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.

...

 

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.

Prior to the global financial crisis, a rough consensus had emerged among academics and monetary policymakers that best-practice for monetary policy was flexible inflation targeting. In the U.S., flexible inflation targeting is implied by the dual mandate given to the Fed, under which monetary policy is required to take into account deviations of both output and inflation from their target levels. But even in countries where the central bank officially targets only inflation, monetary policymakers in practice also aim to stabilize the real economy around some normal level or path.

…

Another important question is whether monetary policymakers should alter their basic framework of flexible inflation targeting to take financial stability into account. My answer to that question is that the "flexible" part of flexible inflation targeting should include contributing to financial stability, provided that it aids in the attainment of the main goals of monetary policy. The main goals in the United States are those of the dual mandate, maximum employment and stable prices; in other countries the main goal is stable prices or low inflation.

Let me cut to the chase: I am increasingly concerned about the risks of our current monetary policy. In a nutshell, my concerns are as follows:

First, I believe we are experiencing financial excess that is of our own making. When money is dirt cheap and ubiquitous, it is in the nature of financial operators to reach for yield. There is a lot of talk about macroprudential supervision as a way to prevent financial excess from creating financial instability. My view is that it has significant utility but is not a sufficient preventative. Macroprudential supervision is something of a Maginot Line: It can be circumvented. Relying upon it to prevent financial instability provides an artificial sense of confidence.

Second, I believe we are at risk of doing what the Fed has too often done: overstaying our welcome by staying too loose too long. We did a good job in staving off the deflationary and depression risks that were present in the aftermath of the 200709 financial crisis. We now risk falling into the trap of fighting the last war rather than the present challenge. The economy is reaching our desired destination faster than we imagined.

Third, should we overstay our welcome, we risk not only doing damage to the economy but also being viewed as politically pliant.

There are some who believe that macroprudential supervision will safeguard us from financial instability. I am more skeptical. Such supervision entails the vigilant monitoring of capital and liquidity ratios, tighter restrictions on bank practices and subjecting banks to stress tests. Although these macroprudential disciplines are important steps in reducing systemic risk, I also think it is important to remember that this is not your grandparents financial system. The Federal Reserve and the banking supervisory authorities used to oversee the majority of the credit system by regulating depository institutions; now, depository institutions account for no more than 20 percent of the credit markets. So, yes, we have appropriately tightened the screws on the depository institutions. But there is a legitimate question as to whether these safeguards represent no more than a financial Maginot Line, providing us with an artificial sense of confidence. [T]he term Maginot Line is commonly used to connote a strategy that clever people hoped would prove effective, but instead fails to do the job.

I was uncomfortable with QE3, the program whereby we committed to a sustained purchase of $85 billion per month of longer-term U.S. Treasury bonds and mortgage-backed securities (MBS). I considered QE3 to be overkill at the time, as our balance sheet had already expanded from $900 billion to $2 trillion by the time we launched it, and financial markets had begun to lift off their bottom. I said so publicly and I argued accordingly in the inner temple of the Fed, the Federal Open Market Committee (FOMC), where we determine monetary policy for the nation. I lost that argument. My learned colleagues felt the need to buy protection from what they feared was a risk of deflation and a further downturn in the economy. I accepted as a consolation prize the agreement, finally reached last December, to taper in graduated steps our large-scale asset purchases of Treasuries and MBS from $85 billion a month to zero this coming October. I said so publicly at the very beginning of this year in my capacity as a voting member of the FOMC. As we have been proceeding along these lines, I have not felt the compulsion to say much, or cast a dissenting vote.

However, given the rapidly improving employment picture, developments on the inflationary front, and my own background as a banker and investment and hedge fund manager, I am finding myself increasingly at odds with some of my respected colleagues at the policy table of the Federal Reserve as well as with the thinking of many notable economists.

