Tighter financial conditions abroad do spill back into the U.S. economy, and policymakers must take this into account in their assessment of appropriate monetary policy. Of course, this does not mean that we will let market volatility dictate our policy stance. There is no such a thing as a “Fed put.” What we care about is the country’s growth and inflation prospects, and we take financial market developments into consideration only to the extent that they affect the economic outlook.

Of course, I am aware of, and closely monitoring, potential risks. But I want to be clear what that means. It’s often said that the economy isn’t the stock market and the stock market isn’t the economy. That’s very true. Short-term fluctuations or even daily dives aren’t accurate reflections of the state of the vast, intricate, multilayered U.S. economy. And they shouldn’t be viewed as the four horsemen of the apocalypse. Remember, the expansion of the 1980s wasn’t derailed by the crash of ’87, and we sailed through the Asian financial crisis a decade later. I say “remember”—some of you here will actually remember and others will remember it from your high school history class.

From a policymaker’s perspective, my concern isn’t as simple as whether markets are up or down. Watching a stock ticker isn’t the way to gauge America’s economic health. As Paul Samuelson famously said, the stock market has predicted nine out of the past five recessions. What’s important is how it impacts jobs and inflation in the U.S.

At the risk of puncturing some of the more colorful theories about what drives the Fed, I lay before you the cold, hard truth: Fed policymakers are even more boring than you think. Because all we see is our mandate. How does this affect American jobs and growth? What does this mean for households’ buying power?

"I am unconvinced that monetary policy should be used as an explicit tool" for stabilizing financial markets, Williams said at the American Economic Association. "The tradeoffs are not favorable at all" in terms of reaching the Fed's goals of stable inflation and full employment, and indeed, targeting financial stability with rate policy could end up undermining the Fed's credibility on its inflation goal.

At [the October 27-28] meeting, the Fed removed language it had inserted in its September statement expressing concern that global weakness could hinder U.S. growth and further depress inflation. Until China's surprise devaluation of its currency on Aug. 11 sent financial markets into a tailspin, the Fed had been expected to begin raising rates in September.

In his interview with the AP, Williams said the Fed had been correct to note these developments in its September statement. But since then, he said, markets have stabilized.

"What has happened in the last six weeks is that volatility has come down," Williams said. "I think the uncertainties, risks, seem to have ebbed."

Though I remain concerned that the U.S. macroprudential toolkit is not large and not yet battle tested, that does not imply that I see acute risks to financial stability in the near term. Indeed, banks are well capitalized and have sizable liquidity buffers, the housing market is not overheated, and borrowing by households and businesses has only begun to pick up after years of decline or very slow growth.
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Nonetheless, the limited macroprudential toolkit in the United States leads me to conclude that there may be times when adjustments in monetary policy should be discussed as a means to curb risks to financial stability. The deployment of monetary policy comes with significant costs.

It would be hard to formulate a quantitative metric of long-run financial stability. It would be hard for policymakers to know how to treat deviations from that metric. Finally, the lags associated with the influence of monetary policy on this metric are highly uncertain. These challenges mean that adding a financial stability mandate would likely generate more public uncertainty about policy choices and economic outcomes. In considering whether to add a third mandate, these potentially large costs would have to be weighed against whatever benefits might be identified.

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.

[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.

We are coming at this from a position of strength, Mr. Williams said. As we collect more data through this spring, as we get to June or later, I think in my own view well be coming closer to saying there are a constellation of factors in place to make a call on rate increases, he said.

I dont see any reason at all that we should raise rates before June. Thats out, he said. Maybe in June it would be the time to contemplate raising rates. Maybe well want to wait longer, but at least it will be an option to decide on, he said. The Fed has a scheduled policy meeting June 16-17.

Mr. Williams said he would like the Fed to drop its commitment to be patient in deciding when to raise rates because it limits the central banks options on when to move. You would want to remove the patient language only to have the ability to make those data-dependent decisions later in the year, he said.
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Mr. Williamss confidence about the monetary policy outlook is rooted in what he sees as labor market strength. He believes weak inflation, which has undershot the central banks 2% target for more than two years, will rise to its desired level by the end of 2016.

He also said falling short on the inflation target wont necessarily stay the Feds hand on rate increases. Because Fed rate actions have to take account of their effect over the long run, its very likely we would start raising interest rates even with inflation below 2%, he said.

Mr. Williams said it is likely that the Fed will see a hot labor market that should in turn produce the wage pressures that will drive inflation back up to desired levels. He said much of the weakness seen now in price pressures is due to the sharp drop in oil prices, which he said isnt likely to last.

