Short-term interest-rate markets have for months priced in a slower tempo of increases than policy makers themselves forecast. Thats risky because the misalignment, a bet against a rate path that the central bank alone controls, could lead to volatility if traders have to adjust rapidly, Lacker said.

When there is that kind of gap, it gets your attention, Lacker, a consistent critic of the Feds record easing who votes on policy next year, said in an Aug. 1 interview at his Richmond office overlooking the James River. It wouldnt be good for it to be closed with great rapidity.

Investors may also be giving too much credence to a phrase in the Feds statement that even after employment and inflation are close to its goals, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the committee views as normal in the longer run.

They may be placing more weight on that than I think it deserves, said Lacker, who dissented against his colleagues at every meeting of the FOMC in 2012. They may think we have more conviction about that than we do.

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.

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.

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.

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.

One has to bear in mind that monetary policy has to lead economic developments. Monetary policy is a bit like duck hunting. If you want to bag a mallard, you dont aim where the bird is at present, you aim ahead of its flight pattern. To me, the flight pattern of the economy is clearly toward increasing employment and inflation that will sooner than expected pierce through the tolerance level of 2 percent.

Some economists have argued that we should accept overshooting our 2 percent inflation target if it results in a lower unemployment rate. Or a more fulsome one as measured by participation in the employment pool or the duration of unemployment. They submit that we can always tighten policy ex post to bring down inflation once this has occurred.

I would remind them that Junes unemployment rate of 6.1 percent was not a result of a fall in the participation rate and that the median duration of unemployment has been declining. I would remind them, also, that monetary policy is unable to erase structural unemployment caused by skills mismatches or educational shortfalls. More critically, I would remind them of the asymmetry of the economic risks around full employment. The notion that we can always tighten if it turns out that the economy is stronger than we thought it would be or that weve overshot full employment is dangerous. Tightening monetary policy once we have pushed past sustainable capacity limits has almost always resulted in recession, the last thing we need in the aftermath of the crisis we have just suffered.

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.

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.

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.

Several financial sector reform programs were prepared within a few months after the Lehman Brothers failure. These programs were supported by national policymakers, including the community of bank supervisors. The programs--national and international--covered some or all of the following nine areas:

(1) to strengthen the stability and robustness of financial firms, "with particular emphasis on standards for governance, risk management, capital and liquidity"
(2) to strengthen the quality and effectiveness of prudential regulation and supervision;
(3) to build the capacity for undertaking effective macroprudential regulation and supervision;
(4) to develop suitable resolution regimes for financial institutions;
(5) to strengthen the infrastructure of financial markets, including markets for derivative transactions;
(6) to improve compensation practices in financial institutions;
(7) to strengthen international coordination of regulation and supervision, particularly with regard to the regulation and resolution of global systemically important financial institutions, later known as G-SIFIs;
(8) to find appropriate ways of dealing with the shadow banking system; and
(9) to improve the performance of credit rating agencies, which were deeply involved in the collapse of markets for collateralized and securitized lending instruments, especially those based on mortgage finance.

There are many models of regulatory coordination, but I shall focus on only two: the British and the American. As is well known, the United Kingdom has reformed financial sector regulation and supervision by setting up a Financial Policy Committee (FPC), located in the Bank of England; the major reforms in the United States were introduced through the Dodd-Frank Act, which set up a coordinating committee among the major regulators, the Financial Stability Oversight Council (FSOC).

In discussing these two approaches, I draw on a recent speech by the person best able to speak about the two systems from close-up, Don Kohn. Kohn sets out the following requirements for successful macroprudential supervision: to be able to identify risks to financial stability, to be willing and able to act on these risks in a timely fashion, to be able to interact productively with the microprudential and monetary policy authorities, and to weigh the costs and benefits of proposed actions appropriately. Kohn's cautiously stated bottom line is that the FPC is well structured to meet these requirements, and that the FSOC is not. In particular, the FPC has the legal power to impose policy changes on regulators, and the FSOC does not, for it is mostly a coordinating body.

After reviewing the structure of the FSOC, Kohn presents a series of suggestions to strengthen its powers and its independence. The first is that every regulatory institution represented in the FSOC should have the goal of financial stability added to its mandate. His final suggestion is, "Give the more independent FSOC tools it can use more expeditiously to address systemic risks." He does not go so far as to suggest the FSOC be empowered to instruct regulators to implement measures somehow decided upon by the FSOC, but he does want to extend its ability to make recommendations on a regular basis, perhaps on an expedited "comply-or-explain" basis.

It could be that large banks can finance themselves more cheaply because they are more efficient, that is, that there are economies of scale in banking. For some time, the received wisdom was that there was no evidence of such economies beyond relatively modest-sized banks, with balance sheets of approximately $100 billion. More recently, several papers have found that economies of scale may continue beyond that level. For example, the title of a paper by Joseph Hughes and Loretta Mester, "Who Said Large Banks Don't Experience Scale Economies? Evidence from a Risk-Return Driven Cost Function" suggests that large institutions may be better able to manage risk more efficiently because of "technological advantages, such as diversification and the spreading of information...and other costs that do not increase proportionately with size." That said, these authors conclude that "[W]e do not know if the benefits of large size outweigh the potential costs in terms of systemic risk that large scale may impose on the financial system." They add that their results suggest that "strict size limits to control such costs will likely not be effective, since they work against market forces..."