[W]ith low interest rates and abundant availability of credit in the nondepository market, the bond markets and other trading markets have spawned an abundance of speculative activity. There is no greater gift to a financial market operatoror anyone, for that matterthan free and abundant money. It reduces the cost of taking risk. But it also burns a hole in the proverbial pocket. It enhances the appeal of things that might not otherwise look so comely. I have likened the effect to that of strapping on what students here at USC and campuses elsewhere call beer goggles. This phenomenon occurs when alcohol renders alluring what might otherwise appear less clever or attractive. And this is, indeed, what has happened to stocks and bonds and other financial investments as a result of the free-flowing liquidity we at the Fed have poured down the throat of the economy.

Many financial pundits protest that weaning the markets of ber-accommodation, however gradually, risks wreaking havoc, so dependent on central bank largess have the markets become. As a former market operator, I am well aware of this risk. As I have said repeatedly, a bourbon addict doesnt go from Wild Turkey to cold turkey overnight. But even if we stop adding to the potency of the financial punchbowl by finally ending our large-scale asset purchases in October, the punch is still 108 proof. It remains intoxicating stuff.

I believe the time to dilute the punch is close upon us. The FOMC could take two steps to accomplish this after ending our large-scale asset purchases.

First, in October, we could begin tapering our reinvestment of maturing securities and begin incrementally shrinking our portfolio. I do not think this would have significant impact on the economy. Some might worry that paring our reinvestment in MBS might hurt the housing market. But I believe the demand for housing is sufficiently robust to continue improving despite a small rise in mortgage rates. The economy is improving. An acceleration of income growth that will result will likely buttress a recovery in housing and compensate for the loss of momentum that occurred during the winter freeze. (As a sidebar, I note that according to the National Association of Realtors, overseas buyers and new immigrants accounted for $92 billion, or 7 percent, worth of home purchases in the U.S. in the 12 months ended in March, with one-fourth of those purchases coming from Chinese buyers. As Californians, you might find it of interest that Los Angeles was the top destination for real estate searches from China on realtor.com; San Francisco was second; Irvine was third.)

Importantly, I think that reducing our reinvestment of proceeds from maturing securities would be a good first step for the markets to more gently begin discounting the inevitable second step: that early next year, or potentially sooner depending on the pace of economic improvement, the FOMC may well begin to raise interest rates in gradual increments, finally beginning the process of policy normalization.

To get a sense of some of the effects of excess liquidity, you need look no further than Neil Irwins front-page, above-the-fold article in the July 8 issue of the New York Times, titled From Stocks to Farmland, Alls Booming, or Bubbling. Welcome to the Everything Bubble, it reads...

I spoke of this early in January, referencing various indicia of the effects on financial markets of the intoxicating brew we (at the Fed) have been pouring. In another speech, in March, I said that market distortions and acting on bad incentives are becoming more pervasive and noted that we must monitor these indicators very carefully so as to ensure that the ghost of irrational exuberance does not haunt us again. Then again in April, in a speech in Hong Kong, I listed the following as possible signs of exuberance getting wilder still:

-The price-to-earnings, or P/E, ratio for stocks was among the highest decile of reported values since 1881;
-The market capitalization of U.S. stocks as a fraction of our economic output was at its highest since the record set in 2000;
-Margin debt was setting historic highs;
-Junk-bond yields were nearing record lows, and the spread between them and investment-grade yields, which were also near record low nominal levels, were ultra-narrow;
-Covenant-lite lending was enjoying a dramatic renaissance;
-The price of collectibles, always a sign of too much money chasing too few good investments, was arching skyward.

I concluded then that the former funds manager in me sees these as yellow lights. The central banker in me is reminded of the mandate to safeguard financial stability.

Since then, the valuation of a broad swath of financial assets has become even richer, or perhaps more accurately stated, more careless. It is worrisome, for example, that covenant-lite lending has continued its meteoric revival and has even surpassed its 2007 highs.

[O]ne has to consider the root cause of the Everything Boom. I believe the root cause is the hyper-accommodative monetary policy of the Federal Reserve and other central banks.

At some point you cross the line from reviving markets to becoming the bellows fanning the flames of the Booming and Bubbling that Neil Irwin writes about. I believe we have crossed that line. I believe we need an adjustment to the stance of monetary policy.

