 billion. The Banks own the Federal Farm Credit Banks Funding Corporation (Funding Corporation), which raises cash in the wholesale markets to fund the lending of the Banks and their affiliated associations. That is, the borrowers obtain credit from their associations (and CoBank in the case of eligible borrowers) and the associations obtain wholesale funding from their affiliated Banks through the Funding Corporation. The Farm Credit Administration (FCA) oversees the FCS and is responsible for supervising and for setting and enforcing rules that safeguard the safety and soundness of the Banks. FCSIC is a government controlled independent entity that insures the timely payment of interest and principal on bonds and notes issued by the Banks through the Funding Corporation. FCSIC is funded by premiums on the Banks, and at the end of 2011 it had an insurance fund of $3.4 billion against guarantees of $184.2 billion in notes and bonds. [1]

The FCS is the only GSE without explicit legislated access to emergency liquidity from the Treasury Department. For example, Fannie Mae, Freddie Mac, and the Federal Home Loan Banks (FHLBanks) have long had legislation granting them a small line of credit at the Treasury, which added to the perception that the taxpayers of the U.S. stood behind them. And, for those three GSEs that backup was greatly expanded during the financial crisis, making more explicit the government guarantee. Those facilities weren’t utilized by the FHLBanks, but they were by Fannie and Freddie, whose solvency was restored with U.S. Government capital injections. About the same time, the supervision of these three GSEs was transferred to a new agency, the Federal Housing Finance Agency (FHFA), which was given much more explicit authority to oversee the activities of the three housing GSEs and to protect their safety and soundness.

The two other Federal Insurance programs[2] also have access to government funds in an extreme situation and that access was expanded during the crisis. The Federal Deposit Insurance Corporation’s (FDIC) $30 billion permanent line of credit to the Treasury was expanded to $100 billion; while the FDIC’s total borrowing authority was temporarily increased to $500 billion. In order to avoid using these extra funds the FDIC’s Deposit Insurance Fund (DIF) used its premium authority to impose a special assessment on insured institutions in which they prepaid their estimated risk-based assessments. During the crisis, the National Credit Union Share Insurance Fund’s (NCUSIF) permanent line of credit with the Treasury was increased from $100 million to $6.0 billion. In addition, the NCUSIF was granted temporary authority to borrow up to $24 billion through the temporary Corporate Stabilization Fund, which expired in December 2010.

Access to back up sources of liquidity was critical in stabilizing the financial system during the financial crisis of 2007-2009 and restoring confidence and more normal flows of credit. In addition to the extraordinary actions just outlined, depository institutions insured by the FDIC and NCUSIF borrowed heavily at the Federal Reserve’s discount window and, in the case of retail credit unions, from the NCUA’s Central Liquidity Fund (CLF). The authority of the CLF to borrow from the Treasury was increased during the crisis. The Federal Reserve also extended its discount window facilities to nonbank borrowers through a variety of facilities designed to get liquidity to money market mutual funds, issuers of commercial paper, and to purchasers of securitized debt.

The FCS does not have explicit access to a federal government source of back up liquidity. After reporting losses in the wake of the collapse of agricultural land values and commodity prices in the early 1980s, Congress passed a series of amendments to the Farm Credit Act of 1971. The Act reorganized the Banks, made FCA an “arm’s-length” regulator with increased supervisory and regulatory powers, including new enforcement authorities, and authorized up to $4.0 billion in federal assistance to the FCS. In total, the FCS received $1.3 billion in federal assistance through government guaranteed Financial Assistance Corporation bonds, which were fully repaid in 2005. As with the housing GSEs in 2008, taxpayer funds were put behind obligations of the Banks and, to forestall a repetition of the problems, more disciplined and tighter supervision was imposed under FCA’s new authorities.

However, in the Agricultural Credit Act of 1987, Congress, rather than giving the Banks explicit access to the Treasury, chose to reinforce the creditworthiness of the obligations of the Banks by creating a Federal insurance corporation to stand behind them and giving the FCSIC the ability to raise funds through collecting an insurance premium from the Banks. In contrast to the FDIC and the NCUSIF as Federal insurance funds, however, the FCSIC itself was not given the explicit authority to turn to the Treasury for funds in an emergency. And, unlike the banks, thrifts, and credit unions whose deposits the FDIC and NCUSIF insure, the entities whose obligations FCSIC insures do not themselves have explicit access to the Federal Reserve or any other lender of last resort.

This lack of access to a lender of last resort was not a problem for the FCS for many years. But it became a potential issue in the freeze up of financial markets after FHFA placed Fannie Mae and Freddie Mac into conservatorship and Lehman Brothers filed for bankruptcy. As reported in its third quarter 2008 report, the unprecedented instability in the global financial markets reduced FCS’ ability to issue debt with preferred maturities and structures. More specifically, FCS operations were funded primarily through short-term discount notes as issuance of longer-term debt had become more restrictive.[3] To provide additional flexibility, the FCA authorized an increase in the ceiling of the Discount Note program from $40 billion outstanding to $60 billion at the Funding Corporation. The shortening of the liability structure of the Banks’ funding in turn implied that the existing holdings of liquid assets might not cover the required 90 days of maturing obligations. The FCA adopted the Market Emergency Standby Resolution, which provided for a waiver if the resolution ever went into effect[4]. In early 2009 it also initiated the monthly collection of regular detailed information about the days of liquidity at each Bank in a specified format.

The disruption of the long-term funding market for FCS obligations was temporary and the consequences were not serious. But, in the view of FCSIC management, that relatively benign outcome was partly due to several favorable circumstances that might not be repeated in a similar future event. First, during the most severe period of the market disruption, the FCS did not have a large amount or very concentrated maturities of notes and bonds coming due. Second, over the several years preceding the crisis the farm economy had been quite prosperous; consequently the performance of the loans made by the FCS had been good. FCA, the System’s regulator had imposed stronger capital regulations in the early 90s requiring that System institutions build and maintain enough surplus to weather stressed environments.[5] Thus, even the slump of commodity prices and freezing up of trade credit that followed the Lehman-related market disruption did not call into question the capital adequacy of the Banks. The consequences for the FCS might have been more serious in the volatile and risk averse environment that naturally follows a financial crisis if FCS maturities had been larger or more “lumpy,” if the farm economy had been more vulnerable to a global slowdown, or if the market had been disrupted for longer. If any of these possibilities had occurred at the same time as the crisis or had other adverse shocks, such as trade restrictions affecting agricultural exports, been experienced, the spill over concerns could have negatively affected the viability of the Banks and caused more lasting constrictions on the funding capacity of the Funding Corporation and the availability of loans to agricultural borrowers.

