William Dudley

I agree with those critics who argue that there was something fundamentally unfair about the disparity in treatment between the few large financial institutions that were saved versus the millions of individuals who lost their homes or their jobs. My response is not particularly satisfying. Recessions inflict considerable pain on innocent bystanders in the economy. Depressions greatly compound this pain. Given the Federal Reserve’s role and authority, what we knew at the time and the powers and tools that were available to us, I think we made good choices. If the large systemic banking organizations had failed, the hardships inflicted on households and small business would have been far worse.

From my perspective, I believe that any critique of the Fed or other agencies should be focused more on the regulatory and supervisory shortcomings—some of which, I admit, were ours—that created the economic and financial market circumstances in which the Fed’s extraordinary interventions proved necessary.

Briefly, let me give you a few examples of events that I never expected to see—ever:

...[N]early a failed Treasury bill auction—total bids were barely sufficient to cover the amount the Treasury was offering. This near-miss occurred despite the fact that money market mutual fund investors were fleeing to rather than away from Treasury securities.

A reference to the 4-week bill auction on August 21

[I]t would be wonderful if we could reduce the “stigma” so that it was inconsequential in the borrowing decision. One of our jobs is to act as the lender of last resort. The “stigma” against borrowing from the discount window can interfere somewhat with that.

...

We believe that the policy change had an impact, in part, because we witnessed—concurrently—a big increase in the amount of collateral pledged by banks at the window. This indicates that banks did view the window as an important liquidity backstop. Over the past few months, total collateral pledged has climbed by more than $150 billion.

...

On August 21, the securities lending fee was lowered to 50 basis points from 100 basis points. This is what we charge primary dealers to borrow Treasury securities from the System Open Market Account. The fee was lowered to encourage greater borrowing of Treasury securities from the Fed’s portfolio in order to ease disruptions in the Treasury bill market. Securities lending did increase and this helped calm the Treasury bill market.

Between Aug. 10 and Aug. 24, the federal funds rate traded below the FOMC's target rate of 5.25 percent. Dudley said ``there was no stealth easing'' during that period, a reference to some economists' suggestions that the central bank wanted rates lower than it was willing to announce publicly during a credit crisis.

He said banks were anticipating an inter-meeting rate cut, so they were reluctant to bid the fed funds rate up to the target. Also, he said the Fed preferred to miss the target on the low side to avoid adding to market disruptions. 

 ``We definitely wanted to get back to target,'' he said, ``and it took a little bit longer than we wanted.''

As reported by Dow Jones Newswires

... I come here to praise TIPS… In my opinion, the benefits of the TIPS program significantly exceed the costs of the program.  

[I]t is interesting that those market participants who are the patients have been clamoring for more medicine in the form of both an increase in the size of the TAF auctions and auctions with longer maturities.

In March, the storm was at its fiercest. Banks and dealers were raising the haircuts they assess against the collateral they finance. The rise in haircuts, in turn, was causing forced selling, lower prices, and higher volatility. This feedback loop was reinforcing the momentum toward still higher haircuts. This dynamic culminated in the Bear Stearns illiquidity crisis.

So how are these facilities supposed to work? What’s the theory? The notion is that the auction facilities should be the main means by which the Fed provides liquidity support to depository institutions and primary dealers. The PCF and PDCF are standby facilities designed to provide reassurance to market participants that sound depository institutions and primary dealers have access to backstop sources of liquidity. But the actual amount of funds advanced through these facilities is likely to be limited in most circumstances.

The Primary Dealer Credit Facility essentially puts the Federal Reserve in the position of tri-party repo investor of last resort. This helps to reassure the two triparty repo clearing banks and the triparty repo investors that the primary dealers will be able to obtain funding. This bolsters confidence in the triparty repo system and reduces the risk of the type of funding run that led to Bear Stearns’ illiquidity crisis.

The auction facilities have several advantages relative to the backstop facilities. First, they are dynamic—the results shift from auction to auction. The information obtained through the auction process facilities price discovery and helps policymakers assess market conditions and sentiment. Second, the auctions appear to have less stigma than the backstop facilities. Stigma is the word used to describe the unwillingness to use a liquidity facility because of fears that such use could send an adverse signal about the health and viability of the borrower.

For the auction facilities, stigma is very low for several reasons. First, many participants participate in the auctions. This provides cover against the potential for an adverse signal from participation. Second, the auctions are conducted for settlement on a forward basis. For example, in the TAF auction, the bidding takes place on Monday and settlement on Thursday. This time lag makes it clear that participants are not bidding because they need immediate funds and are having serious liquidity problems.

So how have the facilities performed in practice? As designed, most of the dollars have been disbursed via the auction facilities, the FX swaps, and the single-tranche OMOs, rather than via the backstop facilities.

In fact, the increase in LIBOR to overnight indexed swap (OIS) spreads may understate the degree of upward pressure on term funding rates. Note that after a Wall Street Journal article on April 16 questioned the veracity of some of the LIBOR respondents and the British Bankers Association threatened to expel any banks that they discovered had been less than fully honest—LIBOR spreads increased further.

[T]he Fed can reduce bank funding risks by providing a safe harbor for financing less liquid collateral on bank and primary dealer balance sheets. Reducing this risk may prove helpful by lessening the risk that an inability to obtain funding would force the involuntary liquidation of assets. The ability to obtain funding from the Fed reduces the risk of a return to the dangerous dynamic of higher haircuts, lower prices, forced liquidations, and still higher haircuts that was evident in March.

We need more transparency and homogeneity in securities. The difficulty in valuing opaque and heterogeneous securities has led to greater illiquidity, price volatility and market risk, bigger haircuts and more forced deleveraging. Opacity has also led to an undue reliance on credit ratings.

On its face, the idea {of issuing Fed debt}, which would require congressional approval, would give the Fed a chance to revive lending without simply dumping trillions of dollars into the economy. But Dudley suggested a separate benefit — keeping the Fed independent from the White House.

Selling "Fed bills has more of an optical advantage, because it has more of a separation from the Treasury," he said in an appearance before the Council on Foreign Relations in New York. "The Fed could conduct its policy, issue its bills and not rely on the Treasury."

From the Q&A session, as reported by the American Banker

Also Friday, Dudley said that even though policymakers are focusing more on creating a Public-Private Investment Fund, there is still life for the concept of a "bad bank" that would relieve institutions of the worst assets plaguing their balance sheets.

"At the moment, the PPIF and 'good bank/bad bank' concept are kissing cousins, with the PPIF leading the race," he said. "But I don't think we'd rule out 'good bank/bad bank' formulations at individual institutions."

'Judging from the Fed's action, at this point in time the Fed has judged buying long-term Treasuries is not the most efficient means of easing financial market conditions,' Dudley said in response to audience questions after giving a speech.

As reported by Reuters

Self-regulation is to regulation as self-importance is to importance.

As reported by the Financial Times

Editor's note:  similar sentiments are expressed here

The Federal Reserve made its decision to lend based on a judgment that a failure of AIG would cause dramatically negative consequences for the financial system and the economy—consequences worse than what occurred in the aftermath of the failure of Lehman Brothers. We stand by that judgment today. In the case of Lehman, some of the most severe repercussions related to the difficulties in coordinating cross-border insolvency regimes and in coordinating the insolvency regimes among different types of institutions within the organization's corporate structure. In light of AIG's unparalleled global footprint—operating in more than 130 countries around the globe—and the multiplicity of different types of financial services entities within its structure—including insurance providers, foreign banks, consumer lending companies and OTC derivatives affiliates—the factors that proved unmanageable in the Lehman insolvency threatened to be much more severe in AIG's case.

As I see it, there are four major reasons behind the dramatic expansion of the Fed’s liquidity programs:

1. To provide liquidity to banks and dealers in order to slow down the deleveraging process.
2. To expand the balance sheet capacity of the private sector to counteract the shrinkage underway in the non-bank financial sector.
3. To restore and improve market function.
4. To ease financial market conditions.

During the crisis, this market became less stable. As the financial condition of some of the major securities dealers worsened, the clearing banks became more reluctant to return the cash that the triparty repo investors had invested the prior evening. The clearing banks were worried that if a dealer were to fail, they could be stuck with a large obligation. The nervousness of the clearing banks, in turn, spilled back to the investors. If there is some chance that I might not get my cash back and instead be stuck with the collateral, do I really want to make the loan in the first place? The Primary Dealer Credit Facility essentially broke this dynamic by putting the Federal Reserve in the position of lender of last resort in the triparty repo system.

In general, I think the facilities have worked quite well. In those areas where the facilities have been active, we generally have seen an improvement in market conditions.

