Financial stability and monetary policy.
Financial conditions should be an important component of the Fed's monetary policy reaction function. I don't think financial stability is a goal that really conflicts with the Fed's dual monetary policy mandate of maximum sustainable employment and price stability. If one accepts the notion that financial conditions are important, you want to conduct monetary policy in a transparent way. If you don't have financial stability, the Fed will lose its ability to influence economic activity. Even though financial stability is important, monetary policy itself is not well suited to deal with financial stability risks. We do have a problem. That's because the other alternatives available to the Fed to deal with financial stability concerns are actually quite limited.
Keywords Financial stability * Financial conditions * Monetary policy * Federal reserve
The topic is financial stability and the normalization of policy. I'm going to propose three short propositions, and then try to defend them. I'll conclude with some remarks about the current monetary policy framework, and why this is a good framework from a financial stability perspective.
Here are my three propositions. The first one is that financial conditions should be an important component of the Fed's monetary policy reaction function. The second is that financial stability, while people propose it as sort of an independent goal of monetary policy, I don't think it's a goal that really conflicts with the Fed's dual monetary policy mandate of maximum sustainable employment and price stability. Some people do see a conflict there. My third proposition is that monetary policy is not likely to be an effective tool to deal with financial stability risk.
Let me turn to the first proposition. People who know that I worked at Goldman Sachs for many years, and then went to the Federal Reserve Bank of New York, are probably not surprised that I think financial conditions should be a key component of the Fed's reaction function. That's something I've been arguing about for about 20 years. I'm pretty happy now that thinking has become a lot more mainstream. If you go read Fed communications and testimony, and the FOMC statements, you see the phrase, "Financial conditions," much more now than in the past. Why have I believed for a long time that financial conditions are so important? Well, there are two broad reasons.
The first reason is that the economy is much more affected by developments in the broad financial markets, what's happening to stock prices, bond yields, credit spreads, and the foreign exchange value of the dollar, than it is just by short-term interest rates. And, second, the linkage between short-term interest rates and financial conditions is highly variable. If there was no variability between the two, you could just focus on short-term rates. That would drive financial conditions, and you'd be done.
But, in fact, as we saw very recently, financial conditions can move a lot even when short-term rates aren't doing much of anything. Good examples of this occurred in the years preceding the financial crisis. Between 2004 and 2006, the FOMC raised its federal funds rate target by a quarter point at 17 consecutive meetings. The funds rate was raised from 1 to 5.25%. Now you would've thought that this would've tightened financial conditions quite a bit. But it didn't. During that period, the stock market rose, bond yields were flat to down, and credit spreads narrowed. Despite all this effort by the Fed to tighten monetary policy, they didn't get much affect on financial conditions. That's one reason why the economy didn't slow until the housing bubble really deflated.
If you think financial conditions are important, there's also another significant implication that I've been pushing for many years. You shouldn't be a big fan of monetary policy rules, like the Taylor Rule. If you go back and look at the FOMC transcripts, you'll see that I have, at times, claimed that the Taylor Rule gives me a headache. The problem is that when financial conditions are changing very quickly, or moving in the opposite direction to the federal funds rate, there's a big risk that the Taylor Rule will just give you the wrong monetary policy prescription.
I want to give you the best, most pertinent example of that. At the September 2008 FOMC meeting--this was two days after the bankruptcy of Lehman Brothers. At the time, and this is in the Teal books that are now part of the public record, the two most popular Taylor Rules, Taylor '93 and Taylor '99, were calling for federal funds rates of 4.3% and 3.7%, respectively.
Now, clearly, that was completely inappropriate given what was happening in the financial markets. But those rates were also way above the rate that the Fed actually had in place at the time, 2%, on its way to 0% at the end of the year.
If one accepts the notion that financial conditions are important, I think there are some pretty important implications for how you should conduct monetary policy. You want to conduct monetary policy in a transparent way, because you want financial market participants to think along with the Fed. As the economic data evolve, expectations concerning the interest rate outlook change. If the Fed is really transparent and clear about how they're thinking, and what their reaction function is, the markets can effectively ease and tighten as the information comes in, even before the Fed actually acts. What that means is that financial conditions can adjust in real time. You don't actually have to wait for the next FOMC meeting.
The second proposition is the Fed's goals with respect to financial stability don't conflict to any significant degree with its dual mandate objectives. I say this for a very simple reason. If you don't have financial stability, the monetary policy transmission, as a mechanism, won't work. The Fed will lose its ability to influence economic activity, and therefore obtain its objectives. As I see it, the financial crisis demonstrates that financial stability is a necessary condition for an effective monetary policy. It's not an either/or question, it's yes/and no question. Monetary policy seeks to achieve its dual mandate objectives not just at a particular point in time, but dynamically over time. That means that financial stability considerations are always relevant, and the Fed always needs to take those risks into account in the conduct of monetary policy. I don't think the Fed did this particularly well in the years preceding the financial crisis. But since then, there's been a lot of work done. Nellie set up a group at the Board that focuses exclusively on financial stability issues.