At the onset of the crisis, the Banks held minimal amounts of U.S. Treasuries that were so much in demand during the height of the crisis. A high proportion of the supposedly liquid assets were in housing GSE obligations and in non-agency MBS and ABS. The latter categories to be sure had been rated AA or AAA, but the prices of these assets fell sharply as the market deteriorated and they did not form an effective liquidity backstop for the Banks.

The FCA and FCS took a number of steps in response to the newly perceived vulnerability. For example, the FCA and FCS explored whether and under what circumstances the Federal Reserve Banks could lend to the Banks under section 13(13) of the Federal Reserve Act during a liquidity crisis in the market. One of the authors of this paper, Kohn, was a party to those discussions when he was at the Federal Reserve. Section 13(13) of the Federal Reserve Act authorizes Federal Reserve lending to individuals, partnerships and corporations collateralized by U.S. Treasury securities or the obligations of U.S. government agencies held by the Banks. The Board's regulation A limits such lending to "unusual and exigent circumstances" and only in cases when the borrower is not able to obtain credit from other sources and when the failure to obtain credit would adversely affect the economy. Based on such considerations, the Federal Reserve Board judged that lending was not warranted at the time, and the Board has followed its longstanding policy of refraining from any commitments about providing such emergency credit in the future.

Somewhat later, FCSIC also approached the Federal Financing Bank (FFB) at the Treasury department about possible borrowing in a future liquidity emergency triggered by a market shutdown. As envisioned by FCSIC, it might issue notes to the FFB or the borrowing might take the form of obligations issued by the Funding Corporation, purchased by the FCSIC and in turn bought by the FFB, with the funds passed back to the holders of maturing FCS obligations. The FFB seemed open to exploring whether and how it may be a potential source of funding for an organization—FCSIC—that was a federal agency and at least implicitly already had full faith and credit backing of the U.S. government.[6] With the guarantee already in place, the FFB would be providing liquidity, not capital, to the FCSIC to make good on guarantees; funding would not increase the exposure of the Federal Government. But the FFB pointed out several ambiguities and uncertainties about the authority of the FCSIC to borrow from the FFB and the modalities of how any such funding would work. And, critically, Office of Management and Budget (OMB) may need to score any agreement between the FFB and FCSIC for budget purposes.

Importantly, the Banks, their regulator the FCA, and the FCSIC as insurer recognized that the Banks themselves needed to hold more high quality liquidity. In late 2008, the FCS formed a liquidity committee to conduct a strategic review of FCS liquidity and to make recommendations to meet future liquidity challenges. Also, earlier in 2008, Congress amended the Farm Credit Act to allow 90% of Federal government guaranteed investments to be deducted from total insured debt on which FCSIC premiums are assessed. In response to these initiatives, the Banks greatly increased their holdings of U.S. Treasury securities and securities with explicit government guarantees. In 2010, the Banks entered into a voluntary agreement in which they agreed to hold the very highest quality and most liquid assets (cash, cash equivalents, or Treasuries maturing in less than three years) to cover the first 15 days of maturing obligations; very high quality securities for the next 30 days and somewhat lesser quality instruments for days 46 through 90. In December 2011, the FCA published a proposed rule closely resembling the 2010 agreement.[7] In general, the FCA proposal would improve the Banks’ liquidity reserve requirement, promote liquidity risk management best practices, and better prepare the Banks to withstand a liquidity crisis. The proposed rule would continue to require the Banks to maintain a liquidity reserve sufficient to fund a minimum of 90 days of maturing obligations but with higher quality instruments that closely mirrors the 2010 voluntary agreement. The proposed rule also requested comment on a new concept that would require all Banks to establish and maintain a supplemental liquidity buffer that would provide a longer-term stable source of funding beyond 90 days. A key aspect of the proposed regulations is the requirement for Banks to have contingency funding plans to ensure they have sufficient liquidity to fund operations under a variety of stress scenarios, including market disruptions and loss of market access, as well as rapid increases in loan demand or drawdowns of unfunded commitments. As of this writing (early November) the final regulation had not been published.

Finally, in response to the concerns raised by the interruption of market access, the FCSIC engaged the authors to examine various liquidity issues around the FCS—access to lender of last resort as compared to other GSEs and Federal insurance corporations, and the liquidity of the Banks. To these ends, in the process of preparing this report, we have had discussions with individuals at FCSIC, the Funding Corporation, the FFB/Treasury, the Federal Reserve, and some other GSEs and government insurance corporations with access to the Treasury as a lender of last resort—the FHLBanks, and the NCUSIF.

Analysis and Recommendations

It is important to emphasize the limited nature of the examination we were asked to undertake and the reach of our recommendations. They are focused solely on liquidity, not solvency or capital, and a liquidity need occasioned by a shock to markets external to the agricultural sector or the FCS. In our conversations, we encountered some concerns about the potential impact of a decline in land prices should agricultural commodity prices fall considerably. Commodity prices have been elevated on balance over recent years by growing demands from emerging market economies, by unusual weather patterns and drought in some regions of the world, and by environmental regulations mandating the use of ethanol in gasoline. Any of these factors could be reversed or market participants could come to the view that prices had overreacted to them. Extended declines in agricultural commodity prices and in the prices of the land used to produce agricultural commodities could cause loan problems at the Banks and their affiliated associations and call into question the adequacy of their capital, which would then have an effect on their access to markets. We did not evaluate the risk of this particular cause of a loss of access to market funding or of the desirability of providing a backup source of funding under these particular circumstances.