But the facilities have not been a panacea for three reasons. First, the facilities cannot address the fundamental problem—the shortage of capital in the banking system...

See Don Kohn's comment on the same day about the Fed's inability to take risk.

In thinking about this balance sheet expansion, I would make three broad points. First, in my mind, the goal is not the expansion of the balance sheet per se, but the objectives that I laid out earlier. In this respect, the expansion of the balance sheet differs considerably from Japan’s experience with quantitative easing...  Although the Fed’s activities have led to a big jump in excess reserves, this increase is incidental—a byproduct rather than goal of the asset-oriented programs.

Second, as a consequence of this my point, the size of the balance sheet, is not a good metric for measuring the impact of the Fed’s facilities or the amount of stimulus that the Fed is providing via these programs...  It is not possible to mechanically map the size of the balance sheet back onto the impact on financial market conditions... The size of the balance sheet is also not a good standard because the use of the different facilities depends on the degree of impairment in market function...

Third, I am not worried at all that the Federal Reserve’s balance sheet expansion will generate an inflation problem... [T]he Federal Reserve now has the tools to allow the conduct of monetary policy to be separated from the size of the balance sheet and the amount of excess reserves in the banking system.

Some skeptics note that when interest on excess reserves was first implemented, the federal funds rate traded somewhat below the rate on excess reserves. This has created worry in some quarters that paying interest on excess reserves might not work very well as a tool for controlling the federal funds rate.

On this issue, two points are warranted. First, the relatively large gap between the interest rate on excess reserves and the federal funds rate was due, in large part, to the impaired condition of the banking system, which inhibited the willingness of banks to arbitrage that gap...

Second, the Federal Reserve could alter its monetary policy framework in order to increase its control of monetary policy in a large excess reserve environment. It is beyond the scope of this speech to get into the details, but we have plenty of options in devising incentives for banks to hold reserves at the Fed that would improve our ability to control the federal funds rate.

If we’re going to go the supplemental financing programme route, we need SFPs to be exempt from the debt ceiling. The other approach is the Fed bill approach. It’s not subject to the debt limit. [Fed bills] can be sold broadly in the market, for example to money-market mutual funds. The problem is then there are two issuers of US government obligations. You don’t want both a three-month Fed bill and a three-month T-bill. It creates confusion. I don’t think it’s a big problem; lots of central banks have authority to issue central bank bills. We don’t want to be in the Treasury’s way so we’d probably restrict maturity to less than 30 days so they have 30 days and up.

I think Treasury is quite sympathetic to letting us do one or the other. We’d like Congress to consider it. It’s nice to have—as opposed to critical. That said, if I could get a belt and suspenders, I’ll take belt and suspenders. As long as people are worried about whether we have adequate tools, it makes sense for us to get more tools even if we don’t think we need them.

Although it is still too early to say the TALF has been a resounding success, we at the Fed are encouraged by the results so far.

The main danger of a Treasury purchase program is that people may wrongfully conclude that there is a risk that you are going to monetize the debt and reinflate.

In my opinion, this crisis should lead to a critical reevaluation of the view that central banks cannot identify or prevent asset bubbles, they can only clean up after asset bubbles burst.

[T]he balance of risks is still tilted toward weakness in growth and employment and not toward higher inflation... the economic contraction appears to be waning and it seems likely that we will see moderate growth in the second half of the year.

[C]oncern about “when” the Fed will exit from its current accommodative monetary policy stance is, in my view, very premature...Why do I believe it is so important to explain the issue of “how” having just argued that “when” is not yet a pressing issue? The reason is that if people believe—correctly or incorrectly—that the Federal Reserve could have a problem managing a smooth exit from its accommodative policy stance, this belief alone could have the adverse effect of causing inflation expectations to become less well anchored and risk premia on long-dated debt securities and loans to rise. These effects could conceivably make it more difficult to generate a sustainable economic recovery.

Despite the recent dip in the size of the balance sheet, the size of the purchase programs underway makes it likely that balance-sheet growth will resume as assets acquired in conjunction with these programs overwhelm any further declines in the funds advanced via the shorter-term liquidity facilities. The size of the Federal Reserve’s balance sheet seems likely to grow to roughly $2.5 trillion, somewhat above the peak reached last December.

Although our ability to pay interest on excess reserves is sufficient to retain control of monetary policy, it is not bad policy to have both a “belt and suspenders” in place. As a result, we are working out ways to drain reserves to provide reassurance that we will not—under any circumstance—lose control of monetary policy.

In terms of imagery, this concern seems compelling—the banks sitting on piles of money that could be used to extend credit on a moment’s notice. However, this reasoning ignores a very important point. Based on how monetary policy has been conducted for several decades, banks have always had the ability to expand credit whenever they like. They don’t need a pile of “dry tinder” in the form of excess reserves to do so. That is because the Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not.

My own personal view is I think it's a little premature to be so confident that you want to pull all these things back right now because the economy still isn't growing very fast and we do have a very high unemployment rate.

In the event that the ability to pay interest on excess reserves for any reason proved insufficient or the excess reserves themselves had unanticipated side effects that the Fed wished to mitigate, we are developing a number of tools that can be used to drain reserves. Two such tools are large reverse repos with dealers and other investors and term deposit facilities for banks.

This crisis has shown us that when all firms or market participants simultaneously take an action that appears to be in their immediate, narrow interest, the collective impact on the system as a whole can be disastrous. We need to find ways to weaken or eliminate these reinforcing mechanisms and we need to introduce new dampening mechanisms into the financial system.

There are also a number of idiosyncratic sources of instability worthy of mention, some of which are unique to our particular system. One source of instability is the tri-party repo system that I discussed earlier. Another is the convention of tying collateral calls to credit ratings. In this case, if a firm’s credit rating is lowered, the firm may have to post additional collateral to its counterparties, eliminating this collateral as a potential source of funding. This phenomenon was a particularly important problem for AIG, which lost its access to the commercial paper market and was subject to increased collateral calls. Both factors caused the liquidity of the AIG parent company to be depleted very quickly. Finally, if asset volatility rises, haircuts can increase. This can lead to haircut spirals in which higher haircuts lead to forced asset sales, increased volatility and still higher haircuts.

In assessing the causes of this crisis, one clear culprit was the failure of regulators and market participants alike to fully appreciate the strength of the amplifying mechanisms that were built into our financial system. These mechanics exacerbated the boom on the way up and the bust on the way down.

In the case of the tri-party repo market, the stress on repo borrowers was exacerbated by the design of the underlying market infrastructure. In this market, investors provide cash each afternoon to dealers in the form of an overnight loan backed by securities collateral.

Each morning, under normal circumstances, the two clearing banks that operate tri-party repo systems permit dealers to return the cash to their investors and to retake possession of their securities portfolios by overdrawing their accounts at the clearing banks. During the day, the clearing banks finance the dealers’ securities inventories.

Usually, this arrangement works well. However, when a securities dealer becomes troubled or is perceived to be troubled, the tri-party repo market can become unstable. In particular, if there is a material risk that a dealer could default during the day, the clearing bank may not want to return the cash to the tri-party investors in the morning because the bank does not want to risk being stuck with a very large collateralized exposure that could run into the hundreds of billions of dollars. Overnight investors, in turn, don’t want to be stuck with the collateral. So to avoid such an outcome, they may decide not to invest in the first place. These self-protective reactions on the part of the clearing banks and the investors can cause the tri-party funding mechanism to rapidly unravel. This dynamic explains the speed with which Bear Stearns lost funding as tri-party repo investors pulled away quickly.

...

Sixth, we could make structural changes to the financial system to make it more stable in terms of liquidity provision. For example, consider the three structural issues outlined earlier that amplified the crisis—tri-party repo, collateral requirements tied to credit ratings, and haircut spirals. In the case of tri-party repo, the amplifying dynamics could be reduced by enforcing standards that limited the scope of eligible collateral or required more conservative haircuts. Formal loss-sharing arrangements among tri-party repo borrowers, investors, and clearing banks might reduce or eliminate any advantage that might stem from running early. Eliminating the market’s reliance on intraday credit provided by clearing banks could eliminate the tension between the interests of clearing banks and investors when a dealer becomes troubled. In the case of collateral requirements, collateral haircuts could be required to be independent of ratings.

Turning to the outlook, the recession now appears to be over, but the economy is still weak and the unemployment rate is much too high. These circumstances underpin the FOMC’s commitment to keeping short term rates exceptionally low for an extended period.

