For the near term, my baseline expectation is that our economy will continue on its path of growth at around 2 percent. To confirm that expectation, it will be important to see a significant strengthening in growth in the second quarter after the apparent softness of the past two quarters. To support this growth narrative, I also expect the ongoing healing process in labor markets to continue, with strong job growth, further reductions in headline unemployment and other measures of slack, and increases in wage inflation. As the economy tightens, I expect that inflation will continue to move over time to the Committee's 2 percent objective.
If incoming data continue to support those expectations, I would see it as appropriate to continue to gradually raise the federal funds rate. Depending on the incoming data and the evolving risks, another rate increase may be appropriate fairly soon. Several factors suggest that the pace of rate increases should be gradual...

There are potential concerns with such a gradual approach... [R]unning the economy above its potential growth rate for an extended period could involve significant risks even if inflation does not move meaningfully above target. A long period of very low interest rates could lead to excessive risk-taking and, over time, to unsustainably high asset prices and credit growth. Macroprudential and other supervisory policies are designed to reduce both the likelihood of such an outcome and the severity of the consequences if it does occur. But it is not certain that these tools would prove adequate in a financial system in which much intermediation takes place outside the regulated banking sector.

My own view is that while the use of macroprudential tools holds promise, we are a long way from being able to successfully use such tools in the United States. There are two major sets of difficulties. First, unlike monetary policy and microprudential regulation, there is not a well-defined framework for identifying emerging imbalances and applying macroprudential tools in response.
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Second, in the U.S., even if such a framework existed, there would still be a problem in terms of timely implementation. The U.S. regulatory structure is fragmented, so that in most cases, no single regulator is able to implement macroprudential tools in a comprehensive manner. As a result, imposing macroprudential tools in the United States would almost certainly leave significant gaps in coverage.

Importantly, policymakers should reassess the assumption that monetary policy and macroprudential regimes can be used independently. This "separation principle" remains widely accepted and continues to argue that macroprudential tools offer the "first line of defense" against risks to financial stability.

Our recent experience, combined with empirical evidence, suggests this view should be challenged. A comprehensive approach that views monetary and macroprudential policy as a complements, reinforced by sound microprudential underpinnings, is the best approach to achieve a stable financial system and the long-run objectives of central banks for sustainable economic growth.

Standing in front of this audience I feel secure in observing that we are all macroprudentialists now.
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In mapping out the range of macroprudential policies, analysts have developed various taxonomies. Common to most is the distinction between tools designed to prevent systemic risk from building by "leaning against the wind" and tools designed to increase the resiliency of the financial system should systemic risk nonetheless build and lead to broad-based stress As I have explained elsewhere, I think a distinction of equal--if not greater--importance is between structural or "through the cycle" tools, on the one hand, and time-varying tools, on the other. Structural macroprudential tools are put in place as a part of the ongoing regulatory structure, but they are designed specifically from a systemic, as opposed to a firm- or asset-specific, perspective.

Many proponents of macroprudential policy seem particularly attracted to time-varying measures for both resiliency and lean-against-wind measures. The aim is to regulate in an explicitly countercyclical fashion through measures that attempt to restrain rapid, unsustainable increases in credit extension or asset prices--either directly or through shifts in incentives--and to relax those measures as economic conditions deteriorate. One can readily understand the conceptual appeal of this approach, but it raises a fair number of significant issues--analytic, practical, institutional, and legal. These include the reliability of measures of excess or systemic risk, the appropriate officials to be making macroprudential decisions, the speed with which measures might realistically be implemented and take effect, and the right calibration of measures that will be efficacious in damping excesses while not unnecessarily reducing well-underwritten credit flows in the economy.

One policy response that the Federal Reserve has advocated and that has now been proposed by the Financial Stability Board (FSB), is for minimum margins to be required for certain forms of securities financing transactions (SFTs) that involve extensions of credit to parties that are not prudentially regulated financial institutions.6 This system of margins is intended to serve the macroprudential aim of moderating the build-up of leverage in the use of these securities in less regulated parts of the financial system and to mitigate the risk of procyclical margin calls by preventing their decline to unsustainable levels during credit booms.

Given the ease with which such transactions may move across borders, it is particularly important that the FSB has proposed a framework that could be applicable in all major financial markets. We will welcome comments on this proposal when, as I expect, the Federal Reserve issues a notice of proposed rulemaking to implement it domestically, probably by using the Federal Reserve's authority under the Securities Exchange Act of 1934 to supplement our prudential regulatory authorities. But it is also important to continue analysis of other macroprudential policy options that would address the risks associated with short-term wholesale funding. Indeed, even the FSB proposal does not extend to SFTs backed by government collateral, a very important source of short-term wholesale funds.

My third policy objective with a macroprudential component relates to central counterparties (CCPs). A key regulatory aim following the crisis, both in the United States and internationally, has been to encourage more derivatives and other financial transactions to be cleared through CCPs. There are important financial stability benefits to be gained from the progress that has been made toward this aim--including multilateral netting, standardized initial and variation margin requirements, and greater transparency.
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Notwithstanding the advances in CCP regulation, questions have been raised in international fora, in discussions among domestic financial and regulatory officials, and by some market participants over whether more needs to be done. To me, at least, some of the most important questions implicate macroprudential concerns. One discrete example is the possibility that CCP margining practices may have a significantly procyclical character that could be problematic in deteriorating financial conditions.