The TBTF theory of why large banks are a problem has to contend with the history of the Canadian and Australian banking systems. Both these systems have several very large banks, but both systems have been very stable--in the Canadian case, for 150 years. Beck, Demirguc-Kunt, and Levine (2003) examined the impact of bank concentration, bank regulation, and national institutions on the likelihood of a country suffering a financial crisis and concluded that countries are less likely to suffer a financial crisis if they have (1) a more concentrated banking system, (2) fewer entry barriers and activity restrictions on bank activity, and (3) better-developed institutions that encourage competition throughout the economy.32 The combination of the first finding with the other two appears paradoxical, but the key barrier to competition that was absent in Canada was the prohibition of nationwide branch banking, a factor emphasized by Calomiris and Haber in their discussion of the Canadian case. In addition, I put serious weight on another explanation offered in private conversation by a veteran of the international central banking community, "Those Canadian banks aren't very adventurous," which I take to be a compliment.

...

Why is the TBTF phenomenon so central to the debate on reform of the financial system? It cannot be because financial institutions never fail. Some do, for example, Lehman Brothers and the Washington Mutual failed in the Great Recession

Almost certainly, TBTF is central to the debate about financial crises because financial crises are so destructive of the real economy. It is also because the amounts of money involved when the central bank or the government intervenes in a financial crisis are extremely large Another factor may be that the departing heads of some banks that failed or needed massive government assistance to survive nonetheless received very large retirement packages.

One can regard the entire regulatory reform program, which aims to strengthen the resilience of banks and the banking system to shocks, as dealing with the TBTF problem by reducing the probability that any bank will get into trouble. There are, however, some aspects of the financial reform program that deal specifically with large banks. The most important such measure is the work on resolution mechanisms for SIFIs, including the very difficult case of G-SIFIs. In the United States, the Dodd-Frank Act has provided the FDIC with the Orderly Liquidation Authority (OLA)--a regime to conduct an orderly resolution of a financial firm if the bankruptcy of the firm would threaten financial stability. And the FDIC's single-point-of-entry approach for effecting a resolution under the new regime is a sensible proposed implementation path for the OLA.

Closely associated with the work on resolution mechanisms is the living will exercise for SIFIs. In addition, there are the proposed G-SIB capital surcharges and macro stress tests applied to the largest BHCs ($50 billion or more). Countercyclical capital requirements are also likely to be applied primarily to large banks. Similarly the Volcker rule, or the Vickers rules in the United Kingdom or the Liikanen rules in the euro zone, which seek to limit the scope of a bank's activities, are directed at TBTF, and I believe appropriately so.

What about simply breaking up the largest financial institutions? Well, there is no "simply" in this area. At the analytical level, there is the question of what the optimal structure of the financial sector should be. Would a financial system that consisted of a large number of medium-sized and small firms be more stable and more efficient than one with a smaller number of very large firms? That depends on whether there are economies of scale in the financial sector and up to what size of firm they apply--that is to say it depends in part on why there is a financing premium for large firms. If it is economies of scale, the market premium for large firms may be sending the right signals with respect to size. If it is the existence of TBTF, that is not an optimal market incentive, but rather a distortion

Would breaking up the largest banks end the need for future bailouts? That is not clear, for Lehman Brothers, although a large financial institution, was not one of the giants--except that it was connected with a very large number of other banks and financial institutions. Similarly, the savings and loan crisis of the 1980s and 1990s was not a TBTF crisis but rather a failure involving many small firms that were behaving unwisely, and in some cases illegally. This case is consistent with the phrase, "too many to fail." Financial panics can be caused by herding and by contagion, as well as by big banks getting into trouble.

In short, actively breaking up the largest banks would be a very complex task, with uncertain payoff.

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.

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.

If macroprudential tools are to play the primary role in the pursuit of financial stability, questions remain on which macroprudential tools are likely to be most effective, what the limits of such tools may be, and when, because of such limits, it may be appropriate to adjust monetary policy to "get in the cracks" that persist in the macroprudential framework.

In weighing these questions, I find it helpful to distinguish between tools that primarily build through-the-cycle resilience against adverse financial developments and those primarily intended to lean against financial excesses.

At this point, it should be clear that I think efforts to build resilience in the financial system are critical to minimizing the chance of financial instability and the potential damage from it. This focus on resilience differs from much of the public discussion, which often concerns whether some particular asset class is experiencing a "bubble" and whether policymakers should attempt to pop the bubble. Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical.

Nonetheless, some macroprudential tools can be adjusted in a manner that may further enhance resilience as risks emerge. In addition, macroprudential tools can, in some cases, be targeted at areas of concern. For example, the new Basel III regulatory capital framework includes a countercyclical capital buffer, which may help build additional loss-absorbing capacity within the financial sector during periods of rapid credit creation while also leaning against emerging excesses. The stress tests include a scenario design process in which the macroeconomic stresses in the scenario become more severe during buoyant economic expansions and incorporate the possibility of highlighting salient risk scenarios, both of which may contribute to increasing resilience during periods in which risks are rising. Similarly, minimum margin requirements for securities financing transactions could potentially vary on a countercyclical basis so that they are higher in normal times than in times of stress.