Lender of last resort. As outlined above and shown in more detail in the appendix, the FCS and FCSIC stand out from other GSEs and Federal insurance corporations in their lack of explicit access to a governmental source of back up liquidity. Legislation explicitly gives Fannie, Freddie, the FHLBanks, the FDIC, and the NCUSIF some access to Treasury liquidity in an emergency. Moreover, the institutions insured by the FDIC and NCUSIF can borrow from the Federal Reserve, which so far has not granted similar access to the Banks.

However, there are reasons to question whether such access for the FCSIC on behalf of the FCS would be in the public interest. For one, to date this lack of formal legislated access to government liquidity has not seemed to have adversely affected the ability of the FCS to fulfill its public policy role of providing competitive financing for the agricultural economy. The spreads of Bank obligations over Treasury securities closely mirror the spreads of the obligations of other GSEs. FCSIC as a federal insurance corporation is probably already backed by the full faith and credit of the U.S. government, at least implicitly, providing some assurance of repayment of the market notes and bonds of the Banks. Moreover, when FCS’ solvency was threatened in the mid-1980s, the Congress structured a work out that involved taxpayer backing and no losses for private investors. More recently in 2008 during an event widely characterized as the “worst financial crisis since the 1930s”, the Funding Corporation was able to raise funds in the open market, albeit only with maturities of a year or less, which allowed the FCS to avoid any liquidity issues and meet all its obligations.

Second, there may be incentive and moral hazard costs to firming up the implicit government backing. The lack of explicit access to a governmental lender of last resort has probably contributed to the willingness of the Banks and their regulator to raise liquidity standards in the wake of the financial crisis. Higher standards have costs in terms of interest forgone and capital held against non-loan assets, and naturally, borrower-owners may not be entirely receptive to making the Banks safer and more liquid—that is, reducing the value of the implicit support of the taxpayers. From the broader public policy perspective that takes account of taxpayer as well as agricultural interests, however, any formal access to government liquidity should not be allowed to reduce the momentum toward making the Banks themselves safer.

If access to government liquidity is granted to the FCSIC on behalf of the FCS, in order to limit moral hazard it should be tailored narrowly to deal with a liquidity event external to the agricultural sector and the Banks. In the event that market access is at risk because of concerns about solvency or lax management of liquidity by the Banks, the FCS should be required to approach the Congress and the administration for legislative help. In these circumstances, Congress should evaluate the causes of the difficulties, the conditions for any assistance, and any flaws revealed in the structure or oversight of the FCS before putting additional taxpayer resources behind agricultural credits. And it should require that investors should look first to the resources of the FCS— the FCSIC fund and its ability to collect fees in the future—before public money is put at risk. In the end, it would be important for a federal insurance program to make good on its commitments--failure to do so might call into question other insurance programs, like the FDIC and the NCUSIF—but under conditions arrived at through the legislative process.

But under a very narrow set of circumstances--when the problem is purely a liquidity issue that cannot be handled by FCSIC and the Banks alone, and it originates external to the agricultural sector and the FCS in a prolonged market shutdown situation--we can see some net benefit to giving the Banks, through FCSIC, a process for applying to the Treasury for back up liquidity. The FCS plays an important role in agricultural finance. Self-insuring against any possible liquidity event could be very expensive and constrain credit availability. Depository institutions have been given access to the Federal Reserve as a liquidity backstop, but in restrictive circumstances and with considerable regulatory and supervisory oversight to limit moral hazard. And other GSEs and Federal deposit insurance corporations can tap the Treasury as a lender of last resort, suggesting that Congress saw the cost of complete self-insurance or the risk of failure as being too high to be in the public interest for these types of institutions. [8]

The potential access would be tail insurance for highly unusual situations that could not be reasonably foreseen. It would not be a substitute for strong liquidity management by the Banks, including holding liquidity against a variety of potential stress situations, as is being required of commercial banks. Access would not act as a substitute for the Funding Corporation utilizing term borrowing as much as is consistent with good risk management and business practices to reduce the FCS vulnerability to market events. And it would be a last resort—to be utilized only after other means of obtaining funding for on- and off-balance sheet obligations had been exhausted. Such means would include utilizing the liquidity reserves of the Banks and temporarily increasing the short-term borrowing of the Funding Corporation, as occurred in the fall of 2008. The utilization of this facility would be reserved for a situation in which there was an extended market shutdown that impaired the ability of the Funding Corporation to raise sufficient funds even in short-term or floating rate markets.

We believe the most direct and logical way to structure any such access is through the FFB, building on the preliminary discussions already held. Any lending by the FFB would be at the discretion of the Secretary of the Treasury, with a clear written understanding that: it would be reserved for a general market closure unrelated to the solvency of the Banks; that it would be a last resort after other sources had been utilized; and that its availability would depend on the Banks following sound liquidity risk management practices.

Within that broad framework, several key issues need to be addressed.

Are FCSIC guarantees already full faith and credit (FFC) obligations of the U.S. government so that FFB access would not increase the credit exposure of the government? If they are, is this explicit or implicit and how is it perceived by the public? If it is implicit and the public is uncertain, an agreement would strengthen the implied guarantee, loosening market discipline, and this could be an important policy issue.
How should any loan from the FFB be structured? There are alternative mechanisms for the FFB to provide liquidity, from lending to the FCSIC to pass on to the Funding Corporation to lending to the Funding Corporation with FCSIC guarantees. The choice could depend in part on what the FCSIC is empowered to do—specifically whether it can borrow from the FFB, which should be clarified. The need for and composition of any collateral backing a loan also should be determined. For example, collateral may not be needed if FCSIC can repay its borrowings with its premium collections. If collateral is appropriate, FCSIC or the Funding Corporation could back a loan with the assets of the Banks, the assets of the FCSIC fund, and a pledge of future insurance premiums from the Banks.
Would there be implications for the budget of the United States? FFB and FCSIC would need to determine, in consultation with OMB, if an agreement would need to be scored by OMB under the Federal Credit Reform Act. Based on the similarity of FCSIC legislative language with that of the FDIC and precedent with the Resolution Trust Corporation, it is possible that an agreement to lend wouldn’t require scoring. If, however, an agreement does need to be evaluated by OMB, the score would depend on estimates of any subsidy, which in turn would be judged by comparing the loan amount to the present value of expected future repayments of any loan. Collateralizing the loans would increase the likelihood of repayment and therefore reduce or eliminate any subsidy. If scoring is required, a Congressional appropriation apparently also would be required, even if the potential lending was found not to entail a subsidy. The FFB does not have signed lending agreements with other GSEs and federal insurance corporations. But these agencies have the explicit authorization of Congress to borrow from the FFB.

