In addition to that we're looking particularly through the stress tests at financial institutions in a low interest rate environment. We have to worry about whether or not they're appropriately dealing with interest rate risk. We have been looking at that and, in fact, our current stress test
I would say at this stage broadly I don't see concerns. But there are pockets, a few things that we've identified that do concern us. For example, underwriting standards and leveraged lending clearly appear to be deteriorating. We have addressed that with supervisory guidance and special exams, and we'll continue to be very vigilant in that area. That's worrisome to us.
There are a few areas within asset price evaluations, broadly speaking. I wouldn't worry, but there are a few areas where I would be concerned. Many people have emphasized farm land as a concern, farm land prices.
So there are a few areas. We have regulatory and supervisory tools. To me, they should be the first line of defense. But I don't rule out monetary policy.

I think a major failure there was in regulation and in supervision, and not -- not just in monetary policy. So, I would say going forward, while I certainly recognize and my colleagues do that an environment of low interest rates can incent the development of bubbles, and we can't take monetary policy off table as a tool to use to address it, it's a blunt tool.
And macro-prudential policies -- many countries do things like impose limits on loan-to-value ratios, not because of safety and soundness of individual institutions, but because they see a housing bubble form and they want to protect the economy from it. We can consider tools like that, and certainly supervision and regulation should play a role and their more targeted policies.
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Nothing is more important than avoiding another financial crisis like the one that we just lived through. So, it's immensely high priority for the Federal Reserve to do what we can to identify threats to financial stability.
One approach that we're, you know, putting in place in part through our Dodd-Frank rulemakings is simply to build a financial system that is much more resilient to shocks. The amount of capital in the largest banking organizations is doubled. We do have a safer and sounder system, and that's important.
But detecting threats to financial stability, we are looking for those threats. I'd say my general assessment at this point is that I -- I can't see threats to financial stability that have built to the point of flashing orange or red. We don't see a broad-based buildup, for example, in leverage or very rapid credit growth. Asset prices generally do not appear to be out of line with traditional metrics. But this is something we're looking at very, very carefully.

So there are a number of reasons why asset purchases, while effective, while I think they have been important, are less -- less attractive tools than traditional interest rate policy. And that's the reason why we've relied primarily on interest rates, but used asset purchases as a supplement when we've needed it to keep forward progress. I think that, you know, obviously, there are some financial stability issues involved there. We look at the possibility that asset purchases have led to bubbly pricing in certain markets or in excessive leverage or excessive risk-taking. We don't think that that's happened to an extent, which is a danger to the system, except other than that, when those positions unwind, like we saw over the summer, they can create some bumpiness in -- in interest rate markets, in particular. Our general philosophy on financial stability issues is, where we can, that we try to address it first and foremost by making sure that the banking system and the financial system are as strong as possible -- if banks have a lot of capital, they can withstand losses, for example -- and by using whatever other tools we have to try to avoid bubbles or other kinds of financial risks. That being said, I don't think that you can completely ignore financial stability concerns in monetary policy, because we can't control them perfectly and there may be situations when financial instability has implications for our mandate, which is jobs and inflation, which we saw, of course, in the Great Recession. So it's a very complex issue. I think it will be many years before central banks have completely worked out exactly how best to deal with financial instability questions. Certainly, the first line of defense for us is regulatory and other types of measures, but we do have to pay some attention to that.

Regulatory policies can lean against emerging asset bubbles and the vulnerabilities that attend them by restraining financial institutions from excessively extending credit. In addition, such policies can build resilience in the financial system, enhancing its ability to absorb and shrug off unexpected losses from any source, including sharp asset price declines.

Of course, monetary policy also has the power to lean against the growth of asset bubbles. While there could be situations in which monetary policy might be needed to try to limit the growth of a bubble, in my opinion such use would represent a failure of regulatory policy, which represents a more tailored response than the flattening out of aggregate demand that would likely result from contractionary monetary policy.

The U.S. regulatory system is fragmented, and, hence, it takes time to choose and implement policies and calibrate them appropriately. It takes time to cooperate, coordinate, and harmonize responses. But such is today's imperative. We must complete in a timely fashion the post-Basel III and Dodd-Frank requirements. It is particularly important to increase the amount, and improve the quality, of required minimum capital; to continue stress testing and capital planning; and to reduce overreliance on unstable short-term wholesale funding. These reforms will build resilience to whatever shocks may come, and will reduce the potential for asset bubbles and excessive credit growth, leverage, maturity transformation, reliance on unstable short-term wholesale funding, and, thus, the potential for future financial crises.

Still, if regulators become fixated on the tools at the expense of compliance and enforcement, the tools themselves will be meaningless. Only when such tools--be they capital-focused, liquidity-focused, margin--and haircut-focused, or underwriting-focused--are fully embedded into a comprehensive system of prudential regulation will they reach their potential in mitigating the growth of asset bubbles and providing resiliency against the awful consequences attendant to their destruction.

“I don’t want to do it all at once, but I think we should begin to taper very soon and hopefully end it by the end of this year,” Plosser said today in an interview in Jackson Hole, Wyoming. “That would be a healthy thing for the economy. We can do it gradually.”

Fed Chairman Ben S. Bernanke said last month the Fed is on track to begin reducing its bond buying later this year and halt the program by around mid-2014 if the economy performs in line with central bank forecasts. Plosser, who doesn’t vote on monetary policy this year, has repeatedly spoken out against additional easing by the Fed.

“I’d like for us to start in September” to taper the purchases, Plosser said in the Bloomberg Television interview with Michael McKee to air July 15. “We don’t want to create another housing boom,” and “we have to be careful of the unintended consequences of our policies.”