Turning to the first issue, identifying asset bubbles in real time is difficult. However, identifying variables that often are associated with asset bubbles—especially credit asset bubbles—may be less daunting. To take one recent example, there was a tremendous increase in financial leverage in the U.S. financial system over the period from 2003 to 2007, particularly in the nonbank financial sector. This sharp rise in leverage was observable...

Turning to the second issue of how to limit and/or deflate bubbles in an orderly fashion, the fact that increases in leverage are often associated with financial asset bubbles suggests that limiting increases in leverage may help to prevent bubbles from being created in the first place. This again suggests that there is a role for supervision and regulation in the bubble prevention process...

Whether there is a role for monetary policy to limit asset bubbles is a more difficult question. On the one hand, monetary policy is a blunt tool for use in preventing bubbles because monetary policy actions also have important consequences for real economic activity, employment and inflation. On the other hand, however, there is evidence that monetary policy does have an impact on desired leverage through its impact on the shape of the yield curve. A tighter monetary policy, by flattening the yield curve, may limit the buildup in leverage.¹

Whether it would be more effective to limit leverage directly by regulatory and supervisory means or via monetary policy is still an open question. But it is becoming increasingly clear that a totally hands off approach is problematic.

[T]he Basel Committee is working on establishing international standards for liquidity requirements. There are two parts to this. The first is a requirement for a short-term liquidity buffer of sufficient size so that an institution that was shut out of the market for several weeks would still have sufficient liquidity to continue its operations unimpaired. The second is a liquidity standard that limits the degree of permissible maturity transformation—that is, the amount of short-term borrowing allowed to be used in the funding of long-term illiquid assets. Under these standards, a firm’s holdings of illiquid long-term assets would need to be funded mainly by equity or long-term debt.³

This issue of compensation is obviously a hugely potent one, as there is a fundamental unfairness in what has happened over the past few years. The actions taken by the Federal Reserve and others to stabilize the financial system had the effect of rescuing many of the same financial institutions that contributed to this crisis. Many of those financial institutions are now prospering, and many of their employees will be highly compensated. This situation is unfair on its face. But it is even more galling in an environment in which the unemployment rate is 10 percent and many people are struggling to make ends meet.

Despite the fundamental unfairness of the situation, I don’t think it is feasible or practical for the Federal Reserve, or any other supervisory entity, to attempt to determine the level of compensation at individual firms on an ongoing basis. A better approach is for supervisors to ensure that a firm’s compensation regime is consistent with an institution’s safety and soundness and with broader financial stability. That can and should have important implications for the level of individual compensation. For example, a trader should not be paid solely on the basis of this year’s accounting profits if those profits are based on the valuation of illiquid assets held on the bank’s books that could easily go down considerably in value before they are liquidated.

The Fed is in the process of implementing a framework that will embed compensation practices more deeply into the supervisory process. We have made it clear to the major banks and dealers that 2009 compensation should be consistent with the recently developed Financial Stability Board principles on compensation, which emphasize the importance of appropriate incentives.

[W]e said we would keep short term rates low, exceptionally low for an extended period.  So until we change that, that’s where we are. Short term rates are going to stay low for a considerable period of time to come... among my very informal set of people that I asked that question they said that “extended” in their minds means at least six months... So what I want to stress is extended means at least six months. It could be a year from now… two years from now. It’s going depend on how the economy develops.

I don’t think that we have an exit problem. I think that we’re going to be able to manage our balance sheet down very, very smoothly. We have a new tool – the ability to pay interest on excess reserves, which means that the growth of our balance sheet is not going cause a problem in terms of future inflation. But other people have different views. And so the bigger our balance sheet gets the more people worry about that potential consequence. If that caused people to be worried about the inflation outlook, that would be counterproductive to our goals in terms of monetary policy.

[A]s our agency mortgage-backed securities purchases come to an end, we’ll probably see a little bit of upward pressure on interest rates. But there’s a big debate about whether they’ll be small or medium or large. So I think we’ll have to wait and see. Obviously, if mortgage rates were to back up a lot and if that had a big consequence for the economy then we very well could rethink the issue about whether we wanted to buy more mortgages.

Gharib: What is considered a lot?

Well I think we’re going to have to see the circumstances at the time. But most people who’ve thought about what’s likely to happen when we pull back from purchasing mortgage backed securities… they’re thinking that this is going to have a relatively small effect on the level of mortgage rates… something on the order of ½ to ¼ percent.

Well, I think that there is a question of how big is too big? I'ld like to see what we can do in terms of addressing the fail problem. But we have more capital, better liquidity, and have a way of resolving those institutions in a way that they can actually be allowed to fail, then I don’t think you necessarily have to break the banks up.  If we can’t succeed in that measure, then I think that Mr. Volcker’s alternative may be the way we’re going to have to go. That said, we have large multinational corporations that do business around the world. We need large banks to service those corporations to have a healthy economic environment.

 I’m also concerned about those proposals under consideration that would move the regulatory and supervisory functions now held by the Federal Reserve to other agencies, new or existing... In my view, further disaggregation or fragmentation of regulatory oversight responsibility is not the appropriate response to our increasingly interconnected, interdependent financial system. Funneling information streams into diverse institutional silos leads to communication breakdowns and too often to failure to "connect the dots."

So what can we do about the “too big to fail” problem? It is clear that we must develop a truly robust resolution mechanism that allows for the orderly wind-down of a failing institution and that limits the contagion to the broader financial system. This will require not only legislative action domestically but intensive work internationally to address a range of legal issues involved in winding down a major global firm.

To solve the too-big-to fail problem, we need to do two things. First, we need to develop a truly robust resolution mechanism that allows for the orderly wind-down of a failing institution and that limits the contagion to the broader financial system. This will require not only domestic legislation, but also intensive work internationally to address a range of legal issues involved in winding down a major global firm.

Second, we need to reduce the likelihood that systemically important institutions will come close to failure in the first place. This can be done by mandating higher capital requirements, improving the risk capture of those requirements and by requiring greater liquidity buffers for such firms.

Extensive study of banking crises shows that they tend to be “protracted affairs” with surprisingly similar, if unpleasant, contours. Downturns average four years, during which the unemployment rate rises an average of 7 percentage points. The peak-to-trough decline in output averages 9 percent.

[W]e need Congress to enact a resolution mechanism that allows large, complex financial firms to be wound down smoothly, without the need for extraordinary interventions. In addition, we need to take steps to make the financial system as a whole more resilient and robust. This requires many steps—some already in train—including higher capital requirements for large banks, bigger liquidity buffers, and changes to ensure that compensation practices are consistent with safety and soundness and financial stability. It's a long list—there is no single silver bullet—and it will take time, but the regulatory community and the political leadership will fail to meet our shared responsibility as stewards if we do not implement the necessary reforms in a timely and effective manner.

"We made a very small technical change" by raising the discount rate, Dudley said. "The action yesterday was really an action about the improvement in banks" and reflected that these institutions no longer need this emergency source of cheap funding the way they did during the depths of the financial crisis, the official said.

The discount rate increase "is not at all a signal of any imminent tightening" in monetary policy, and the Fed's commitment to keep rates very low for an extended period "is still very much in place," Dudley said. He added any increase in the short-term rates that affect the economy is "off in the future."

As reported by Dow Jones Newswires

There are a number of reasons that a financial conditions framework is likely to be useful when evaluating the economic outlook and the conduct of monetary policy. Most important, monetary policy works its magic through its effect on financial conditions; it does not operate directly on real economic variables. That is because the level of the federal funds rate influences other financial market variables such as money market rates, long-term interest rates, credit spreads, stock prices and the value of the dollar, and it is these variables that influence real economic activity.

In my view, sustainable global growth requires a shift toward a higher consumption share in the emerging world matched by a shift away from consumption in the United States.

I think it is underappreciated how important harmonization is to ensure success of the global regulatory reform effort. Without harmonized standards, financial intermediation would inevitably move toward geographies and activities where the standards are more lax.  This, in turn, would provoke complaints from those who cannot make such adjustments as easily. The political process, in turn, would be sensitive to such complaints, creating pressure for liberalization, which would cause the tougher standards to unravel over time...

...There is understandable and genuine concern that the impact of moving to global standards will fall disproportionately on some types of firms. In my view, the way to mitigate these issues is to have a long phase-in period in the transition to the new standards rather than to soften or alter the standards to shelter those firms that happen—perhaps by historical accident—to be starting in a less advantageous position. The focus should be more on the side of all ending up in a similar place, rather than on the relative degree of difficulty in getting there.