We recommend that an agreement between FCSIC and the FFB be established well before any precipitating event--as soon as possible after the preceding issues have been dealt with, rather than waiting for a crisis situation to arise. Under the circumstances in which the FCA and FCSIC determine it needs to be activated, the Secretary of the Treasury could then make a judgment based on the already established agreement.

We recommend that the effort to craft such an agreement be discussed with the appropriate Congressional committees. Because the Congress did not explicitly authorize the FCS to borrow from the Treasury, it appears Congress believed that the insurance fund it authorized would be sufficient to deal with any problem. Due to the 2007-2009 financial crisis, the FCSIC and Treasury are considering circumstances when that backstop might not be sufficient. Without Congressional consultation, an adverse reaction by Congress to a surprise activation of the facility in the middle of a market crisis could well be destabilizing for markets generally as well as for the FCS.

Bank Liquidity. Because the facility we envision could only be used in the event of an extreme generalized market shut down, it is imperative that the Banks continue to hold ample liquidity against various contingencies. As noted, considerable progress had been made in this regard since the fall of 2008. The exact requirements of the final FCA regulation on liquidity are not available as of this writing in early November. Assuming it closely mirrors the proposed regulations of December 2011, we would emphasize several issues. First is the critical role of stress tests in assessing liquidity and liquidity management. The Banks need to be prepared to handle combinations of stresses that, while falling short of complete market shutdown over a prolonged period, would be very serious and challenging. For example, in a market panic the prices of all but the highest quality and most liquid assets, such as Treasury securities, could fall eroding the value of assets available for short-term sale to meet obligations.

Second, it is important that those stress tests include the contingent need for funding and liquidity that a take down of off-balance sheet obligations could pose. In particular, the FCS has some commitments to extend credit to borrowers on their demand. In periods of high commodity price volatility the draws on those commitments tend to increase (especially in response to spikes in commodity prices that cause grain elevators to need more credit to maintain hedges). Usually, these draw downs have been funded by increases in the issuance of discount notes, but if those notes are already on the rise because of a partial market shutdown, further sharp increases could be problematic. At a minimum the Banks under the direction of the FCA need to engage in a thorough analysis of how large any such draws might be under various circumstances, how those circumstances might coincide with other market disruptions, and the potential liquidity implications of draws on unfunded commitments in the midst of other adverse market events. The results will vary among individual Banks and each should be able to cope with a liquidity stress arising from its particular circumstances—the stress tests should be individually tailored under the direction of the FCA.

Finally, the FCA is considering whether the largest Banks should be held to higher standards for liquidity (and capital) under stress scenarios. The resources of the System--the capital and liquidity of other institutions plus the insurance fund-- would be quite stretched if either one of the two larger institutions had problems meeting its obligations and the other banks or FCSIC were required to step in. From the perspective of the FCS, the two largest Banks are systemically important in that problems at one of those institutions could cause market participants to have legitimate questions about the viability of the whole FCS. Market participants view the FCS as a single entity. A clear lesson of the recent financial crisis is that trouble in very large components of a financial system can threaten the whole system, in part by raising questions about the implications for other components of the system through interconnections, such as the joint and several liability of the Banks. As a consequence, the Dodd-Frank Act and the new banking regulations growing out of the Basel process incorporate higher requirements for systemically important financial institutions (SIFIs). Although CoBank and AgriBank have over $50 billion in assets, they are not subject to the SIFI rules of the Dodd-Frank Act. Nonetheless, we believe stress tests and the resulting liquidity requirement should incorporate interconnections and make allowance for the systemic importance of institutions—the macro-prudential overlay—as well as the particular risk profile of each individual institution.

The liquidity standards for banks coming from the Basel Committee on Bank Supervision are being discussed and modified this year and, consequently, the resulting liquidity regulations for U.S. banks have not yet been proposed. What is appropriate for commercial banks may not be exactly applicable to FCBs, but the general principles are the same and FCA should monitor this progress of the Basel and U.S. processes for ideas about best-practice liquidity regulation that should be applied within the FCS.

Resolution. As the number of Banks shrinks, the opportunities to handle a troubled institution unable to meet its obligations by merging it into a stronger institution also diminish. In particular, if one of the two larger Banks were to be in trouble, the orderly wind down of the institution’s book of business and repayment of insured obligations would be handled by FCSIC. This could be challenging in a number of dimensions, even if the resources of the FCSIC fund were ultimately adequate to meet the Banks’ obligations. Among those challenges could be accessing the liquidity to fund an orderly wind down as obligations came due. FCSIC has options in this regard, including its power to issue guarantees and operate the Bank in conservatorship or receivership using all of the Banks’ borrowing authorities. But we recommend that FCSIC consider carefully how it would handle such a situation and what sources of liquidity it could access.

Download the full paper with the appendix » (PDF)

Footnotes

[1] The Federal Agricultural Mortgage Corporation (Farmer Mac) provides a secondary market to agricultural lenders. Farmer Mac’s debt securities are not insured by FCSIC.

[2] For more information on the FCSIC, the NCUSIF, the FDIC, and the FHLBanks, please refer to the appendix. Fannie and Freddie were not included in the report or appendix, as they are now government owned and their final structure and status are yet to be determined.

[3] See Farm Credit System Quarterly Information Statement—Third Quarter 2008, page 9.

[4] A waiver was never granted and the Banks did not exceed the original Discount Note ceiling.

[5] Total System capital to assets grew from 9 percent in 1991 to 15 percent in 2011. The quality of this capital also improved with retained earnings representing 83 percent of total capital compared with 58 percent 20 years ago.