As part of the FOMC's monetary policy deliberations now, on a regular basis, the Fed takes up financial stability issues, and issues a financial stability report.
My third proposition is that even though financial stability is important, monetary policy itself is not well suited to deal with financial stability risks. Now some disagree with this. Former Governor Jeremy Stein used to argue that monetary policy has the advantage that it can get in all the cracks. But I think this is more than offset by the fact that monetary policy, unfortunately, is a very blunt instrument. You might have excesses in one particular area of the financial sector or of the economy that you want to address. But the problem is if you tighten monetary policy, in response, that will actually affect the entire economy. Monetary policy may not enable you to hit the target that you're actually shooting at.
Of course, the fact that monetary policy as a financial stability tool isn't very attractive means that we do have a problem. That's because the other alternatives available to the Fed to deal with financial stability concerns are actually quite limited. Macroprudential tools in the U.S., for example, putting limits on the housing loan-to-value ratio, are extremely difficult to implement. The ability of the Fed to influence developments in the nonbanking part of the financial sector is also very constrained. In fact, I think the situation's even worse than that. The Fed's scope for action in the financial stability space has actually eroded in recent years. For example, consider the guidance that the Fed issued on leveraged loans in 2014. That was ruled by the GAO as subject to congressional review. In other words, Congress could take up that guidance and overturn it. That's made the Fed much more cautious about using that kind of guidance.
Moreover, the tools available to the Fed to address financial stability have been trimmed back. If you look at section 13-3, the Fed can no longer lend to a single institution. But section 13-3 isn't so great anyway. It can't be used during peacetime. It only can be done if you're in the middle of a financial crisis.
I personally think that it would be better to have a standing lender of last resort for systemic nonbanking financial firms in peacetime, and in a trade for that have prudential supervision of those entities, rather than the current regime where they're not really subject to much prudential supervision, and there's no lender of last resort backstop for those entities. I think a standing lender of last resort facility in place that was broad based would reduce the risk of contagion and runs from nonbanking financial firms, one of the problems that we saw during the financial crisis.
Let me wrap up with just a few thoughts on the relationship between the Fed's choice of its monetary policy framework and financial stability. People don't often make that connection, but I think there is one.
As you're aware, very recently the Fed decided that they're going to stick with their current monetary policy framework. In other words, they're going to use the interest rates they pay on excess reserves as their primary tool. The system's going to have lots of excess reserves. The Fed will set the IOER at a level consistent with what they want to achieve in terms of monetary policy. That is in contrast to the old regime where the Fed was adding just a small amount of reserves to the system, intervening every day to make sure just the right amount of banking reserves were in the system to keep the federal funds rates balanced at their target.
I think the current regime has a number of advantages over the old system. It's much easier to operate. You don't have to do much on a day to day basis. The fact that there's a lot more reserves in the banking system also has some other benefits. It facilitates payment flows. It reduces daylight overdrafts. But beyond that there's a really important financial stability benefit. It means that banks don't have to trade reserves among themselves. That's because reserves are now abundant rather than scarce. That eliminates a whole unnecessary layer of financial intermediation. It eliminates all the counterparty risk between banks as they trade reserves among themselves, without disturbing the ability of banks to actually move money from savers to borrowers.
As a result, the current regime is actually safer, in terms of less bank counterparty risk, and the financial system is simpler, which I think is also an important benefit. It doesn't get much attention, but the regime the Fed switched to following the financial crisis is not only a good framework for conducting monetary policy, but it also has virtues on the financial stability front. Thanks.
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William C. Dudley is a Visiting Scholar, Princeton University and a former President & CEO, Federal Reserve Bank of New York. He became the 10th president and chief executive officer of the Federal Reserve Bank of New York on January 27, 2009. In that capacity, he served as the vice chairman and a permanent member of the Federal Open Market Committee (FOMC), the group responsible for formulating the nation's monetary policy. Previously, he served as an executive vice president of the Markets Group at the New York Fed, where he also managed the System Open Market Account for the FOMC. The Markets Group oversees domestic open market and foreign exchange trading operations and the provisions of account services to foreign central banks. Prior to joining the Bank in 2007, he was a partner and managing director at Goldman, Sachs & Company and was the firm's chief U.S. economist for a decade. Prior to joining Goldman Sachs in 1986, he was a vice president at the former Morgan Guaranty Trust Company. He was an economist at the Federal Reserve Board from 1981 to 1983. He received his doctorate in economics from the University of California, Berkeley in 1982 and a bachelor's degree from New College of Florida in 1974. In 2012, he was appointed the chairman of the Committee on the Global Financial System of the Bank for International Settlements (BIS). Previously, he served as chairman of the former Committee on Payment and Settlement Systems of the BIS from 2009 to 2012. He was a member of the board of directors of the BIS.
William C. Dudley (1)
Published online: 28 March 2019
Presentations made at the session Financial Stability and the Normalization of Monetary Policy at the NABE Economic Policy Conference, March 1, 2019.
[mail] William C. Dudley
(1) Princeton University, Princeton, NJ, USA
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