My view is that these [post-crisis] regulations are new, and we should be willing to adjust them as we learn. That said, we should also recognize that some reduction in market liquidity is a cost worth paying in helping to make the overall financial system significantly safer.

We should distinguish between systemic risk and market risk. The risks to investors generally represent market risk and do not appear to pose risks to the financial system as a whole. The movement of these risks away from the nation's most systemically important financial institutions is one of many reasons that they are far stronger and more resilient than before the crisis.

Tausche: So do you think the system really would be more secure if you broke up the banks and gave the Fed and the U.S. economy three or more new pure play investment banks that they would have to hold capital against and would still have inherent risk in the business model but not cushioned by other business units? Would that really be the ideal outcome for you for the economy?

Kashkari: Well, we haven't decided what the ideal structure looks like. What I’m saying is and what we in Minneapolis are saying is a bunch of these transformational solutions were taken off the table in 2010. It was too – they are too bold coming out of the crisis. I'm saying now is the time to reflect on the last seven or eight years. What have we learned, what progress has been made, what gaps remain? Breaking up the banks is one of the options that we looked at yesterday, Professor Johnson at MIT talked about it. Professor Admati from Stanford talked about increasing the capital requirements so banks are so strong they virtually can't fail. You can never eliminate all risk and I don't think we would want to, but I think we can go further than we've gone today. And it's all about cost benefit analysis. Where's the optimal safety versus cost versus risk for the economy and for the country?

The immediate market response, and for a number of weeks, to the Fed [liftoff] decision was quite tranquil. It was a decision that I believe had been well communicated and was expected, and there was very little market reaction.

Around the turn of the year we began to see more volatility in financial markets. Some of the precipitating factors seem to be the movement in Chinese currency and the downward move in oil prices. I think those things have been the drivers and they have been associated with broader fears that have developed in the market about the potential for weakening global growth, with spillovers to inflation, so I don't think it's mainly our policy.

Although post-crisis regulatory changes have likely increased the costs of market making, markets were already undergoing dramatic changes well before the crisis. High-frequency and algorithmic trading firms already accounted for a large and growing share of transactions in the interdealer market, altering the speed and nature of market making. As traditional dealers have lost market share, they have sought to remain competitive by internalizing a greater share of their customer trades, finding matches between their own customers and keeping those trades off the public interdealer markets. But internalization does not eliminate the need for a public market, which is where price discovery mainly occurs. Dealers need to place the orders that they cannot internalize onto that market, and at times of market stress such as on October 15, they will likely need to put most of their orders onto the public market.

I continue to feel that cumulative progress is consistent with liftoff relatively soon. In weighing the timing of a liftoff decision, I'm trying to keep the endgame in focus. For me, the endgame is to begin and sustain an orderly process of normalization when the time is right and when the balance of risks gives us confidence we will not be forced to reverse course. It's also vital, in my view, to keep attention mostly on the real side—the Main Street economy. Financial market gyrations should be influential in a decision only to the extent they could plausibly affect real activity through pretty clear and understood channels.

If effective monetary policy means taking away the punch bowl just as the party gets going, then effective financial stability policy might mean taking away the punch bowl before the guests have even arrived because the risks to financial stability build up over time and action likely needs to be taken earlier in order to be effective. Contributing to the need for early action is the challenge of having to coordinate policy action across multiple regulatory bodies. If the need for monetary policy to be forward looking is a difficult concept for the public to grasp, the need for financial stability policy to act well before there are clear signs of instability may be even more difficult to explain. In thinking about the design of the financial stability regime, it might behoove policymakers to consider whether it would be better for central banks to keep their monetary policy and financial stability policy discussions separate so as to avoid jeopardizing the independence of monetary policy.

Notwithstanding the fact that the law does not prescribe broad structural changes, some observers may judge whether reform has gone far enough based on the extent of changes in the scope or scale of the U.S. systemic banking institutions relative to the crisis. These eight banking institutions now hold $10.6 trillion in total assets and account for 57 percent of total assets in the U.S. banking system today--not materially different from the $9.4 trillion and 60 percent of total assets in 2009. And while some of the U.S. systemic banking institutions have reduced their capital markets activity, they remain the largest dealers in those markets. To be fair, we are entering an important period when the more stringent standards that we are putting in place to reduce expected losses to the system should inform the cost-benefit analysis of these institutions' size and structure. As standards for systemically important firms tighten, some institutions may determine that it is in the best interest of their stakeholders to reduce their systemic footprint.