[6] The Resolution Trust Corporation (RTC) was also created without explicit access to the Treasury, but during the thrift crisis the RTC was allowed to borrow from the FFB. See “Authority of the Federal Financing Bank to Provide Loans to the Resolution Trust Corporation,” 14 Op. O.L.C. 20, OLC LEXIS 54 (February 14, 1990); “Debt Obligations of the National Credit Union Administration,” 6 Op. O.L.C. 262 , 1982 OLC LEXIS 62 (May 24, 1982).

[7] See 76 FR 80817 (December 27, 2011) at http://www.fca.gov/handbook.nsf.

[8] The Federal Reserve also can buy U.S. agency securities in the course of its open market operations, and this could include FCS securities. But it makes these purchases only “in the open market”—i.e. in the secondary market. While helpful in restoring market liquidity in a prolonged crisis, such purchases would not provide immediate funding liquidity in a market shutdown.

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Farm Credit System Liquidity and Access to a Lender of Last Resort (with Appendix)

Authors

Donald Kohn
Natalie McGarry

Unconventional Times, Unconventional Measures: A Conversation with Federal Reserve Board Governor Jeremy Stein

Thu, 11 Oct 2012 10:00:00 -0400

Event Information

October 11, 2012
10:00 AM - 11:00 AM EDT

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

Amid a weak and uneven economic recovery, the Federal Reserve announced in mid-September that it would undertake further large-scale asset purchases, sometimes known as “quantitative easing,” in order to provide additional support to the U.S. economy. With its traditional tool of monetary policy—the federal funds rate—at close to zero, the Federal Reserve has entered new policy territory by implementing several waves of quantitative easing over the last four years. While such programs are designed to ease financial conditions and, in turn, foster demand and increase employment, they are thought by some to carry important risks. As a result, they have been the source of some controversy.

On October 11, Economic Studies at Brookings hosted a discussion with recently appointed Federal Reserve governor, Jeremy Stein. Vice President and Co-Director of Economic Studies Karen Dynan gave introductory remarks, and Brookings Senior Fellow Donald Kohn moderated a question and answer session. Governor Stein also took questions from the audience.

The event was broadcast live on C-SPAN »

Read Jeremy Stein's prepared speech at federalreserve.gov »

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Banks and Capital Flows: Policy Challenges and Regulatory Responses

Wed, 26 Sep 2012 14:00:00 -0400

Event Information

September 26, 2012
2:00 PM - 3:30 PM EDT

Falk Auditorium
Brookings Institution
1775 Massachusetts Avenue NW
Washington, DC 20036

Financial integration offers many benefits, but also poses risks. Recent events—from the U.S. subprime mortgage crisis to capital flow reversals and the European banking crisis—have shaken the faith that even advanced economies can harness the benefits of greater financial flows and deepen financial integration without incurring costs. These observations point to the question of how best to benefit from greater financial integration while limiting adverse effects, especially the risks posed by cross-border banking flows.

On September 26, Global Economy and Development at Brookings hosted a discussion to launch a new report by the Committee on International Economic Policy and Reform (CIEPR)—a group of independent economic experts that includes academics as well as former government and central bank officials. In this report, the committee draws on the growing body of evidence on cross-border banking flows in an effort to better understand their effects in practice. Building on this analysis, the committee makes specific policy proposals for improving domestic banking regulation and also for cross-border regulatory coordination. Panelists included committee members José De Gregorio, former Chilean central bank governor; Hyun Song Shin of Princeton University; and Jean Pisani-Ferry of Bruegel. Brookings Senior Fellow Donald Kohn also joined the panel. Brookings Senior Fellow and Cornell University Professor Eswar Prasad, who is also a member of CIEPR, moderated the discussion. After the program, the panelists took audience questions.

You can follow the conversation on this event on Twitter using the hashtag #CIEPR.

Read the CIEPR report, titled "Banks and Cross-Border Capital Flows: Policy Challenges and Regulatory Responses" »

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Full Event - Banks and Capital Flows: Policy Challenges and Regulatory Responses

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Banks and Capital Flows: Policy Challenges and Regulatory Responses

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09 ciepr banking capital flows

The European Crises—Banking Challenges

Donald Kohn — Thu, 12 Jul 2012 00:00:00 -0400

Editor's Note: Donald Kohn delivered the following remarks at a National Bureau of Economic Research conference on the euro crises on July 12, 2012. While the conference was conducted under the Chatham House Rule, Kohn has elected to post his speech on the Brookings website.

For my contribution to this panel, I’ve been asked to reflect on my experience as a policy maker dealing with banking challenges as it might apply to the Euro area. The most important and fundamental challenge is restoring confidence in banks and the flow of private capital into the banking system. We met with some success in bringing private capital into the banking system in the U.S. in 2009, and I will look at what we did to bring this about and reflect on European actions in this light.

The U.S. Response

It’s useful to start by recalling what didn’t work in the U.S. In the summer of 2008, Congress authorized infusions of capital and liquidity for Fannie Mae and Freddie Mac. The theory was that the availability of government backstops would restore confidence and make their very use unnecessary (Secretary Paulson’s “big bazooka”.) Before long, however, the government assistance had to be activated. The problems of these two GSEs were too deep for market confidence to be bolstered by a promise; and the possibility of government capital coming in actually scared off private equity capital, which saw itself at risk of substantial dilution by the government with uncertain governance consequences. So, just promising support often isn’t enough and can even be counterproductive.

In October 2008, following the passage of TARP, the government followed what was then the standard playbook—derived from earlier experience in Scandinavia and elsewhere— for dealing with a banking crisis: inject capital; guarantee senior debt; make liquidity readily available at the central bank discount window; and ease monetary policy aggressively. These actions were helpful, but they were not comprehensive enough to restore confidence and end the adverse spiral of asset price declines, tightening credit, and sharply weakening spending. Private capital continued to shun banks and other financial institutions.