In general, the macroprudential tools can be classified into two categories: structural tools and cyclical tools. The structural tools aim to build the resiliency of the financial system throughout the business cycle. These tools include the Basel III risk-based capital requirements, minimum liquidity requirements, central clearing for derivatives, and living will resolution plans.

In contrast, the cyclical tools are aimed at mitigating the systemic risk that can build up over the business cycleMacroprudential tools aimed at addressing these emerging risks include the countercyclical capital buffer, the capital conservation buffer, and stress test scenarios. The countercyclical capital buffer allows regulators to increase risk-based capital requirements when credit growth is judged to be excessive and leading to rising systemic risk. The capital conservation buffer ensures that banks raise capital above regulatory minimums in good times so that when they cover losses in bad times, their capital ratio will stay at or above the regulatory minimum. The stress tests can include scenarios that become more severe during strong economic expansions. Other possible cyclical tools, not yet established in the U.S. but used in other countries, include loan-to-value ratio limits and debt-to-income ratio limits that vary over the cycle. In some countries, these macroprudential tools have been targeted at particular sectors like housing credit or household credit. For example, Canada tightened loan-to-value and debt-to income limits on mortgage lending over the 2009 to 2012 period.3 Beginning in 2010, Israel also implemented a package of macroprudential tools to restrict the supply of housing credit.4 Spain introduced dynamic loan-loss provisioning in 2000.5 This method builds up reserves during good economic times according to the historical losses experienced by the asset classes held in the banks portfolio. This buffer is then available to absorb losses in bad times.

For more than 75 years following passage of the Banking Act of 1933, the motivation for banking regulation was fairly simple: the government had granted deposit insurance and access to the discount window to depository institutions to forestall runs and panics. The resulting moral hazard and the use of insured deposits as a funding source for these institutions justified prudential measures, including prohibitions on non-banking activities, aimed at maintaining safe and sound banks, which would in turn protect taxpayers.

There is now more widespread agreement that these aims should vary according to the size, scope, and range of activities of banking organizations. Most significantly, banks of a size and complexity such that serious stress or failure could pose risks to the entire financial system need regulation that incorporates the macroprudential aim of protecting financial stability. There is also a good argument that very large banks that fall short of this level of systemic importance should nonetheless be regulated with an eye to macroprudential aims, such as the ability of the banking system as a whole to provide credit.

Although individual community banks may be an important source of credit, particularly in local economies outside urban areas, neither systemic risk nor broad macroprudential considerations are significant in thinking about prudential regulation of community banks. So what should the aims of such regulation be? The basic answer is it should protect the deposit insurance fund. In other words, the traditional microprudential approach to safety and soundness regulation continues to be appropriate for these banks.

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.

What can the central bank do when financial stability is threatened? If it has effective macroprudential tools at its disposal, it can deploy those. If it does not itself have the authority to use such tools, it can try to persuade those who do have the tools to use them. If no such tools are available in the economy, the central bank may have to consider whether to use monetary policy--that is, the interest rate--to deal with the threat of financial instability. At the moment in the U.S., though there may be some areas of concern, I do not think that financial stability concerns warrant deviating from our traditional focus on inflation and employment.

A decision on whether to use the interest rate to deal with the threat of financial instability is always likely to be difficult--particularly in a small open economy, where raising the interest rate is likely to produce an unwanted exchange rate appreciation. So a critical question must be whether effective macroprudential policies are to be found in the country in question.

I had some experience with these issues while at the Bank of Israel... Starting in 2010, the Bank of Israel adopted several macroprudential measures to address rapidly rising house prices…

The success of these policies was mixed. The limit …on the share of any housing loan indexed to the short rate substantially raised the cost of housing finance and was the most successful of the measures. Increases in both the LTV and PTI ratios were moderately successful. Increasing capital charges and risk weights appeared to have little impact in practice.

This experience led me to three conclusions on the effectiveness of macroprudential policies. First, we were very cautious in using these new tools because we did not have good estimates of their strength and effectiveness. Quite possibly, we should have acted more boldly on several occasions. Second, use of these tools is likely to be unpopular, for housing is a sensitive topic in almost every country. And third, coordination among different regulators and authorities can be complicated.

The difficulty of coordinating among different independent regulators makes it likely that the degree to which macroprudential policies can be successful depends critically on the institutional setup of financial supervision in each country…

Overall, it is clear that we have much to learn about both the effectiveness of different macroprudential measures, and about the best structure of the regulatory system from the viewpoint of implementing strong and effective macroprudential supervision and regulation. And, while there may arise situations where monetary policy needs to be used to deal with potential financial instability, I believe that macroprudential policies will become an important complement to our traditional tools. Learning how best to employ all of our potential policy tools, and arrive at a new set of best practices for monetary policy, is one of the key challenges facing economic policymakers.

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.

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.

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.

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.