Although anecdotes of diminished liquidity abound, statistical evidence is harder to come by. Indeed, there is relatively little evidence of any deterioration in day-to-day liquidity. Traditional measures of liquidity, such as bid-asked spreads, are generally no higher than they were pre-crisis. Turnover, an alternative measure of day-to-day liquidity, is lower, but it is unclear whether this reflects changes in liquidity or perhaps changes in the composition of investors. The share of bonds owned by entities that tend to hold securities until maturity, such as mutual funds and insurance companies, has increased in recent years, which would lead turnover to decline even with no change in market liquidity. In some markets, the number of large trades has declined in frequency, which could signal reduced market depth and liquidity, but could also reflect a shift in market participants' preferences toward smaller trade sizes.

Finding a high-fidelity gauge of liquidity resilience is difficult, but there are a few measures that could be indicative, such as the frequency of spikes in bid-asked spreads, the one-month relative to the three-month swaption implied volatility, the volatility of volatility, and the size of the tails of price-change distributions for certain assets. We see some increases in the values of these indicators, which provide some evidence that liquidity may be less resilient than it had been previously. But this evidence is not particularly robust, and, given the limitations of the existing data, it is difficult to know the extent to which liquidity resilience may have declined.

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We are in the early stages of data-based analysis of possible recent changes in the resilience of market liquidity. An upcoming study of the October 15 event will shine some light on the functioning of the U.S. Treasury market, but there is still much we need to learn. More broadly, at the Board, we will closely monitor and investigate the extent of changes in the resilience of liquidity in important markets, while deepening our understanding of different contributors and how market participants are adapting.

St. Louis Federal Reserve Bank President James Bullard warned Tuesday that low interest rates may be feeding a new asset price bubble.

Bullard said he is open to weighing evidence that conditions are different than in the late 1990s when the stock market went through a high-tech "dot.com bubble," but said it appears to him that stock valuations, particularly in the tech-heavy Nasdaq Composite index are high.

Bullard cited a number of what he considers danger signs of a possible stock bubble and asked "do low interest rates feed this process?"

"The net wealth to disposable income ratio has returned to a high level," he observed in remarks prepared for delivery to an Emerging Venture Leaders Summit. "It has been high and volatile since the mid-1990s."

He also said the Nasdaq is "near a high in real terms" and "the price-earnings ratio is relatively high but still below the 1990s peak."

"Can the U.S. escape the boom-bust cycle this time?"

Answering his own question, Bullard said, "My view is that low interest rates tend to feed bubble processes."

Bullard, who will be a voting member of the Fed's policymaking Federal Open Market Committee next year, said "the Fed should hedge against the possibility of a third major macroeconomic bubble in the coming years by shading interest rates somewhat higher than otherwise.

"The benefit would be a longer, more stable economic expansion," he added.

As we consider the decision of policy rate normalization, we are mindful of possible spillovers to other economies, including emerging market and developing economies. In an interconnected world, fulfilling the Federal Reserve's objectives under its dual mandate requires that we pay close attention to how our own actions affect other countries and how developments abroad, in turn, spill back into U.S. economic conditions.

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In order to minimize the likelihood of surprises and thus avoid creating unnecessary market and policy volatility, we are striving to communicate our policy strategy clearly and transparently. Beyond communicating our intentions, we also emphasize that monetary policy normalization in the United States will occur in the context of a strengthening U.S. economy, which should benefit the emerging market and developing economies.

Still, one feature of the era after the first increase of the federal funds rate will, in all likelihood, be higher U.S. and global interest rates compared with their extraordinarily low levels of recent years. The increase in global interest rates could cause investors to adjust their portfolios, triggering capital outflows from emerging market and developing economies.

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Once we begin to remove policy accommodation, the Committee's assessment is that economic conditions will likely warrant raising the federal funds rate only gradually. Thus, we expect that the target federal funds rate will remain for some time below levels viewed as normal in the longer run. But that is only a forecast, and monetary policy will, in practice, be determined by the data--primarily data on inflation and unemployment.