A final example of the government’s failure to restore confidence was Secretary Geithner’s first press conference, at which he laid out the key elements of the government’s approach to stabilizing the financial sector. Those steps were ultimately successful. However, expectations for the event were too high—and perhaps unable to be met, especially so early in the new administration. In part because it was so early, the Secretary was unable to give detailed plans for implementation, which undermined the credibility of the proposed steps and created uncertainty. Financial problems continued to mount, confidence fell further, and the economy slid even deeper into recession.

The key to turning the situation around was identifying all the problems and coming up with detailed and credible plans for dealing with them across their many dimensions. A critical aspect of restoring confidence is size; enough resources need to be made available to deal with issues, even if the needs turn out to be greater than is first estimated—it’s the tail risk that dominates the psyches of investors in a financial crisis.

The most fundamental problem was the direction of the economy. Efforts to stabilize the financial sector and attract private capital are unlikely to be successful if the economy is contracting rapidly, as it seemed to be in early 2009. Private capital is not going to come into banking if loan losses are growing substantially and difficult to predict and asset prices are falling. Activist and aggressive fiscal and monetary polices—a strategy for getting out of recession— were necessary complements to various programs to stabilize the financial system.

Within the financial sector three problems were identified: funding liquidity for banks and other intermediaries; the solvency of banks and other systemically important institutions; and restarting buying and trading in key asset markets— for legacy assets on the books of the banks and also securitization markets to get new credit flowing.

Liquidity. In a crisis, the distinction between liquidity and solvency problems is not clear. A lack of liquidity causes fire sales of assets; declines in asset prices lower net worth and collateral values for borrowing, raise questions about viability, and result in lower credit ratings, which increase the demand for liquidity, and cause credit supplies to tighten. The proximate cause of the failure of a financial institution is almost always a drying up of funding, but concerns about solvency can underlie the reluctance to lend.

The central bank must take liquidity concerns off the table as best it can. It must stop the feedback loops keyed to liquidity, and afford itself and other authorities a basis for judging and dealing with underlying solvency issues. The Federal Reserve pulled out all the stops to supply liquidity in the fall of 2008 and early 2009. It lent to nonbanks as well as banks; it provided an intermediary function where markets were frozen—not only for interbank markets, but in nonbank markets like commercial paper. Its actions have often been characterized as market maker of last resort as well as lender of last resort. Valuing collateral in such a situation presents challenges. Market prices reflect panic selling rather than fundamental values. Bagehot is clear on this issue: central banks cannot chase those valuations down—they must value collateral as it would be in calmer markets. But what those underlying values might be is far from clear and central banks should be very careful about putting taxpayer money at risk.

Solvency. The public fisc cannot be the main source of long-term support for a dynamic banking system. While public capital injections can be useful to fend off collapse, private capital will reduce the need for public support and is the ultimate source of solvency in a market system. There are two ways to bring in private capital: One is to compel a capital infusion, say through forced conversions of debt for equity—the “bail in” by creditors now contemplated as part of saving or resolving a troubled institution; the second way to get private capital in, and the far better choice, is to attract that capital. This is what happened in the US and its success depended on a number of elements.

One such element was the ready, public, availability of information that allowed potential investors to judge the underlying condition of individual companies. In this regard, the publication of each institution’s performance in a credible stress test in the spring of 2009 was critical. In general, transparency in a crisis is hard because of the potential for the information to destabilize those institutions that are seen to be vulnerable, but it is essential in order to strengthen the less vulnerable that may be suffering from contagion brought on by a lack of information. To be transparent in a crisis you need a source of government capital to be available to those institutions that are not in good shape and can’t access markets.

Another element was incentives for current owners and managers to avoid public funding—for the institutions to raise private capital even at the expense of considerable dilution of existing shareholders. The cost of public funding in the US was perceived as high, not so much because of the dividend on the preferred shares, but more because of the nonprecuniary costs of public funds. These included intrusive regulation of compensation and close Treasury and Congressional oversight. And institutions were required to raise capital in private markets to retire government capital—and generally at $2 of private for $1 of repayment. This gained private validation of the ability of these institutions to survive and access markets and an extra margin of safety to assure that they would not need another infusion of government support.

Also critical was clarity on the goals of the capital raising. At the end of the stress test, each institution was given a dollar amount of capital it needed to raise to repay government capital or avoid further infusions. The amount was based on comparing the post-stress capital ratio to a safe level, but the emphasis for the institutions was on the numerator of the capital ratio, not the ratio itself, so requirements could not be met by deleveraging, except for some special cases of disposal of noncore assets that had previously been agreed with regulators.

Asset markets. The U.S. authorities took several steps to restart trading in critical asset markets. They initiated public-private partnerships for the legacy assets on the books of the banks. That program never amounted to much in dollar terms, but the announcement of the program helped to firm prices for those assets, which was crucial to limiting losses and helping the banks begin to manage out of impaired positions. The second program was aimed at restarting securitization markets so credit to households and businesses would flow better outside the banking system. Under Talf, the Federal Reserve provided leverage by lending to private purchasers of securitization assets; the government took some of the default tail risk with Tarp. Both of these programs used small amounts of public capital to attract larger amounts of new private investment in important asset markets.

The European Response

I don’t want to hold up U.S. actions as the only right way to approach a banking crisis. Ultimately it was successful in restoring confidence and bringing in new private capital, but there were some false starts, and, in a number of respects, the circumstances in the U.S. in 2009 and Europe today differ both economically and politically. But it may be instructive to examine the European response to their banking and economic crisis in light of what was done over here.

My first observation is for the need to attack all the problems on a broad front at the same time. The fiscal, banking, and competitiveness issues in the euro area are all interlinked. You can’t stabilize the banking system without solving the sovereign debt problems and vice versa. For many euro area banks, sovereign debt is the counterpart of the legacy real estate assets on the books of U.S. banks. Neither the banking or sovereign problems will be soluble without better plans for restarting growth and for restoring competitiveness in current account deficit countries without years of austerity and recession. This characterization isn’t entirely fair, but the European response to their serious problems has had a bit of a “whack a mole” quality to it. Issues arise in a particular area, a summit is called, and an announcement made about how that particular problem will be addressed. Over time, progress has been made on several fronts, but it has been slow and episodic, and the overall strategy for dealing across many areas and their interactions has not been made clear.