The process is also fragile because some countries seem intent on strengthening their own set of standards before the international process has had a chance to reach consensus. Although it is understandable that countries would want to move quickly to strengthen their regulatory regimes, such actions should not be undertaken in a way that is immutable and unresponsive to the emerging international consensus.¹

The early stages of past recoveries have been led by consumer spending, particularly for durable goods and residential investment... It is unlikely that we will experience this type of strength this time.

Testing of reverse-repurchase agreements] could be fairly large, because the one question we’re going to have to answer is how fast can we drain a large amount of reserves.  That might affect the timing of when we actually finally act.

Despite the fact that it is hard to discern bubbles, especially in their early stages, I conclude that uncertainty is not grounds for inaction. Instead, the decision whether to act depends on whether appropriate tools can be deployed to limit the size of a bubble and whether the benefits of acting and deploying such tools are likely to exceed the costs.

That cost-benefit calculus, in turn, depends crucially on the tools we can deploy to limit the growth of bubbles and the consequences when they burst. In this respect, I will argue that, in most cases, use of the bully pulpit and macroprudential tools, such as rules limiting loan-to-value ratios or leverage, are likely to prove superior to monetary policy.

The federal funds rate needs to be exceptionally low for an extended period to contribute to easier financial conditions to support economic activity... In the current environment, we are not getting the job gains that we would like to get. We would like to see employment gains much more substantially than what we’ve gotten. What that tells us is that monetary policy needs to be on a very easy setting right now.

I will try to define some of the important characteristics of asset price bubbles. I will argue that bubbles do exist and that bubbles typically occur after an innovation that has created uncertainty about fundamental valuations. This has two important implications. First, a bubble is difficult to discern and, second, each bubble has unique characteristics. This implies that a rules-based approach to bubbles is likely to be ineffective and that tackling bubbles to diminish their potential to destabilize the financial system requires judgment.

I will try to define some of the important characteristics of asset price bubbles. I will argue that bubbles do exist and that bubbles typically occur after an innovation that has created uncertainty about fundamental valuations. This has two important implications. First, a bubble is difficult to discern and, second, each bubble has unique characteristics. This implies that a rules-based approach to bubbles is likely to be ineffective and that tackling bubbles to diminish their potential to destabilize the financial system requires judgment.

That said, there is some evidence that a tighter monetary policy will reduce desired leverage in the financial system by flattening the yield curve and reducing the profitability of maturity transformation activities.¹² To the extent this is true, that may imply a somewhat more favorable trade-off in “leaning against” a bubble. More research is needed on this subject. For now at least, monetary policy appears to be inferior to macroprudential tools that seek either to limit the size of prospective bubbles or to strengthen the financial system so that it is more resilient when asset prices fall sharply.

[While there has been some encouraging economic news,] it still seems likely the economic recovery will be more muted.

Coupled with the benign outlook for inflation, these headwinds to growth and employment explain why the Federal Reserve is keeping short-term interest rates unusually low. We want to do all we can to support more rapid economic and employment growth, subject to keeping inflation low and stable, and inflation expectations well anchored... But we are still far from where we want to be.

 Growth in the third quarter may turn out to be a bit less than we saw in the first half of the year, though we think there is only a slight risk of a double dip.  

[S]ome simple calculations based on recent experience suggest that $500 billion of purchases would provide about as much stimulus as a reduction in the federal funds rate of between half a point and three quarters of a point.  But this estimate is sensitive to how long market participants expected the Fed to hold on to these assets.

In making our assessments about next steps, we need to be a bit humble about our capacity to forecast how market participants would respond to our actions. We do not control their behavior nor have much historical experience that we can draw on to easily assess how they are likely to behave. Even viewpoints that turned out to be incorrect could persist for a long time and generate adverse consequences. It is not enough for us to be right in theory. We also have to be convincing in practice and in explaining why concerns we think are misplaced are indeed unwarranted.

If we were to go down this path, it would be important to note that any provision of more information on our inflation objective would not be a signal that the inflation element of the dual mandate had become more important than the full employment objective. Instead, it would principally reflect the fact that inflation being “too low” (just like inflation being “too high”) is an impediment to achieving the full employment objective of the dual mandate.

If we judged it desirable, we could go still further and provide more guidance on how monetary policy would react to deviations from any stated inflation objective. One possibility would be to keep track of inflation shortfalls when the federal funds rate is constrained by the zero bound, as is the case today. For example, if inflation in 2011 were a 0.5 percentage point below the Fed’s inflation objective, the Fed might aim to offset this miss by an additional 0.5 percentage point rise in the price level in future years.

In the current environment, such an approach would have some advantages as well as some disadvantages. When there is a large amount of slack in the economy, the Federal Reserve might not easily be able to hit an inflation objective soon. But, the central bank could plausibly promise to make up the difference later on. Indeed, the further the Fed fell behind its inflation objective in the near term, the more inflation would need to increase in order to push the actual path of prices up to the path consistent with price stability over the long run. To the extent this policy was more credible, it might do a better job keeping inflation expectations from falling. This might make monetary policy more stimulative and, thus, might help the FOMC achieve its objectives more quickly.

Viewed through the lens of the Federal Reserve’s dual mandate—the pursuit of the highest level of employment consistent with price stability, the current situation is wholly unsatisfactory. Given the outlook that the upturn appears likely to strengthen only gradually, it will likely be several years before employment and inflation return to levels consistent with the Federal Reserve’s dual mandate.

...

We have tools that can provide additional stimulus at costs that do not appear to be prohibitive. Thus, I conclude that further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long.

So what about the long-run consequences [of higher capital standards]? It would be prudent to assume that requiring banks to hold more capital and higher cost capital is likely to result in somewhat higher lending spreads.

Although any increase will be a real cost, this appears to be a necessary and appropriate price to pay for a much more resilient financial system. The cost represented by higher lending spreads has to be weighed against the benefits of a more robust and resilient banking system. Recent years have surely taught us that easy access to credit that is underpriced because it is not backed by sufficient capital is not a sustainable route to prosperity. Indeed, to the extent that tougher standards reduce the misallocation of resources in the real economy that often accompanies periods of financial excess, ensure more consistent access to finance over time and encourage investment by holding out the prospect of greater economic stability, the new standards could be consistent with a more rapid sustainable growth rate over the long run.

There’s no question in my mind that there’s going to be some consequences for lending margins. Careful review of this suggests that the adjustment to lending margins is going to be quite modest.

Viewed through the lens of the Federal Reserve's dual mandate—the pursuit of the highest level of employment consistent with price stability, the current situation is wholly unsatisfactory. Given the outlook that the upturn appears likely to strengthen only gradually, it will likely be several years before employment and inflation return to levels consistent with the Federal Reserve's dual mandate.

Later, in remarks to reporters:

In a recent speech, I said that both the current levels of unemployment and inflation and the timeframe over which they are likely to return to levels consistent with our mandate are unacceptable. I said that I thought further Fed action was likely to be warranted unless the economic outlook were to evolve in a way that made me more confident we would see better outcomes for both employment and inflation before too long.

The Fed cannot wave a magic wand and make the problems remaining from the preceding period of excess vanish immediately. But we can provide essential support for the needed adjustments.

You know, I think there's sorta two sort of critiques of the large scale asset purchase program. One, it won't be effective. It doesn't do that much. And-- and we agree with that, that we don't think that this large scale asset purchase program's going to have a huge, powerful effect on-- on the U.S. economy.

And two, I think there's a lotta concern about exit. Once-- when the time comes and the U.S. economy finally does pick up speed and inflation starts to rise, will we-- will we be-- will-- will-- will we be able to exit from this program smoothly without a long term inflation problem? And I think the answer to that second question is really critical. And our answer to that question is very much yes.

I think people do not understand clearly-- and this is partly on us to communicate clearly our ability to manage this when we actually exit -- we can have an enlarged balance sheet and not have an-- a long term inflation problem.

Well, I think there is a fair amount of empirical evidence that suggests that there is a stall speed for the economy. One interesting fact from the post war-- World War II period in the United States is we've never had a three-tenths of a percent rise in the unemployment rate without actually once it goes up three-tenths of a percent, we end up having a full blown recession.

And the next-- increase after three-tenths of a percent, the smallest is 1.9 percentage points. So that we've never had an increase in the unemployment rate of just a half a percent, or just one percent, or just one and a half percent.  So that does suggest that that-- that once you get to a certain point, and an unemployment rate goes up enough, that starts to weigh on confidence, that starts to weigh on spending. If spending is cut back, that leads to more unemployment, and the economy cycles down into recession.

Several notable forces combined to encourage the resumption of stronger growth. On the policy side, as I mentioned, the Federal Open Market Committee provided further stimulus through purchasing Treasury securities. This, plus the lagged effects of its previous measures, helped to improve financial conditions.