With respect to bubbles, I've stated my strong preferences to use macroprudential and supervision policies to address areas where we see concerns. And as I mentioned, we're doing that in the case of, for example, leveraged lending. But I would never take off the table totally the idea that monetary policy might be needed to address financial stability concerns. To me, now I don't see financial stability concerns at the level at this point where they need to be a key determinant of monetary policy. And it's not my preference as a first line of defense by any means. But I would never want to take off the table that in some circumstances, particularly if macroprudential tools failed, monetary policy might be called on to play a role. But we're not there.

It is not uncommon to hear it suggested that the crisis could have been prevented or significantly mitigated by substantially tighter monetary policy in the mid-2000s. At the very least, however, such an approach would have been insufficient to address the full range of critical vulnerabilities I have just described. A tighter monetary policy would not have closed the gaps in the regulatory structure that allowed some SIFIs and markets to escape comprehensive supervision; a tighter monetary policy would not have shifted supervisory attention to a macroprudential perspective; and a tighter monetary policy would not have increased the transparency of exotic financial instruments or ameliorated deficiencies in risk measurement and risk management within the private sector.

Some advocates of the view that a substantially tighter monetary policy may have helped prevent the crisis might acknowledge these points, but they might also argue that a tighter monetary policy could have limited the rise in house prices, the use of leverage within the private sector, and the excessive reliance on short-term funding, and that each of these channels would have contained--or perhaps even prevented--the worst effects of the crisis.

[V]ulnerabilities from excessive leverage and reliance on short-term funding in the financial sector grew rapidly through the middle of 2007, well after monetary policy had already tightened significantly relative to the accommodative policy stance of 2003 and early 2004. In my assessment, macroprudential policies, such as regulatory limits on leverage and short-term funding, as well as stronger underwriting standards, represent far more direct and likely more effective methods to address these vulnerabilities.

In my remarks, I will argue that monetary policy faces significant limitations as a tool to promote financial stability: Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment. As a result, I believe a macroprudential approach to supervision and regulation needs to play the primary role. Such an approach should focus on "through the cycle" standards that increase the resilience of the financial system to adverse shocks and on efforts to ensure that the regulatory umbrella will cover previously uncovered systemically important institutions and activities. These efforts should be complemented by the use of countercyclical macroprudential tools, a few of which I will describe. But experience with such tools remains limited, and we have much to learn to use these measures effectively.

I am also mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk, and of the limits of macroprudential measures to address these and other financial stability concerns. Accordingly, there may be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risks to financial stability. Because of this possibility, and because transparency enhances the effectiveness of monetary policy, it is crucial that policymakers communicate their views clearly on the risks to financial stability and how such risks influence the appropriate monetary policy stance. I will conclude by briefly laying out how financial stability concerns affect my current assessment of the appropriate stance of monetary policy.

In light of the considerable efforts under way to implement a macroprudential approach to enhance financial stability and the increased focus of policymakers on monitoring emerging financial stability risks, I see three key principles that should guide the interaction of monetary policy and macroprudential policy in the United States.

First, it is critical for regulators to complete their efforts at implementing a macroprudential approach to enhance resilience within the financial system, which will minimize the likelihood that monetary policy will need to focus on financial stability issues rather than on price stability and full employment

Second, policymakers must carefully monitor evolving risks to the financial system and be realistic about the ability of macroprudential tools to influence these developments. The limitations of macroprudential policies reflect the potential for risks to emerge outside sectors subject to regulation, the potential for supervision and regulation to miss emerging risks, the uncertain efficacy of new macroprudential tools such as a countercyclical capital buffer, and the potential for such policy steps to be delayed or to lack public support.14 Given such limitations, adjustments in monetary policy may, at times, be needed to curb risks to financial stability.

These first two principles will be more effective in helping to address financial stability risks when the public understands how monetary policymakers are weighing such risks in the setting of monetary policy. Because these issues are both new and complex, there is no simple rule that can prescribe, even in a general sense, how monetary policy should adjust in response to shifts in the outlook for financial stability. As a result, policymakers should clearly and consistently communicate their views on the stability of the financial system and how those views are influencing the stance of monetary policy.