Second, it is critical to avoid announcements of general plans without specifics and timelines. Such announcements create uncertainty rather than resolving it. And vague plans without consideration to all ramifications can have unintended consequences. We saw this very clearly in the market response to the initial announcement of the plan to recapitalize Spanish banks, which raised questions about the implications for private holders of Spanish sovereign debt. Somehow, private investors need to be drawn into investing in euro zone sovereign debt and banking equity and debt; a prerequisite for this would be an understanding of the standing of these investors after government support has been provided. Much has been made of the steps towards a “banking union”. But specifics about the elements and a timeline are lacking. How are supervision, deposit insurance, and resolution to be consolidated and the authority of national regulators to be reduced? What will be the source of funds to back up any insurance fund and handle resolutions and how will responsibility for past losses be split among the private sector holders of debt, the national authorities, and supra national sources of funds? Private capital will be reluctant to come in when so many elements of the structure of regulation and responsibility are unclear.

The ECB has appropriately and constructively become more aggressive in backstopping the liquidity of euro area banks; its actions in creating the LTROs last fall and winter slowed a very dangerous deleveraging dynamic that had taken hold after new capital requirement ratios for banks had been announced. However, a portion of the additional liquidity was invested in sovereign debt, further strengthening the ties between banks and sovereigns, with adverse effects over time. This is another illustration of the difficulty of designing policies without unforeseen consequences. It would be good to be able to backstop the medium-term funding needs of the banks on an ongoing basis without strengthening those ties that other policy initiatives are attempting to loosen.

The Europeans have been largely unsuccessful at attracting private capital to banks to relieve the pressure on sovereigns. One problem has been informational; the stress tests on European banks were not sufficiently tough, credible, and transparent for investors to feel they could differentiate the fundamentally sound institutions from those that would require government assistance or resolution. Credibility will require that the tests be controlled by the supra-national EBA or other supra-national institution like the ECB, with much less input from national authorities who can be suspected of protecting their national champions. As noted above, credible and transparent stress tests require a back up source of government capital available to stabilize weaker entities, and a source with enough capacity has been missing. Finally, the capital requirements coming out of the stress tests have been specified in ratios, not in euros of additional capital required, and that has fueled deleveraging and renationalization of euro area banking as banks retreated from cross-border lending.

I recognize that dealing with the banking crisis is harder in the European context than it was in the U.S.—and that was no piece of cake. Addressing these issues—not only banking but debt sustainability, competitiveness, and growth—effectively will require nations to relinquish a good deal of sovereignty to create a real economic union to go along with the currency union, now that the adjustment mechanism of realigning exchange rates has been foregone and integrated product and financial markets have left the real and financial sectors of many countries exposed to problems in other individual countries. The formation of an effective economic union implies reforms to economic structures and governmental oversight in many of the countries but also ceding decision-making to supranational authorities who can credibly apply a euro-wide perspective and overcome national interests. And the adjustment and transition will require some sharing of the cost of past mistakes made by the private sector and national authorities in many countries. All this needs to occur within the context of a political system that was not built to support crisis decision-making and democratic accountability for significantly expanded powers at the supranational level. But clearly something fundamental needs to change if the banking and other crises are to be overcome. I hope the experience of the U.S. can be instructive in delineating some of the requirements.

Authors

Donald Kohn

Publication: National Bureau of Economic Research

Image Source: SUSANA VERA

A Conversation about the Greek Elections and the Future of the Eurozone

Donald Kohn, Douglas J. Elliott and Michael W. Klein — Mon, 18 Jun 2012 00:00:00 -0400

Following the New Democracy party's victory in the Greek elections on June 17, Donald Kohn, Douglas Elliott and Michael Klein discussed the vote's implications for Greece and the euro, the situation in Spain and the G20 summit.

“My point of view: we dodged a bullet, but the gun is still loaded. And even outside of Greece, maybe particularly outside of Greece, there are many other areas where things could go wrong.” - Doug Elliott

“The election is good news for the global financial system because if nothing else it’s going to buy some time and give these guys a chance to adjust to potential downside risk.” - Donald Kohn

Topics covered by Elliott, Klein and Kohn include:

The worst case scenario that was avoided with the New Democracy party's victory.
The short- and long-term problems facing Greece, including its unsustainable debt level in the government and the country's lack of competitiveness in private sector business.
Whether the election's results will effect other European leaders' willingness to help by moving Greece's deficit targets.
What this result may mean for Spain, Portugal and other countries facing similar situations.
Europe's negative effect on financial markets and the global economy, including the United States.

Audio

Conference Call on the Election in Greece

Authors

UNITED STATES - The U.S. Economy: Sustaining the Recovery—Policy Challenges, Political Differences and an International Context

Mon, 04 Jun 2012 11:41:00 -0400

Publication: Think Tank 20: New Challenges for the Global Economy, New Uncertainties for the G-20

How Has Monetary Policy Changed in the Last 25 Years?

Thu, 03 May 2012 16:42:00 -0400

Donald Kohn delivered the opening speech at the 25th annual conference of Vanderbilt's Financial Markets Research Center. The conference addressed changes in the financial markets over the years, asking whether financial markets have become more efficient and more stable or whether they are becoming more volatile, more complex and more costly.

Kohn provided background on how monetary policy has changed over the past 25 years. The conference's agenda and scheduled speakers are available at Vanderbilt's Financial Market Research Center's website.

Downloads

0503_monetary_policy_kohn

Authors

The Renminbi’s Role in the Global Monetary System

Tue, 07 Feb 2012 10:30:00 -0500

Event Information

February 7, 2012
10:30 AM - 12:00 PM EST

Falk Auditorium
The Brookings Institution
1775 Massachusetts Ave., NW
Washington, DC

China now has the world’s second largest economy and is a key driver of global growth. But of the six largest economies in the world, China’s renminbi is the only currency not used as a global reserve asset. Although it has recently taken steps to promote the renminbi’s international use, the Chinese government has still not been willing to open its economy to the free flow of capital nor allow a flexible exchange rate. Nevertheless, the sheer size of China’s economy and its rising shares of global output and trade foreshadow a rising role for the renminbi in international finance and trade. The deeper question, however, is whether the renminbi’s global stature will match that of the Chinese economy— and perhaps surpass the U.S. dollar.