After all, soft patches are not uncommon during economic recoveries.

Moreover, although we do need to remain ever-watchful for signs that low interest rates could foster a buildup of financial excesses or bubbles that might pose a medium-term risk to both full employment and price stability, risk premia on U.S. financial assets do not appear unduly compressed at this juncture.

A related concern is whether the Federal Reserve will be able to act sufficiently fast once it determines that it is time to raise the IOER. This concern reflects the view that the excess reserves sitting on banks' balance sheets are essentially “dry tinder” that could quickly fuel excessive credit creation and put the Fed behind the curve in tightening monetary policy.

In terms of imagery, this concern seems compelling—the banks sitting on piles of money that could be used to extend credit on a moment's notice. However, this reasoning ignores a very important point. Banks have always had the ability to expand credit whenever they like. They didn't need a pile of “dry tinder” in the form of excess reserves to do so. That is because the Federal Reserve's standard operating procedure for several decades has been a commitment to supply sufficient reserves to keep the fed funds rate at its target. If banks wanted to expand credit that would drive up the demand for reserves, the Fed would automatically meet that demand by supplying additional reserves as needed to maintain the fed funds rate at its target rate. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves on their own balance sheets or can source whatever reserves they need from the fed funds market at the fed funds rate.

It is also worth pointing out in passing that a failure to raise short-term interest rates at the appropriate moment based on our dual mandate objectives would also be a losing strategy with respect to net income. Inflation would climb, bond yields would rise and the Fed would ultimately be forced to raise short-term rates more aggressively, or to sell more assets at lower prices to regain control of inflation. This would almost certainly result in larger reductions in net income than a timelier exit from the current stance of monetary policy.

Nevertheless, there are important mitigating factors that suggest that it would be unwise for the Federal Reserve to over-react to recent commodity price pressures. First, despite the general uptrend, some of the recent commodity price pressures are likely to be temporary. In particular, much of the most recent rise in food prices is due to a sharp drop in production caused by poor weather rather than a surge in consumption (Chart 26). More typical weather and higher prices should generate a rise in production that should push prices somewhat lower. This is certainly what is anticipated by market participants, as shown in Chart 27.

"Today you can buy an iPad 2 that costs the same as an iPad 1 that is twice as powerful," Dudley said. "You have to look at the prices of all things."

This prompted guffaws and widespread murmuring from the audience, with one audience member calling the comment "tone deaf."

"I can't eat an iPad," another said.

As reported by Reuters

It is important to emphasize that we at the Federal Reserve have been expecting the economy to strengthen. We provided additional monetary policy stimulus via the asset purchase program to help ensure that the recovery regained momentum. A stronger recovery with more rapid progress toward our dual mandate objectives is what we have been seeking. This is welcome and not a reason to reverse course.

Moreover, the rise in commodity prices is likely to put further upward pressure on headline inflation in the coming months. Provided commodity prices level off around current levels, the effect on inflation should be transitory. But we will need to ensure that commodity price pressures do not cause inflation expectations to become unmoored. If that were to occur, it would be more difficult to keep inflation in check.

To sum up, economic conditions have improved in the past year. Yet, the recovery is still tenuous. And, we are still far from the mark with regard to the Fed's dual mandate. In particular, the unemployment rate is much too high.

We’re probably going to have excess slack in the U.S. labor market at least through the end of 2012, and that’s one reason that colored my view that we shouldn’t be overly enthusiastic about tightening monetary policy too early.

As reported by Bloomberg News

Dudley said that while the effect of higher oil prices on monetary policy depends on the circumstances, the rise in those prices had led to the U.S. economy losing "a little bit of momentum over the past two months."   The rise in oil prices is "a negative for the growth outlook because it does crimp real incomes and it will probably have some effect on consumer confidence," Dudley added.

As reported by Dow Jones Newswires

Too often the questions asked are: What is most beneficial to the banks of my particular country? Do the regulations bolster or harm my "national champion"? The focus shifts away from the goal of bolstering global financial stability to finding ways of tilting or adjusting the new standards to achieve a national competitive advantage.

This is in not in anyone's interest. As discussed earlier, every nation has an interest in promoting financial stability globally, since the effects of systemic financial stress in one place can swiftly spread throughout the global economy. Moreover, although a relatively loose regulatory regime may attract business from other financial centers, there is no free lunch here. A more lax regulatory regime is likely to expose that country’s taxpayers to huge tail risks.

[W]e currently operate with a financial system that is largely regulated on a country-by-country basis.

This is not tenable. What’s required is not some global authority dictating what national authorities can do but instead greater cooperation and trust in exchanging information and agreement on harmonized standards such as those laid out in the Basel III capital requirements and the CPSS-IOSCO Principles for Financial Market Infrastructures. There needs to be a good faith commitment to try to achieve a level playing field. The regulations and supervisory practices that are put in place should be determined by what is good for the public good writ large, rather than what benefits some narrow set of private financial institutions or markets.

We can exit and will exit when time comes but that doesn't mean that exit is close at hand.

Provided [commodity] prices stabilize (or indeed retreat), I would expect headline inflation to move back to a mandate-consistent rate.

[W]e still have a considerable way to go to meet the Fed’s dual mandate of full employment and price stability.

The recovery remains moderate and we still have a considerable way to go to meet the Fed's dual mandate of full employment and price stability.

“It is important for us not to overreact to this inflation, raise interest rates dramatically, to snuff this inflation out because if we did we would have a very bad consequence for economic activity and employment,” Dudley said today in response to questions in Middletown, New York. “We are trying to strike the appropriate balance.”

“The rise in gasoline prices is really troubling to everyone,” Dudley said today in response to audience questions after a speech in Fishkill, New York. “So far, the pass through of higher energy prices seems to be very modest. That is consistent” with the historic trend.

“We will do whatever we need to do to keep inflation in check over the medium to long term,” Dudley said. “It is important we don’t overreact” to the temporary increase in food and energy prices.

For the Federal Reserve, pursuing the dual mandate of full employment and price stability allows us to make an important contribution to global stability and growth. Ensuring low and stable inflation preserves the purchasing power of the dollar and sustains its attractiveness as a medium of exchange. Supporting maximum sustainable employment means that we have an important growth mandate.

This remains the case even when we are at the so-called zero bound with respect to short-term rates. In this context, I believe that our large-scale asset purchase programs were fully consistent with our global responsibilities.

The statement issued by the FOMC earlier this week presents a sober assessment of the state of the U.S. economy...

In light of the current outlook, the FOMC in its statement noted that we now anticipate that we are likely to keep short-term interest rates exceptionally low at least through mid-2013. We also discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. Further details on the discussion at the meeting will be available when the minutes are published in three weeks time. I will not comment on monetary policy any further today.

“We very much still expect the economy to recover,” Dudley, 58, said today in response to audience questions after a speech in Newark, New Jersey. Growth during the second half of 2011 will be “significantly firmer” than in the first six months, and the risk of recession remains “quite low,” he said.

"We have plenty of ammunition left."

William C. Dudley said U.S. economic performance is “at worst, mixed,” with negative news offset by loosening credit, firmer retail sales and stronger bank balance sheets.

Banks are “in much better shape” than a year ago, with “huge liquidity buffers compared to where they were in 2008,” Dudley said today in response to an audience question after a speech in Lyndhurst, New Jersey.  Real-estate financing is “a little more available today than” 12 months ago.

Some of the weakness in economic activity in the first half of the year was due to temporary factors such as the hit to household income from higher food and energy prices, and supply chain disruptions following the tragic earthquake in Japan. These restraining forces have abated and thus, we should see stronger growth in the second half. But it is clear that not all of the weakness was due to these one-time factors—and in light of this, I have revised down my expectations for the pace of recovery going forward.

I would argue that progress on the liquidity front has not progressed as far as desired.First, many banks remain dependent on short-term funding to finance longer-term assets from counterparties that tend to flee at the first signs of distress. In particular, money market mutual funds remain vulnerable to runs. Such runs can occur even when the underlying risks remain negligible, making money market mutual funds a source of instability. Just a question from an investor about the fund manager’s exposures can cause the fund manager to withdraw funding from a counterparty. This may be market discipline, but it does not operate in a way that makes the financial system more stable.

 Without robust growth, the economy is more vulnerable to negative shocks, which unfortunately seem to keep coming. It is like riding a bicycle—at a slow speed, the bicycle wobbles and the risk of falling rises.

“I don’t think the Fed has run out of bullets,” though there are “costs” associated with its options, Dudley said. The Fed could extend its commitment to keep interest rates low or could embark on another round of so-called quantitative easing, he said.

