I was quoted in the Washington Post on Feb. 21 as saying that we had suffered for too long from “Lindsay Lohan” Congresses.[6] Like Ms. Lohan, the American Congress is a beautiful creation, blessed with enormous talent. But it has been waylaid by addiction—in the case of the Congress to spending and debt―and by a proclivity for shoplifting―in the case of the Congress to pocketing for their immediate gratification the economic future of our children and grandchildren and our grandchildren’s children.

Dallas Fed President Richard Fisher, speaking to reporters after a townhall-style event with local business leaders in this central Texas town, said he wants the dollar to be more than "the best horse in the glue factory."

The topic of the Atlanta Fed's annual financial markets conference this year is "Up From The Ashes: The Financial System After the Crisis."

Lockhart admitted that the title had been chosen earlier this year when, he said "we didn't anticipate fully Europe's sovereign debt troubles."

What's more, "We didn't predict the (Icelandic) volcano, so I'm not quite sure what ashes we're talking about," he joshed.

Sales present an unusual challenge for the Federal Reserve, because they require us to be able to make a particular kind of credible commitment. To understand this commitment, I think that it’s useful for me to talk through a situation that I see as roughly analogous.

Suppose Sarah owns two houses on the same block. Sarah decides that she wants to sell both houses. How should Sarah accomplish this change?

Clearly, if Sarah tries to sell both of her houses at once, she’s going to suffer some serious losses. The houses are on the same block, and so they end up competing with each other. Sarah needs to sell the houses slowly over time, so that they don’t compete with each other. Obviously, how slowly would depend on the particulars of market conditions. In my neighborhood right now, selling one house per year would be about the right speed.

So suppose Sarah puts one house on the market and tells everyone that she’s not going to sell the other one until a year later. Then, she sells the first house after a month. It sells at a high price, because the buyers don’t want to wait a whole year to get a house on this particular block.

At this stage, Sarah is supposed to wait a year to sell her second house. But Sarah was only planning to wait so long to sell the second house to protect the first house from competition. Once the first house is sold at a high price, she has no reason to wait. She will not fulfill her promise to wait a year.

Now think about what Sarah’s inability to wait means for her first sale. The potential buyers of the first house will all realize that they won’t have to wait a year to get a house on the same block. They will not be willing to pay a high price for the first house. And so Sarah’s lack of credibility means that the first house will necessarily sell at the same price as if she’s actually selling both houses at the same time.

The Federal Reserve faces exactly these same problems when undertaking to sell MBSs. Like Sarah, if the Federal Reserve were to sell its holdings of MBSs all at once, the sales price of the MBSs would be low. Long-term interest rates would spike up, which the Federal Reserve doesn’t want. Like Sarah, the Federal Reserve can avoid this problem by spacing its sales out over time. But just like Sarah, the Federal Reserve faces a commitment problem. The Federal Reserve wants to sell gradually in large part to ensure that its early sales of MBSs are at a high price. But once those early sales are made, the Federal Reserve has an increased incentive to sell its remaining MBSs rapidly. And as in Sarah’s case, if the market believes that the Federal Reserve will act on this increased incentive, the Federal Reserve will only be able to sell its early MBSs at a low price. Under this story, any MBS sales—no matter how small—may have big effects on long-term interest rates.

So far, sales sound pretty challenging! Fortunately, the analogy between the Federal Reserve and Sarah is incomplete. The difference gets at the very heart of what the Federal Reserve is about. Our structure—and in particular our independence from Congress and the president—means that we are set up to act in the public’s long-run interest, not to maximize short-run political or monetary gain. This structure means that, with the right set of policymakers on the FOMC, the Federal Reserve can credibly make and keep long-run commitments. Indeed, our credibility has been critical in the past crisis. Since July 2007, the monetary base has more than doubled, and the public debt has gone up by over 30 percent. At the same time, though, long-run inflationary expectations—as embedded in the prices of 5-year and 10-year inflation-indexed TIPS bonds—have moved slightly, if at all. The public and markets trust the Federal Reserve to keep inflation under control—and we will fulfill their trust.

Our structure means too that the Federal Reserve can credibly commit to selling its MBSs slowly over time. Along these lines, in testimony before Congress in late March, Chairman Bernanke described how he expected MBS sales to work. He emphasized that the timing of initiating sales, like any other move by the FOMC, would depend on its assessment of economic conditions. But once conditions are right, he suggested that the Federal Reserve could reduce its balance sheet by pre-announcing and then implementing a slow, gradual path of sales.

Well, Congressman, these specific allegations you've made I think are absolutely bizarre, and I have absolutely no knowledge of anything remotely like what you just described.

In response to a question from Rep. Ron Paul concerning the Fed's alleged role in financing Saddam Hussein's military and the Watergate break-in.