There is a ring of truth to the idea that low interest rates might be acting as life support for companies that are destined to fail. The flip side of that coin, however, is that low rates gave good companies the ability to get back on their feet before they went bankrupt. Its important to provide an economic environment that allows fundamentally sound firms to thrive. That may provide a temporary crutch to some companies that will eventually go bankrupt, but over the longer term, the right companies will survive. Nothing in life is perfect, and in terms of a trade-off, Im happy with a few bad companies staying in the game for a while if it means a lot of good ones have a chance to survive, too.

Born of necessity during the depths of the financial crisis as part of an effort to restore confidence in the U.S. financial system, supervisory stress testing has in the intervening five years become a cornerstone of a new approach to regulation and supervision of the nation's largest financial institutions. First, of course, it is a means for assuring that large, complex financial institutions have sufficient capital to allow them to remain viable intermediaries even under highly stressful conditions. More broadly, supervisory stress testing and the associated review of capital planning processes have provided a platform for building out a regulatory framework that is more dynamic, more macroprudential, and more data-driven than pre-crisis practice...

While some important features of capital planning are observable only during the formal CCAR process, most of the risk-management and capital planning standards incorporated in CCAR are operative and observable by supervisors throughout the year. These should be an important focus of ongoing supervisory oversight and of discussions between firms and supervisors. Only in unusual circumstances should supervisors learn for the first time during CCAR of significant problems in the quality of the capital planning processes, and only in unusual circumstances should firms be surprised at the outcome of the qualitative assessment.

We have already taken steps to further this integration of CCAR and regular supervision. At the end of each CCAR process our supervisors send to each firm a letter detailing their conclusions concerning the qualitative assessment. To the extent weaknesses or areas for improvement are identified, those letters provide a basis for regular stocktaking by both firms and supervisors. More generally, last year we released a paper on our expectations for all aspects of capital planning, providing greater detail than what is included in the annual CCAR instructions.

I anticipate that we will take additional steps to integrate ongoing supervisory assessments of risk-management and other internal control processes with the annual CCAR exercise, and to assure that communications in both directions are heard. One such step has just recently begun: The committee chaired by senior Board staff that is responsible for the oversight of CCAR, supported by the relevant horizontal assessment teams, will directly engage with firms during the course of the year to evaluate progress in remediating weaknesses or other issues identified in the post-CCAR letters. Increasingly, our regular supervisory work on topics such as risk-identification and internal audit will focus on processes that are critical to risk management and capital planning at the firms, areas of focus for CCAR. The aim of these and additional measures is to make CCAR more the culmination of year-round supervision of risk-management and capital planning processes than a discrete exercise that takes place at the same time as the supervisory stress tests...

Although strong capital regulation is critical to ensuring the safety and soundness of our largest financial institutions, it is not a panacea, as indeed no single regulatory device can ever be. Similarly, supervisory stress testing and CCAR, while central to ensuring strong capital positions for large firms, are not the only important elements of our supervisory program. Having said that, however, I hope you will take at least these three points away from my remarks today.

First, supervisory stress testing has fundamentally changed the way we think about capital adequacy. The need to specify scenarios, loss estimates, and revenue assumptions--and to apply these specifications on a dynamic basis--has immeasurably advanced the regulation of capital adequacy and, thus, the safety and soundness of our financial system. The opportunities it provides to incorporate macroprudential elements make it, in my judgment, the single most important advance in prudential regulation since the crisis.

Second, supervisory stress testing and CCAR have provided the first significant form of supervision conducted in a horizontal, coordinated fashion, affording a single view of an entire portfolio of institutions, as well as more data-rich insight into each institution individually. As such, these programs have opened the way for similar supervisory activities and continue to teach us how to organize our supervisory efforts in order most effectively to safeguard firm soundness and financial stability.

Finally, supervisory stress testing and CCAR are the exemplary cases of how supervision that aspires to keep up with the dynamism of financial firms and financial markets must itself be composed of adaptive tools. If regulators are to make the necessary adaptations, they must be open to the comments, critiques, and suggestions of those outside the regulatory community. For this reason, transparency around the aims, assumptions, and methodologies of stress testing and our review of capital plans must be preserved and extended.