Without robust growth, the economy is more vulnerable to negative shocks, which unfortunately seem to keep coming. It is like riding a bicycle—at a slow speed, the bicycle wobbles and the risk of falling rises. Politics here and abroad have not helped. The intense debate around raising the debt ceiling and the subsequent downgrading of the federal debt took a toll on household and business confidence. More recently, the difficulties in Europe, along with lower U.S. growth prospects made investors less inclined to take risks. So, we saw a major stock market sell-off and widening credit spreads. All these events increase the downside risks to the growth outlook.

[Tag:  Escape velocity]

We could do more in both [balance-sheet expansion and communication] directions. For instance, we could elaborate on our forward commitment to keep short-term rates low. Indeed, I believe it would be desirable if the committee were able to provide additional guidance as to the economic conditions that the committee would expect to see before raising interest rates.

It would be greatly beneficial if the Administration and Congress could more effectively work together to craft a coherent fiscal policy. As I see it, this would consist of two elements—continued near-term fiscal support to underpin economic activity and long-term fiscal consolidation to ensure debt sustainability. Without action in Washington, fiscal policy will turn sharply restrictive in 2012—exerting a direct drag on real GDP growth of more than one percentage point. At the same time, the long-term path under current policy is unsustainable.

Dudley said there “should be no anxiety” about whether the Fed’s enlarged balance sheet will cause the economy to overheat. The ability to pay interest on excess reserves “basically allows us to keep credit expansion under control,” he said. Market participants “accept this view,” as long-term inflation expectations are “very well-behaved,” he said.

[B]ecause the outlook for unemployment is unacceptably high relative to our dual mandate and the outlook for inflation is moderate, I believe it is also appropriate to continue to evaluate whether we could provide additional accommodation in a manner that produces more benefits than costs, regardless of whether action in housing is undertaken or not.

After a brief run-up during the second quarter of 2011—reflecting the pass-through from higher commodity prices and supply-chain disruptions—inflation has retreated and may be headed down further.

Eventually, as economic and financial conditions improve, the pursuit of the dual mandate will lead to a different monetary policy stance, one that requires higher short-term interest rates. And, the Federal Reserve will also eventually shrink the size of its balance sheet. These actions will tend to increase the Treasury's net interest costs and pull down the Federal Reserve's remittances to the Treasury. Together, these two effects will sharply push up the Treasury's net interest burden.

The Fed’s outlook for low interest rates until late 2014 “is a forecast of what we currently anticipate we’re going to do,” and policy makers could decide to raise their benchmark rate earlier or later, depending on how the economy evolves, Dudley said.

While difficult work still lies ahead, countries in the euro area have made meaningful progress toward achieving long- term fiscal sustainability.

I do not anticipate further efforts by the Federal Reserve to address the potential spillover effects of Europe on the United States.”

Dudley said the Fed might “reconsider” additional stimulus measures if the economy got worse.

He described the conditions that would prompt this: “If we get back into a situation where the U.S. economy is faltering and we’re not having the kind of economic growth putting the unemployment rate on a clearly downward trajectory. If inflation is well behaved or if inflation expectations are starting to falter.”

On the inflation front, the overall rate of increase of consumer prices, as measured by the 12-month change of the price index for personal consumption expenditures, slowed to 2.3 percent in February from a recent peak of 2.9 percent last September. Even though the recent rise of gasoline prices mentioned above could interrupt this pattern, we expect this moderation of overall inflation to resume later this year.

"Actions such as our purchase of U.S. government securities are driven exclusively by our monetary policy goals,” Dudley said. He added “these policy actions will not continue beyond the moment they become inconsistent with our dual mandate objectives."

As long as the U.S. economy continues to grow sufficiently fast to cut into the nation’s unused economic resources at a meaningful pace, I think the benefits from further action are unlikely to exceed the costs.

I would be willing to consider tightening policy at a somewhat earlier stage if growth strengthened sufficiently to materially improve the medium-term outlook and substantially reduce tail risks, or if there was evidence of a genuine threat to medium-term inflation, including a rise in inflation expectations. In such a case, I would anticipate that the first step would be to bring in the late 2014 date of the policy guidance.  This would effectively tighten financial conditions not only by changing the expected path of short-term interest rates, but also by bringing forward the expected start of balance sheet normalization.

“A glaring vulnerability exists with money-market mutual funds.”

“Money funds should have capital buffers and modest limits on investor withdrawals. Such reforms are necessary to protect the economy from financial instability in the future.”

“Contrary to what some in the industry suggest, run risk didn’t end when the SEC sensibly tightened rules on money-fund holdings in 2010.”

“I seriously doubt that the reforms I propose would lead to the demise or even the radical restructuring of the money- market-fund industry,”

Money funds are particularly prone to run at times of stress because the funds themselves are highly exposed to runs from their own investors. This is due to shortcomings both in design and regulation. They are marketed as offering stable net- asset values. Investors who put a dollar in believe they can always take a dollar out. But this hasn’t always been true, and it won’t necessarily always be true in the future. Money funds take risks, and sometimes these risks turn sour.

In the absence of further monetary easing, I concluded that growth would remain too subdued over the next several years to make big inroads into the spare capacity that remains from the Great Recession. As a result, unemployment would remain unacceptably high, with economic risks skewed to the downside. Meanwhile, with substantial slack in labor markets and inflation expectations stable, inflation was likely to remain a bit below our 2 per cent longer-run objective.

In this situation, I concluded that our policy framework means that further monetary policy easing was appropriate provided that the benefits of using the tools available outweighed the costs. In my judgment, this standard has been satisfied here. I am confident that the costs are manageable, based in part on the experience we have of using the tools these past four years and that the benefits substantially exceed the costs, recognizing, of course, that our actions are not so powerful that they will instantly transform the economic outlook.

In terms of our monetary policy regime, the FOMC statement noted that the Committee expects to maintain a highly accommodative stance of monetary policy "for a considerable time after the economic recovery strengthens." This is important because in situations such as the one we find ourselves in today, when monetary policy is somewhat constrained because we cannot lower the federal funds rate below zero, one of the most powerful things a central bank can do is to provide guidance as to how it will behave in the future. In this respect, I am pleased that we have drawn a sharper distinction between what we expect the economy to look like in a few years time and how we expect to set policy based on that outlook.

Another reason why monetary policy has become less effective in stimulating the economy is because the impetus from a given level of monetary accommodation likely has become attenuated—that is, less powerful—over time. Historically, attenuation has not been important because monetary policy typically has not stayed exceptionally easy for long periods of time. But this time is different and that difference may be important.

I would give each of these four explanations some weight for why the recovery has been consistently weaker than expected. But I would add a fifth, monetary policy, while highly accommodative by historic standards, may still not have been sufficiently accommodative given the economic circumstances.

When we achieve a stronger recovery in the context of price stability, I'll view it as consistent with our goals and not a reason to pull back on our policies prematurely. If you're trying to get a car moving that is stuck in the mud, you don't stop pushing the moment the wheels start turning, you keep pushing until the car is rolling and is clearly free.

Today, though, we are focusing on a second impediment to the impact of monetary policy on the economy through housing and mortgage finance: the significant widening of the spread between yields on mortgage-backed securities in the secondary market and primary mortgage rates. Actions taken by the FOMC such as its MBS purchase program operate principally on the secondary rate. For these actions to achieve their full impact, reductions in the secondary rate need to also pass through to the primary rate. To the extent that the primary-secondary rate spread widens the reduction in pass-through limits the full impact of the policy actions.

Let me be clear. We must deal with the fire sale issue in tri-party repo and the heightened run risk it creates. I believe there are three potential ways forward, all of which are superior to the status quo. First, tri-party repo transactions could be restricted to open market operations (OMO) eligible collateral… Thus, one could construct an effective lender of last resort backstop for an OMO-eligible- only tri-party repo system.

However, there are also some significant disadvantages to such an approach. The less liquid collateral could just migrate to be financed elsewhere, with associated run and fire sale risks… [T]his approach would do little to mitigate the risk of fire sales of a defaulted dealer’s collateral by its investors once a dealer is bankrupt.

The second option is to have a mechanism or process to facilitate the orderly liquidation of a defaulted dealer’s collateral. One could imagine a mechanism that was funded by tri-party repo market participants and potentially backstopped by the central bank…

Because no single market participant has a strong incentive to develop such a mechanism, however, sustained regulatory pressure may be required to reach such a solution. From the perspective of the tri-party repo borrowers and investors, the status quo undoubtedly is viewed as superior because neither group is forced to fully bear the externalities associated with their actions. Instead they anticipate that emergency liquidity would be made available in the event of a future systemic crisis.