In short, the recent crisis has underscored the need both to strengthen our monetary policy and financial stability frameworks and to better integrate the two. We have made progress on both counts, but more needs to be done. In particular, the complementarities among regulatory and supervisory policies (including macroprudential policy), lender-of-last-resort policy, and standard monetary policy are increasingly evident. Both research and experience are needed to help the Fed and other central banks develop comprehensive frameworks that incorporate all of these elements. The broader conclusion is what might be described as the overriding lesson of the Federal Reserve's history: that central banking doctrine and practice are never static.

But I do believe that big money does organize itself somewhat like feral hogs. If they detect a weakness or a bad scent, they’ll go after it.

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My personal feeling is that you don’t walk up to a lion and flinch.

Financial stability is a necessary prerequisite for an effective monetary policy.  There is a critical chain of linkages from monetary policy to banking and onwards to the real economy.  Financial stability is a necessary condition for those linkages to operate effectively.  Thus, it is a necessary condition for monetary policy to be able to achieve its economic objectives.  

MCKEE: Over the next five years, two of your researchers recently published a paper suggesting investors can expect abnormally high excess returns on the S&P. Do you agree with their conclusion?

DUDLEY: I learned not to follow forecasts of the stock market.

MCKEE: They base that on the current equity risk premium, which was 5.4 percent as of December, a record high. Does that concern you?

DUDLEY: Well, the equity risk premium is as high as it is because, one, PE ratios aren't that high. So if we take the price-earnings ratio of the stock market, it's around 16, 17. So you flip that to get the E-to-P ratio. It's around 6 percent. And you compared that to real interest rates. TIPS yields are negative. So that equity risk premium, that difference between the two is very, very wide. So that would argue that the stock market isn't grossly overvalued, but there are other ways of looking at it.

If you talk to Bob Shiller, who's a very respected academic who's looked at the stock market, you look at the stock market relative to the trailing 10-year earnings, the stock market actually looks quite expensive. So it really depends on what framework you use to evaluate the stock market.

[I]t is reasonable to ask whether systemic risks can in fact be reliably identified in advance... To respond to this point, I will distinguish, as I have elsewhere, between triggers and vulnerabilities. The triggers of any crisis are the particular events that touch off the crisis--the proximate causes, if you will. For the 2007-09 crisis, a prominent trigger was the losses suffered by holders of subprime mortgages. In contrast, the vulnerabilities associated with a crisis are preexisting features of the financial system that amplify and propagate the initial shocks. Examples of vulnerabilities include high levels of leverage, maturity transformation, interconnectedness, and complexity, all of which have the potential to magnify shocks to the financial system. Absent vulnerabilities, triggers might produce sizable losses to certain firms, investors, or asset classes but would generally not lead to full-blown financial crises

In light of the current low interest rate environment, we are watching particularly closely for instances of "reaching for yield" and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals. It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices. For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move. Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves.

The Fed vice chairman said the central bank’s low-rate policies are intended “to promote a return to prudent risk-taking” in credit markets. “Obviously, risk-taking can go too far,” Yellen said today at an International Monetary Fund panel discussion on monetary policy in Washington.

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“I don’t see pervasive evidence of rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would threaten financial stability,” Yellen said. “But there are signs that some parties are reaching for yield, and the Federal Reserve continues to carefully monitor this situation.”

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The Fed vice chairman said in her remarks that she was “persuaded” by Columbia University economist Michael Woodford’s theories that keeping interest rates “lower for longer” are suitable for times of high unemployment and weak demand. The FOMC’s decision to tie the benchmark interest rate to economic indicators aligns with the “lower for longer” approach, she said.

As reported by Bloomberg Businessweek

I still believe the following, which is that monetary policy is a very blunt instrument. If you are raising interest rates to pop an asset bubble, even if you were sure you can do that, you might, at the same time, be throwing the economy into recession, which kind of defeats the purpose of monetary policy.

And therefore, I think the first line of defense—I mean, I think, we have a sort of a tripartite line of defense. We start off with very extensive and sophisticated monitoring at a much higher level and much more comprehensively than we’ve had in the past. Then we have supervision and regulation, where we work with other agencies to try to cover all the empty or uncovered areas in the financial system. And then, in addition, we try to use communication and similar tools to affect the way that financial markets respond to monetary policy. So we do have some first lines of defense, which I think should be used first.

That being said, you know, I think that given the problems that we’ve had—not just in the United States, but globally in the last 15, 20 years—that we need to at least take into account these issues as we make monetary policy. And I think most of the people on the FOMC would agree with that. What that means exactly depends on the circumstances. I think if the economy is in very weak condition and interest rates are very low for that purpose, it’s very difficult to contemplate raising rates a lot because you’re concerned about some sector in the financial sphere. On the other hand, if you’re in an expansion and there’s a credit boom going on, that—the case in that situation for making policy a little bit tighter might be better.

So, as I’ve said many times, I have an open mind in this question. We’re learning; all central bankers are learning. But I think I still would agree with the point I made in my very first speech in 2002, as a Governor at the Federal Reserve, where I argued that the first line of defense ought to be the more targeted tools that we have, including regulatory tools and, to some extent, macroprudential tools like some emerging markets use.

While some of the more notorious pre-crisis components of the shadow banking system are probably gone forever, current examples include money market funds, the triparty repo market, and securities lending.

From the perspective of financial stability, the parts of the shadow banking system of most concern are those that create assets thought to be safe, short-term, and liquid--in effect, cash equivalents. For a variety of reasons, demand for such assets has grown steadily in recent years, and is not likely to reverse direction in the foreseeable future. Yet these are the assets whose funding is most likely to run in periods of stress, as investors realize that their resemblance to cash or insured deposits in normal times has disappeared in the face of uncertainty about their underlying value.