On February 7, Global Economy and Development at Brookings hosted a discussion on the renminbi’s prospects as an international currency and its implications from two perspectives—the balance and sustainability of China’s own economic development and the associated implications for the global monetary system. The panelists included Brookings Senior Fellow Eswar Prasad, author of a new report, “The Renminbi’s Role in the Global Monetary System”; Senior Fellow Donald Kohn; and Stephen Roach, senior lecturer and senior fellow of the Jackson Institute at Yale University. Greg Ip, U.S. economics editor for The Economist, moderated the discussion.

After the program, the panelists took audience questions.

Video

Audio

The Renminbi’s Role in the Global Monetary System

Transcript

Uncorrected Transcript (.pdf)

Event Materials

20120207_renminbi

Participants

Moderator

Greg Ip

U.S. Economics Editor
The Economist

Panelists

Stephen Roach

Senior Lecturer and Senior Fellow of the Jackson Institute, Yale University
Non-Executive Chairman of Asia, Morgan Stanley

Monetary Policy in 2011: Unconventional and Necessary

Donald Kohn — Wed, 14 Dec 2011 10:34:00 -0500

In 2011, as in 2010, the Federal Reserve took “unconventional” steps to boost economic growth and speed a very sluggish recovery from the “great recession.” In the early part of the year the labor market seemed to be on an improving trajectory, with some substantial gains in employment in late winter. But by late spring, it was clear that the pace of economic growth had slowed. To some extent, temporary factors were responsible for the disappointing performance—the effects of the earthquake in Japan on auto supply chains and the sharp rise in energy prices, which ate into Americans’ spendable income. But the underlying pace of growth also seemed to be slower than expected and insufficient to reduce a still very elevated unemployment rate. Inflation was high for a time, but was expected to come down as energy and other commodity prices leveled out and then fell and as auto production ramped up, taking pressure off vehicle prices.

In its public pronouncements, the Federal Reserve was very clear that it thought that a variety of policy steps, for example in fiscal and housing policies, would be required to really get the economy moving. But it also saw itself as having scope to do more to help the recovery along, and in August and September it acted. In August the Federal Open Market Committee (FOMC) announced that it expected the federal funds rate to remain at its current extraordinarily low level at least through mid-2013; and in September it announced a "Maturity Extension Program" for its portfolio of Treasury securities whereby it would sell shorter-term securities and use the proceeds to buy longer-term securities.

Both of these actions helped to lower longer-term interest rates: The communication about rates by reducing market participants' views about the likely path of interest rates, or at a minimum lowering the odds on any tightening before mid-2013; the maturity extension (popularly known as Twist) by taking longer-term securities off the market, reducing the rates on these securities, and inducing their former holders to buy other long-term securities thereby spreading the fall in rates through the markets. Lower rates should boost spending by reducing the cost of borrowing to finance purchases, by bolstering the prices of equity and other assets so people are wealthier, and by reducing the foreign exchange value of the dollar making U.S. exports more competitive in global markets.

The actions were controversial. Three members of the FOMC dissented; they felt the steps were unnecessary, ineffective, and potentially counterproductive in that they would ultimately produce higher inflation. Those concerns were also prominent in political discourse; the Federal Reserve has been attacked quite vociferously by Republican candidates for president and the Republican congressional leadership took the unprecedented step of writing to the FOMC just before its September meeting urging it not to engage in the maturity extensions. Those dissents and "advice" clearly did not deter the FOMC, but they did keep it in the spotlight. At the same time, many economists and other commentators, focused on promoting a faster recovery, were making suggestions for monetary policy frameworks and intermediate targets that would encourage even easier policy for longer and loosen constraints from temporarily higher inflation. The sharp contrast in the policy positions being advocated highlights the difficulty of the policy choices and the challenges in explaining those choices to the public.

As 2011 draws to a close, the economy has shown some encouraging signs of slightly stronger growth, despite the bad news from the Euro area and the financial market volatility and risk aversion the problems there have imparted to global financial markets. Still, the obstacles to good growth remain considerable; in addition to European problems and continuing fiscal policy disarray here at home, the housing market remains in the doldrums and income growth for most households has been very weak. At the same time, inflation continues to abate. Thus before long the Federal Reserve could well be facing the same question it grappled with last summer: Is there anything it can do to help the recovery without endangering long-term price stability?

It's clear from the speeches of FOMC members and the minutes of FOMC meetings that a number of approaches are under consideration, falling into the two buckets we sampled last summer-communication to change expectations and portfolio adjustments to directly lower long-term rates. On the communication side, the FOMC seems to be contemplating being even more explicit about its expectations for the path of interest rates, making a more definitive commitment to an inflation target, and providing a fuller (and I'm sure it hopes more readily understood and accepted) explication of how its policy choices should help the country reach the Federal Reserve's dual objectives of stable prices and high employment. With respect to its portfolio, various FOMC members have raised the possibility of resuming purchases of mortgage-backed securities, hoping to help the housing market by reducing mortgage rates.

Meanwhile the Federal Reserve must prepare for the potential of even greater disruption from the problems in Europe. This fall it agreed with other major central banks to reduce the interest rate on the dollars it swaps with them. These swaps make dollars available to be lent out by foreign central banks to banks in their home countries or currency areas. European banks have faced mounting difficulties funding themselves in a variety of markets. The ECB has acted to make euros more readily available to them; the Federal Reserve's action should help the ECB supply dollars as well to slow the deleveraging process and associated tightening of credit conditions in Europe.

Stronger growth in the U.S. and more settled conditions in Europe would enable the Federal Reserve to begin to contemplate unwinding its unconventional polices and dimming the intense spotlight on its actions. Unfortunately, as 2011 draws to a close, that doesn't seem yet to be in the cards.

Authors

Donald Kohn