Third, if borrowers and investors did not embrace an orderly collateral liquidation mechanism, supervisory oversight could be brought to bear to limit the use of tri-party repo funding on the grounds that it is still an unstable source of funds. For example, the use of tri-party repo could be restricted unless borrowers demonstrated that there was an adequate means of orderly collateral liquidation upon the failure of a major dealer.

Turning next to the issue of money market mutual funds, further reform to directly address the incentive for investors to run is essential for financial stability.

In November, the Financial Stability Oversight Council (FSOC) put out for comment three alternative paths forward:13

1. Moving to a floating net asset value (NAV).
2. Retaining a stable NAV, but adding a new NAV buffer and a minimum balance requirement. The minimum balance would be at risk for 30 days following withdrawals. If the fund subsequently “broke the buck” during this period by suffering losses greater than the size of its NAV buffer, the minimum balance would be first in line to absorb these losses.
3. A larger NAV buffer than in the second alternative, but without a minimum balance at risk buffer.

I have stated my views on money fund reform before. Although any of these proposals—depending on the fine print of course—would likely be an improvement over the status quo, the first and third proposals don’t fully eliminate the incentives to run. In the case of a floating rate NAV, fund managers faced with large redemption requests typically sell their most liquid assets first, leaving the remaining investors with a riskier, less-liquid portfolio and a greater risk of loss. Similarly, with a stable NAV and a capital buffer, unless the capital buffer were very large, there would still be an incentive to run because the buffer might not prove large enough to shield the investor from loss.

Because the second option is the only one that actually creates a disincentive to run, as I stated before the FSOC proposal, I view it as the best one for financial stability purposes.

It is worth pausing here to review in a little more detail the two key functions performed by a lender of last resort. The first function is to provide a precautionary backstop: to reduce the risk of a financial panic beginning in the first place by ensuring that collateral can always be financed…

The second function of a lender of last resort is to prevent the fire sale of assets by firms facing a sudden loss of funding from spreading contagion across the system and disrupting the provision of credit to the economy. This is particularly important during a financial panic, when the demand for liquidity increases sharply. Only the central bank has the ability to meet this increased demand under any potential circumstances.

We have banking activity—maturity transformation—taking place today outside commercial banks. If we believe these activities provide essential credit intermediation services to the real economy that could not be easily replaced by other forms of intermediation, then the same logic that leads us to backstop commercial banking with a lender of last resort might lead us to backstop the banking activity taking place in the markets in a similar way.

However, any expansion of access to a lender of last resort would require legislation and it would be essential to have the right quid pro quo—the commensurate expansion in the scope of prudential oversight…

If quantitative thresholds are good for interest rate guidance, why not also have such thresholds for the asset purchase program? There are two reasons. There is somewhat more uncertainty about the efficacy and costs associated with asset purchases than rate guidance and we are likely to learn more about the efficacy and costs as the program unfolds.

So what is this likely to mean in practice? In my view, we should calibrate the total amount of purchases to that needed to deliver a substantial improvement in labor market conditions, by allowing the flow rate of purchases to respond to material changes in the labor market outlook. This makes sense because the benefits of additional accommodation will gradually diminish as we get closer to our full employment and price stability objectives and become more confident that we will reach them in a timely manner. At some point, I expect that I will see sufficient evidence of economic momentum to cause me to favor gradually dialing back the pace of asset purchases.

Of course, any subsequent bad news could lead me to favor dialing them back up again.

The U.S. is in the middle of an energy revolution marked by a steady rise in oil and natural gas production. Just as significant, the sharp fall in natural gas prices in the U.S. has created a huge impetus to investment in energy-intensive manufacturing, such as in petrochemicals. Because the lead times on such investment are long, this impulse will likely persist for many years.

I conclude that costs specific to balance sheet expansion have turned out to be no greater than I had anticipated and, because we have less uncertainty about those costs, they are lower than I would have expected in a risk-adjusted sense. Let me start with three commonly cited potential costs—impairment of market functioning, the unanchoring of inflation expectations, and threats to financial stability.

… Although the costs specific to the asset purchase program appear well-contained, it is also true that the costs increase as the program gets larger. In part, this is due to fact that as the balance sheet increases in size, the risk of a period of low or zero remittances to Treasury also increases. As we acquire more longer-dated assets funded with reserves, the Fed takes on more interest rate risk. This is how the policy works. A byproduct is that our net income and remittances will be unusually elevated for a while, then are likely to fall substantially for a period, before returning to more normal levels. This is because our interest expense will increase substantially when we begin normalizing rates…

There are several important points to make here. First, the potential impact of the purchase program on future Fed remittances was known at the onset of the program—we have no new information here. The outcome depends on how the economy evolves, how we respond, and whether we decide to sell long-dated assets in the portfolio or not.

Second, it is important not to put excessive weight on the possibility of a period of zero remittances. Our mandate is economic not fiscal—our job is to return the economy to full employment and price stability. Moreover, in considering the fiscal consequences of our actions, what matters is not what happens to our remittances—that is far too narrow a perspective — but how our actions affect the federal debt-to-GDP ratio over time. This is the metric we should be focusing on in assessing the potential fiscal consequences of our actions.

Long-term yields rose sharply in 1994 and 2004 when economic recoveries got underway in earnest after sustained periods of unusually low short-term rates. Compared to those episodes, the risk of a spike in long-dated yields this time around may be somewhat lower for two reasons. First, this risk is receiving much attention. Big market moves are typically associated with surprises. For the market to reprice suddenly, I presume there would need to be some new information that led investors to significantly revise their view of the outlook or the Fed's reaction function.

Second, the Fed's expansion of its own balance sheet may be a stabilizing influence. For example, the rise in interest rates during the prior episodes was amplified by convexity-related hedging generated by the lengthening of expected mortgage duration. This should be a less powerful force this time around because the Fed holds a substantial portion of the agency MBS market.

At some point, I expect that I will see sufficient evidence of improved economic momentum to lead me to favor gradually dialing back the pace of asset purchases. Of course, any subsequent bad news could lead me to favor dialing them back up again. As Chairman Bernanke said in his press conference following the March FOMC meeting "when we see that the…situation has changed in a meaningful way, then we may well adjust the pace of purchases in order to keep the level of accommodation consistent with the outlook."

The United States could be doing better. The U.S. fiscal policy program, for example, does not appear well-calibrated to the current set of economic circumstances. We have too much fiscal restraint in the short term, and too little consolidation in the long term.

Because the outlook is uncertain, I cannot be sure which way—up or down—the next change will be. But at some point, I expect to see sufficient evidence to make me more confident about the prospect for substantial improvement in the labor market outlook. At that time, in my view, it will be appropriate to reduce the pace at which we are adding accommodation through asset purchases. Over the coming months, how well the economy fights its way through the significant fiscal drag currently in force will be an important aspect of this judgment.

....

There is a risk is that market participants could overreact to any move in the process of normalization. Indeed, there is some risk that market participants could overreact even before normalization begins, when the pace of purchases is adjusted but the level of accommodation is still increasing month by month.11 Not only could such responses threaten financial stability, but also they might make it harder to calibrate monetary policy appropriately to the economic situation. We will need to think long and hard about how best to develop policy in a way that enables us to respond flexibly to a changing economic outlook, but in a way that is not disruptive to the economy.

As the first nation to experience the zero bound in modern times, Japan was an early pioneer in developing unconventional tools and strategies. Its experiences, both good and bad, along with lessons from other periods such as the Great Depression, have helped to inform the policies adopted by the United States (U.S.) and other nations in recent years. The evolution of policy in Japan, in turn, has been informed, in part, by the experience of the U.S. and other nations.

So what have we learned to date? Let me highlight six key points.

First, and most importantly, managing expectations is critical in the execution of monetary policy at the zero bound...

Second, in managing expectations, good communication is essential...

Third, actions speak louder than words alone. Thus, there is an important role for asset purchases that ease financial conditions to support growth and keep inflation expectations well anchored.

Fourth, the policy instruments interact so that policy as a whole exceeds the sum of its parts.

Fifth, at the zero lower bound, risk management becomes extremely important. In particular, because the costs of getting stuck in a liquidity trap with chronic deflation are high, a central bank should put substantial weight on avoiding this outcome.

Sixth, the constraints imposed by the zero bound limit what monetary policy can accomplish by itself. This increases the importance of complementary fiscal, financial, and structural policy actions. Credible fiscal policies, actions to ensure a healthy financial system, and structural reforms that lift the potential for growth are very important.