[L]et me close by addressing a question that often arises about the use of a supervisory stress test, such as those conducted by the Fed, with common scenarios and models. Such a test may create the possibility of, in former Chairman Bernanke's words, a "model monoculture," in which all models are similar and all miss the same key risks. Such a culture could possibly create vulnerabilities in the financial system. At the Fed we try to address this issue, in part, through appropriate disclosure about the supervisory stress test. We have published information about the overall framework employed in various aspects of the supervisory stress test, but not the full details that banks could use to manage to the test. This--making it easier to game the test--is the potential negative consequence of transparency that I alluded to earlier.

I think our experience suggests that it's hard to have great confidence in predicting what the market reaction will be to Fed decisions, and there have been surprises in the past. I don't think the committee anticipated that its decision would cause the "taper tantrum."

And all I can say is that uncertainty in the markets at this point about long-term rates doesn't appear to be unusually high. And we can only do what is in our power to attempt to minimize needless volatility that could have repercussions for other countries or for financial stability more generally, and that is to attempt to communicate as clearly as we can about our policy decisions, what they will depend on and what we're -- what we're looking at.

I think that the Federal Reserve has actually already had a sea change in terms of how they think about the risks of financial instability and the risk of asset bubbles. I think prior to the crisis I think the view was - could be characterized by Alan Greenspan's views on the subject, which was basically bubbles are very hard to identify in real time, monetary policy not so effective in responding to asset bubbles, so let's just wait for the asset bubbles to burst and we'll clean up the asset - and we'll clean up after the fact. Now that didn't work out so well in the financial crisis. And it's actually a position I did not agree with even prior to the financial crisis. I think the new view, which is one that I've shared for a long time, which is I think you need to try to identify asset bubbles in real time. And I think you have to look around and see what tools you have, either monetary policy, or macro-prudential tools or just the bully pulpit to try to address those emerging imbalances.

So I think that financial stability is very definitely on the Fed's radar. And it's been so for quite awhile, and the reason very simple, Matt, I mean you can't have an effective monetary policy if you have financial instability, as we saw in the crisis. Financial instability essentially rendered monetary policy pretty impotent for awhile. So I think that financial stability is a necessary condition to have an effective monetary policy.

The fact that the Board of Governors has set up this financial stability committee it's just a logical next step. We were already looking at this. We've been looking at this for several years very carefully. We had regular briefings at the FOMC on financial stability issues. The Conference of Presidents of the 12 Federal Reserve banks have their own committee on financial stability. We - there's an office of financial stability at the Board of Governors staffed by a lot of very talented people that are looking at this. So I don't think you should think of the new committee that Stanley Fischer's going to head as sort of a big new step. I think it's just the next step in an evolution forcing us to think a lot more clearly and harder around financial stability.

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I think the challenge for the U.S. in terms of financial stability is what macro-prudential tools are available to deal with incipient bubbles, and how do you actually get those tools implemented. I think in the U.S. it's a little bit more challenging than some other countries because the regulatory apparatus is pretty complex. Different agencies have different responsibilities. We do have a financial stability oversight council though that can actually be a forum for taking these things on, but and that's what we have to do. We have to figure out how to actually do, implement macro- prudential tools to respond to incipient bubbles. And that's going - we'll have to see if we can do that well or not.

ASMAN: Now, there is also a charge, uh, and this one, I think, may be more on target, that the Fed is a little too concerned these days, for the past year or so, about how the markets will react to its policies. That is, there are people like Paul Volcker, who really squashed inflation by his actions back in the day. He didn't give a damn what the market felt about what needed to be done to maintain the integrity of the dollar.

Is it true that the Fed is paying too much attention to what the market is doing?

FISHER: I think there are some differences of opinion on that. I don't agree with that. I -- by the way, was trained by the same man that trained Paul Volcker. I'm very much a Volckerite. And I think what we should focus in on is the real economy.

I have argued publicly that 0 interest rates and this massive monetary accommodation, obviously, has distorted the markets. These valuations are very, very high, because the rates are so much lower because interest rates are so low. And eventually, they'll have to be an adjustment.

But, you know, the real thing is whether the real economy, putting people back to work, keeping inflation under control, propelling the economy forward toward greater prosperity, that's what I worry about.

And I am less worried about the money changers and whether or not we're going to disappoint some of them. As long as it doesn't lead to crippling the economy...