I especially appreciate Charlie’s mentioning my modest book collection. Part of that collection consists of documents and writings of British prime ministers. One of my favorites is Gladstone. He used to say that “only love has made more fools of men than contemplating the nature of money.” Yet, that is precisely what Charlie Evans and I and Ben Bernanke and our colleagues at the Federal Reserve do: We spend practically every waking hour contemplating the nature of money and the proper shape and conduct of our monetary system. So if you detect an air of distraction in Charlie Evans now and then, be kind. He has not gone mad or foolish on us; he is just hard at work noodling through our predicament and conjuring up Chicago’s recommendations on what we at the Federal Open Market Committee should do.

The U.S. economy will continue to suffer from a bout of anemia while the housing and financial markets settle down. I take comfort, however, in knowing that markets eventually clear if we at the Fed do our job and the other regulators and fiscal authorities do theirs. Even in the egocentric present, when gloomy analysts lament “unprecedented problems,” we must never lose faith in the economic machine that has propelled the U.S. economy to unprecedented prosperity.   

Here is a simple analogy to help you think about our effort. The Federal Reserve is charged with conducting monetary policy that sustains noninflationary economic growth. We have at our disposal a tool called the federal funds rate, which we set as the base lending rate for the economy. Think of the fed funds rate as a monetary spigot, and the Fed’s goal is keeping the lawn of the economy green and healthy. If we turn the spigot up too forcefully, we will flood and kill the grass with inflation. If we provide too little, the lawn turns brown, starved for money. To get the money from the spigot to the lawn requires a working system of pipes and sprinkler heads. The “shadow banking system,” however, looks like a Rube Goldberg device designed by a hydrologist on acid, with pipes and conduits that lead every which way and not always toward the goal of sustainable economic growth. Moreover, the system of pipes and outlets is clogged with the muck and residue of a prolonged and frenetic period of unrestrained growth and abuse. Until the confusion and the debris are cleared away, financial intermediaries will be reluctant to book new loans or incur additional risk. This retards the impact of additional monetary accommodation.

Thus, even as we have been cutting the fed funds rate—even as we have been opening the monetary spigot—interest rates for private sector borrowers have not fallen correspondingly, and rates for some borrowers have increased. The grass is turning brown.

Most of the quantitative studies of optimal monetary policy have also assumed that the shocks hitting the economy have a time-invariant Gaussian distribution, that is, a classical bell curve with symmetric and well-behaved tails. In reality, however, the distribution of shocks hitting the economy is more complex. In some instances, the uncertainty facing the economy is clearly skewed in one direction or another; again, this is likely when there are significant financial disruptions. The Federal Reserve often reports on our judgments regarding the degree of skewness and the associated economic costs by giving assessments of the “Balance of Risks” in the press releases that are issued following FOMC meetings.

In addition, at least in some circumstances, the shocks hitting the economy may exhibit excess kurtosis, commonly referred to as tail risk because the probability of relatively large disturbances is higher than would be implied by a Gaussian distribution. In that light, one element of the recent enhancements to the Federal Reserve’s communication strategy is that FOMC participants now provide assessments of the relative degree of uncertainty. For example, in the “Summary of Economic Projections”issued in late November, FOMC participants indicated that the degree of uncertainty regarding the economic growth outlook was relatively high compared to the average degree of uncertainty over the past two decades. This account could be interpreted as a statement that the Committee perceived the tail risk as unusually large.

With a nonquadratic objective function (consistent with the importance of uncertainty for the course of monetary policy) as well as nonlinear dynamics and non-Gaussian shocks, optimal monetary policy will also be nonlinear and will tend to focus on risk management.

Another key issue is that we need to greatly improve the quality of the written documents that go with this process. The current Monetary Policy Report is really terrible. It’s dull; it’s sex made boring. I don’t want to criticize too much, but it is. ... If it were a textbook, and I can tell you I know a lot about this, you wouldn’t sell one copy. [Laughter] So it’s a problem.

The analysis in our study suggests that although Iceland's economy does have some imbalances that will eventually be reversed, financial fragility is currently not a problem, and the likelihood of a financial meltdown is low.

The great Argentine footballer, Diego Maradona, is not usually associated with the theory of monetary policy. But his performance against England in the World Cup in Mexico City in June 1986 when he scored twice is a perfect illustration of my point. Maradona’s first “hand of God” goal was an exercise of the old “mystery and mystique” approach to central banking. His action was unexpected, time-inconsistent and against the rules. He was lucky to get away with it. His second goal, however, was an example of the power of expectations in the modern theory of interest rates. Maradona ran 60 yards from inside his own half beating five players before placing the ball in the English goal. The truly remarkable thing, however, is that, Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do. Because they expected Maradona to move either left or right, he was able to go straight on.

Monetary policy works in a similar way. Market interest rates react to what the central
bank is expected to do.

I have more in common with you graduates than people might think. After all, before long, after my term at the Federal Reserve comes to an end, I too will be looking for a job.