Once the U.S. economy began to improve and the Federal Reserve began to discuss a gradual reduction in purchases, many market participants who had been invested “alongside” the Federal Reserve became active sellers.

This was particularly true for highly leveraged investors who had borrowed “short” and invested “long” by engaging in the so-called “carry trade” – an issue of particular relevance in emerging markets where interest rates were considerably higher than in the United States. The result was a fairly significant increase in long-term rates and a repatriation of funds that had been previously borrowed short and invested long in emerging-market securities.

The unwinding of the carry trade was a particularly thorny issue for countries with high dollar-denominated yields and fixed exchange rates, and for countries that had high yields and a policy of gradual currency appreciation relative to the dollar. The speed and magnitude of the readjustment highlighted just how low long-term rates had been pushed. It also suggested that many models of the impact of Federal Reserve asset purchase programs had not fully accounted for potential investor reaction to the policy, or the impact of a sudden reassessment of investor desire to engage in the carry trade.
…
In sum, this episode made clear the importance of Federal Reserve communication and market understanding about programs and policies. The episode also underlined the importance of calibrating investor reactions into models of policy impact.
…
Importantly, I suspect that the benign reaction to the gradual tapering of stimulus over the last 6 months may be instructive as we consider how best to wind down the Federal Reserve’s balance sheet once the tapering of asset purchases is complete. While the optimal program for reducing the Fed’s balance sheet will need to be dependent on the state of the economy, the recent tapering experience suggests to me that a predictable, transparent reduction in the balance sheet could be done in ways that may minimize the risk of financial disruption.

Let me offer one scenario that I have been considering, in light of the sorts of financial stability concerns that I and my colleagues keep in mind. In one scenario, a reduction in the balance sheet, when that becomes appropriate, could be implemented as a basically seamless continuation of the tapering program used for reductions in the purchase program. For example, the Committee could decide to reinvest all but a given percentage of securities on the balance sheet as they reach maturity, and increase that percentage at each subsequent meeting, assuming conditions allow.

Such a tapering of the reinvestment program could allow for a gradual and transparent reduction in the Fed’s balance sheet. As the economy moved closer to the Federal Reserve’s 2 percent inflation target and full employment, there could be a gradual reduction in the reinvestment policy – which would allow for a predictable reduction in the size of the balance sheet. However, the pace of reinvestment should always be considered in the context of the economic outcomes we are seeking to achieve. If the economy was substantially stronger or substantially weaker than was expected, the reinvestment program would need adjustment. Again, I mention this as simply one scenario for consideration.
…
[A] positive collateral impact of using reverse repos and interest on excess reserves in these ways is that the ability to control short-term rates would not be tied to actions that impact the size of the Federal Reserve’s balance sheet. This means the Federal Reserve could have additional financial stability tools at its disposal, if it chose to maintain a larger-than-traditional balance sheet with a greater mix of assets. Naturally, maintaining a large balance sheet comprising both U.S. Treasury securities and mortgage-backed securities would provide the Federal Reserve with continuing options for impacting long-term interest rates and the spread between mortgage-backed securities and U.S. Treasury securities. For example, if a bubble seemed to be developing in housing markets generally, the Federal Reserve would have the option of addressing it by selling MBS or long-duration U.S. Treasury securities. This again is a notion that I consider worthy of further exploration and debate.

There are many important regulatory requirements applicable to large financial firms. Boards must of course be aware of those requirements and must help ensure that good corporate compliance systems are in place. But it has perhaps become a little too reflexive a reaction on the part of regulators to jump from the observation that a regulation is important to the conclusion that the board must certify compliance through its own processes. We should probably be somewhat more selective in creating the regulatory checklist for board compliance and regular consideration. One example, drawn from Federal Reserve practice, is the recent supervisory guidance requiring that every notice of a "Matter Requiring Attention" (MRA) issued by supervisors must be reviewed, and compliance signed off, by the board of directors. There are some MRAs that clearly should come to the board's attention, but the failure to discriminate among them is almost surely distracting from strategic and risk-related analyses and oversight by boards.