The cosmological constant is that if you heat up the labor market, get the unemployment rate down to 5% or below, thats going to create pressures in the labor market causing wages to rise, he said.

Mr. Williams said there is a disconnect between Fed officials and markets expectations for the path of short-term rates. He said he hopes that can be bridged by effective communication explaining central bank policy choices.

I have no desire to raise rates just to raise rates. Im not worried about financial stability, personally. Im not worried about risks of low interest rates on their own. I am focused on the very pedestrian issue of achieving the Feds employment and inflation goals, and will make policy with those factors in mind, Mr. Williams said.

He said that when the Fed does raise rates, he would prefer a gradual path, but he doesnt expect it to replay the series of steady, small rate increases seen a decade ago. He said he could see the Fed taking whatever action is needed at a given meeting, rather than putting rates on a steady upward path.

But others argued for a more activist approach, with monetary policy being used to try to stem developing imbalances before they caused harm to the real economy. BIS and OECD economist William White characterized these approaches as clean or lean.13 That is, should monetary policy clean up the mess after a bubble bursts, or should it lean against a bubble that appears to be forming?

The Fed needs a framework to incorporate systemic risk mitigation into monetary policymaking. Systemic risk creates a mean-variance trade-off for policy.

It has become a mantra in central banking that robust micro- and macro-prudential regulatory and supervisory policies should provide the first and second lines of defense for financial stability. Still, some are concerned that is not enough and call for including a financial stability goal in the monetary policy mandate as well. Doing so, however, raises the important issue of how one commits to taking financial stability into account while simultaneously preserving the nominal anchor. If financial stability and price stability goals are in conflict, there is a risk that price stability will be subordinated to the financial stability goal, with serious long-run consequences for economic performance.

This issue of the appropriate role of monetary policy in fostering financial stability at the potential cost to inflation goals has been playing out in policy debates and decision in two Scandinavian countries: Norway and Sweden These examples illustrate the tradeoff between price and macroeconomic goals on one hand, and financial stability goals on the other, when using monetary policy to mitigate risks to financial stability.

So far, its unclear how durable a slippage in inflation expectations resulting from a focus on financial stability concerns will prove to be. Nonetheless, it is an apt reminder of the potential long-run costs of losing sight of the price stability mandate. The steadfastness of the nominal anchor in most advanced economies has been, and continues to be, a key factor in many central banks ability to maintain low and stable inflation during and after the global financial crisis. It was forged over many years of consistent commitment to price stability and successfully taming the inflation dragon. If the anchor were to slip, it would wreak lasting damage to a central banks control over both inflation and economic activity, at considerable cost to the economy. This applies equally to deviations above and below the target.

So far, I have focused on the immediate spillovers of U.S. monetary policy abroad and the feedback of those effects to the U.S. economy. More tacitly than explicitly stated has been my view that the United States is not just any economy and, thus, the Federal Reserve not just any central bank. The U.S. economy represents nearly one-fourth of the global economy measured at market rates and a similar share of gross capital flows. The significant size and international linkages of the U.S. economy mean that economic and financial developments in the United States have global spillovers--something that the IMF is well aware of and has reflected in its increased focus on multilateral surveillance. In this context and in this venue, it is, therefore, important to ask, what is the Federal Reserve's responsibility to the global economy?

First and foremost, it is to keep our own house in order. Economic and financial volatility in any country can have negative consequences for the world--no audience knows that more than this one--but sizable and significant spillovers are almost assured from an economy that is large

As the recent financial crisis showed all too clearly, to achieve this objective, we must take financial stability into account [O]ur efforts to stabilize the U.S. financial system also have positive spillovers abroad.

These financial stability responsibilities do not stop at our borders, given the size and openness of our capital markets and the unique position of the U.S. dollar as the world's leading currency for financial transactions.

But I should caution that the responsibility of the Fed is not unbounded. My teacher Charles Kindleberger argued that stability of the international financial system could best be supported by the leadership of a financial hegemon or a global central bank. But I should be clear that the U.S. Federal Reserve System is not that bank. Our mandate, like that of virtually all central banks, focuses on domestic objectives. As I have described, to meet those domestic objectives, we must recognize the effect of our actions abroad, and, by meeting those domestic objectives, we best minimize the negative spillovers we have to the global economy. And because the dollar features so prominently in international transactions, we must be mindful that our markets extend beyond our borders and take precautions, as we have done before, to provide liquidity when necessary.