Lael Brainard

[Brainard’s] concern is that stresses in emerging markets including China and slow growth in developed economies could spill over to the U.S. “This translates into weaker exports, business investment and manufacturing in the United States, slower progress on hitting the inflation target, and financial tightening through the exchange rate and rising risk spreads on financial assets,” Ms. Brainard said Monday in response to questions from The Wall Street Journal.

“Recent developments reinforce the case for watchful waiting,” she said.

We recognize that depository institutions come in many sizes, have different business models, and manage different risks. As a result, it is often necessary to tailor regulations to the institution. Applying a one-size-fits-all approach to regulations may produce a small benefit at a disproportionately large compliance cost to smaller institutions.

Of particular concern in this regard is the need to ensure our regulations are appropriately calibrated for smaller institutions. For example, because the largest banks present the greatest risk to the stability of our financial system, many of the regulations passed under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) are specifically targeted at these firms. It would be counterproductive to apply those same expectations to small banks. Accordingly, we think it is important to tailor rules whenever possible to clearly differentiate expectations for different portfolios of banks and reduce undue burden on community banks. Tailoring regulations may be more challenging in some areas, such as rules that provide transparency and fairness in consumer transactions. Those are standards that apply throughout the financial system.

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.

...
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.

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

No doubt, ongoing technological advances and the evolving competitive lending landscape will continue to present both challenges and opportunities for community bankers who are deeply committed to the provision of credit to small businesses. I remain confident that community bankers will continue to play a vital role in the small business lending landscape as the respective business models of online platforms and community banks evolve. The advantage that comes from close relationships with their customers and intimate knowledge of their communities that lie at the heart of community banking will continue to provide a powerful advantage in serving the vital banking needs of small businesses, even as the use of nontraditional sources of data and electronic processing platforms may permit faster loan decisions, especially for smaller loan amounts, to a broader set of borrowers.

There is a risk that the intensification of international cross currents could weigh more heavily on U.S. demand directly, or that the anticipation of a sharper divergence in U.S. policy could impose restraint through additional tightening of financial conditions. For these reasons, I view the risks to the economic outlook as tilted to the downside. The downside risks make a strong case for continuing to carefully nurture the U.S. recovery--and argue against prematurely taking away the support that has been so critical to its vitality.
...
Although the outlook for domestic demand is good, global forces are weighing on net exports and inflation, and the risks from abroad appear tilted to the downside. Our economy has made good progress toward full employment, but sluggish wage growth suggests there is some room to go, and inflation has remained persistently below our target. With equilibrium real interest rates likely to remain low for some time and policy options that are more limited if conditions deteriorate than if they accelerate, risk-management considerations counsel a stance of waiting to see if the risks to the outlook diminish.

"There are certain aspects of the U.S. outlook that are encouraging. The improvement in the labor market has been extremely steady," said Brainard, who last month argued that the Fed should hold off until it was clear that a global slowdown would not push the U.S. recovery off course.

"There are still margins of slack in the U.S. labor force but we've certainly made some progress there," Brainard told a conference organized by the European Central Bank.

But wage growth has not been in line with the rise in employment, Brainard said, calling this trend puzzling. She noted that core inflation has remained below target and needed to be carefully monitored.

Brainard also singled out the dollar's appreciation over the past year, which has led to a "material" tightening of conditions.

"If you look at the cross currents, and one measure of those is the extent to which the currency has appreciated as expectations of divergence have grown, we have seen about 15 percent broad real appreciation in the exchange rate over the past year, which is a drag on prices and exports. We've already seen by that measure some material tightening in the United States."

The feedback loop between market expectations of divergence between the United States and our major trade partners and financial tightening in the United States means that material restraint to U.S. conditions is already in place. Looking ahead, a further weakening of foreign growth could pose downside risks to the U.S. outlook. Under normal circumstances, policy in the United States could adjust to signs that spillovers from developments abroad were affecting activity in the United States. But with policy rates in the United States at the lower bound, the ability to offset spillovers from adverse developments in foreign economies with conventional policy is constrained, suggesting greater caution than normal.

A broad deterioration in foreign growth prospects, together with greater risk sensitivity in the wake of the crisis and changes in the rate of potential output growth, may be contributing to a "new normal." The new normal is likely to be characterized by a lower level of interest rates than in the decades preceding the crisis, which counsels a cautious and gradual approach to adjusting monetary policy.
...
The slow progress on inflation, together with the likely low level of the longer-term neutral real rate and the slow pace at which the very low shorter-term rate may move to the longer-term rate, suggest that the federal funds rate is likely to adjust more gradually and to a lower level than in previous expansions. In short, "gradual and low" is likely to be the new normal.

In circumstances where many economies face common negative shocks or where negative shocks in one country are quickly transmitted across borders, it is natural to consider whether coordination can improve outcomes. Under certain conditions--such as flexible exchange rates, deep and well-regulated financial markets, and flexible product and labor markets--policies designed for the domestic economy can readily offset any spillovers from economic conditions abroad, and policies designed to address domestic conditions can achieve desirable outcomes both within the national economy and more broadly.

In some circumstances, however, cooperation can be quite helpful. If, for example, economies face a common challenge, coordination can communicate to markets that policymakers recognize the challenge and will work to address it. Reducing uncertainty about the direction of policy and addressing concerns about policies working at cross-purposes can boost the confidence of businesses and households. With intensified transmission effects in the vicinity of the zero lower bound, there is a risk that uncoordinated policy on its own could have the effect of shifting demand across borders rather than addressing the underlying weakness in global demand. The difficult start to the year should be a prompt for greater policy coherence and clarity. This might be a good time for policymakers to reaffirm their commitment to work toward the common goal of strengthening global demand.

An important concern about persistently low inflation is that it can lead to a fall in longer-term inflation expectations, making it much more difficult to achieve our inflation target. For the most part, longer-term inflation expectations appear to have remained reasonably stable, though there are some concerning signs. Longer-term inflation expectations of professional forecasters and primary dealers have held quite steady in recent years at levels consistent with the FOMC's target. However, households' inflation expectations appear to have moved down somewhat recently.

In today's circumstances, policy could usefully follow two simple guidelines. First, we should not take the strength in the U.S. labor market and consumption for granted. Given weak and decelerating foreign demand, it is critical to carefully protect and preserve the progress we have made here at home through prudent adjustments to the policy path. Tighter financial conditions and softer inflation expectations may pose risks to the downside for inflation and domestic activity. From a risk-management perspective, this argues for patience as the outlook becomes clearer.

We should put a high premium on clear evidence that inflation is moving toward our 2 percent target. Inflation has persistently underperformed relative to our target. Moreover, measures of inflation compensation and some survey-based measures of inflation expectations suggest that inflation expectations may have edged lower. Given the currently weak relationship between economic slack and inflation and the persistent, depressing effects of energy price declines and exchange rate increases, we should be cautious in assessing that a tightening labor market will soon move inflation back to 2 percent. We should verify that this is, in fact, taking place.