Our view is that asset purchases work primarily through the asset side of the balance sheet by transferring duration risk from the private sector to the central bank’s balance sheet.  This pushes down risk premia, and prompts private sector investors to move into riskier assets.  As a result, financial market conditions ease, supporting wealth and aggregate demand.  The fact that such purchases increase the amount of reserves in the banking system and the size of the monetary base is a byproduct—not the goal—of these actions.

However, our policy approach was far from perfect. Comparing actual growth to the growth projections by FOMC participants in the Summary of Economic Projections shows that we were consistently too optimistic about growth over the 2009-2012 period. As a result, with the benefit of hindsight, we did not provide enough stimulus...

Also, we could have done better in communicating our intentions and goals. We put too much emphasis, too early, on the exit. At an earlier stage, we should have put greater emphasis on our commitment to use all our tools to the fullest extent possible for as long as needed to achieve our dual mandate objectives.

Our policies also had a “start-stop” aspect to them that may have undercut their effectiveness. For example, until September 2012, our large-scale asset programs generally specified the total size of the program, with a purchase rate and an expected ending date. This created a void when the programs ended and made our policy response sporadic and hard to forecast. This limited the scope for market prices to adjust in anticipation of our future actions in ways that would help stabilize the economy.

Another shortcoming was in our use of forward guidance with respect to the path of short-term interest rates. Although calendar-based guidance worked reasonably well in influencing expectations about the future path of short-term rates and thus the shape of the yield curve, it was clumsy in a number of respects. For example, if we moved the forward date guidance out in time, did this reflect a change in our reaction function, the amount of desired policy stimulus or greater pessimism about the outlook?

Of course, as we have learned, we have acted to rectify these shortcomings. For example, our asset purchases are now outcome based, tied to the goal of substantial improvement in the labor market outlook, and our forward guidance on short-term rates is tied to unemployment and inflation thresholds rather than to a calendar date.

I'm uncertain about what's going to happen to the economic outlook over the near term because I don't really understand really well how the tug-of-war between the fiscal drag and the improving economy are going to sort of work their way out over the next couple months. I think three or four months from now I think you're going to have a much better sense of is the economy healthy enough to overcome the fiscal drag or not.

…

It's something that I certainly have my eye on, but I'm not very nervous about the fact that inflation's come in a little low relative to our 2 percent target because inflation expectations are still well-anchored. If inflation expectations were coming down, then I'd be a lot more concerned. If inflation expectations are well-anchored, what that means is inflation expectations are higher than the current rate of inflation, and so that'll tend to pull inflation back upwards a little bit.

MCKEE: Over the next five years, two of your researchers recently published a paper suggesting investors can expect abnormally high excess returns on the S&P. Do you agree with their conclusion?

DUDLEY: I learned not to follow forecasts of the stock market.

MCKEE: They base that on the current equity risk premium, which was 5.4 percent as of December, a record high. Does that concern you?

DUDLEY: Well, the equity risk premium is as high as it is because, one, PE ratios aren't that high. So if we take the price-earnings ratio of the stock market, it's around 16, 17. So you flip that to get the E-to-P ratio. It's around 6 percent. And you compared that to real interest rates. TIPS yields are negative. So that equity risk premium, that difference between the two is very, very wide. So that would argue that the stock market isn't grossly overvalued, but there are other ways of looking at it.

If you talk to Bob Shiller, who's a very respected academic who's looked at the stock market, you look at the stock market relative to the trailing 10-year earnings, the stock market actually looks quite expensive. So it really depends on what framework you use to evaluate the stock market.

MCKEE: What do you think of the Brown-Vitter legislation, a 15 percent capital ratio for the biggest banks?

DUDLEY: I think that this is all about costs versus benefits. You could - you could go with a proposal that raised capital requirements on large institutions a lot, which is what the Brown-Vitter legislation does. There are going to be consequences of that. It's going to drive up the cost of credit in the economy. It's going to probably tighten credit conditions for a while. And so you have to weigh that cost versus - versus the benefit of reducing the probability of these firms failing.

I think the - the Dodd-Frank Act basically envisions that there's a more efficient way to achieve the same outcome of ending too big to fail. We all want to end too big to fail, but we should also want to end it in the most efficient way possible, the way that causes the least damage to the economy, that causes the least increase in the spread between the cost of deposits and borrowing.

The other important point to make here is when we're doing purchases, if we continue to do purchases, we're adding stimulus. And people act like if we dial the rate of purchases down somehow we're tightening monetary policy. What we're actually doing is adding less stimulus.

Financial stability is a necessary prerequisite for an effective monetary policy.  There is a critical chain of linkages from monetary policy to banking and onwards to the real economy.  Financial stability is a necessary condition for those linkages to operate effectively.  Thus, it is a necessary condition for monetary policy to be able to achieve its economic objectives.  

If labor market conditions and the economy’s growth momentum were to be less favorable than in the FOMC’s outlook—and this is what has happened in recent years—I would expect that the asset purchases would continue at a higher pace for longer.

If the economic data over the next year turn out to be broadly consistent with the outlooks that the FOMC sees as most likely, the FOMC anticipates that it would be appropriate to begin to moderate the pace of purchases later this year. Under such a scenario, subsequent reductions might occur in measured steps through the first half of next year, and an end to purchases around mid-2014. Under this scenario, at the time that asset purchases came to an end, the unemployment rate likely would be near 7 percent and the economy’s momentum strengthening, supporting further robust job gains in the future.

As is well known, total inflation, as measured by the personal consumption expenditures (PCE) deflator, has slowed sharply over the past year and is now running below the FOMC’s expressed goal of 2 percent... A decomposition of core inflation reveals that some of the decline is due to slowing in the rate of increase in prices of non-food and non-energy goods. This probably is due in large part to the softening of global demand for goods and the modest appreciation of the dollar that has occurred since mid-2011.

In the service sector, the rate of increase in prices of medical services and “non-market” services—the latter includes some financial services—also has slowed notably recently. In contrast, the rate of increase in prices for other non-energy services has been relatively stable. Comparing this set of conditions to that in 2010, the recent slowing of inflation has been less widespread across core goods and core services, and inflation expectations so far have declined less appreciably than they did in 2010. Thus, my best guess is that core goods prices will begin to firm in the months ahead as global demand begins to strengthen and inventories get into better alignment with sales.

As Chairman Bernanke stated in his press conference following the FOMC meeting, if the economic data over the next year turn out to be broadly consistent with the outlooks that the FOMC sees as most likely, which are roughly similar to the outlook I have already laid out, the FOMC anticipates that it would be appropriate to begin to moderate the pace of purchases later this year. Under such a scenario, subsequent reductions might occur in measured steps through the first half of next year, and an end to purchases around mid-2014. Under this scenario, at the time that asset purchases came to an end, the unemployment rate likely would be near 7 percent and the economy’s momentum strengthening, supporting further robust job gains in the future.

As I noted last week in our regional press briefing, a few points deserve emphasis. First, the FOMC’s policy depends on the progress we make towards our objectives. This means that the policy—including the pace of asset purchases—depends on the outlook rather than the calendar. The scenario I outlined above is only that—one possible outcome. Economic circumstances could diverge significantly from the FOMC’s expectations. If labor market conditions and the economy’s growth momentum were to be less favorable than in the FOMC’s outlook—and this is what has happened in recent years—I would expect that the asset purchases would continue at a higher pace for longer.

...

[E]ven under this scenario, a rise in short-term rates is very likely to be a long way off.  Not only will it likely take considerable time to reach the FOMC’s 6.5 percent unemployment rate threshold, but also the FOMC could wait considerably longer before raising short-term rates.  The fact that inflation is coming in well below the FOMC’s 2 percent objective is relevant here.  Most FOMC participants currently do not expect short-term rates to begin to rise until 2015. 

To begin to taper, I have two tests that must be passed: (1) evidence that the labor market has shown improvement, and (2) information about the economy’s forward momentum that makes me confident that labor market improvement will continue in the future. So far, I think we have made progress with respect to these metrics, but have not yet achieved success.

With respect to the first metric, {the} decline in the unemployment rate overstates the degree of improvement.

…

With respect to the second metric, …—confidence that the economic recovery is strong enough to generate sustained labor market improvement—I don’t think we have yet passed that test. The economy has not picked up forward momentum and a 2 percent growth rate—even if sustained—might not be sufficient to generate further improvement in labor market conditions. Moreover, fiscal uncertainties loom very large right now as Congress considers the issues of funding the government and raising the debt limit ceiling. Assuming no change in my assessment of the efficacy and costs associated with the purchase program, I’d like to see economic news that makes me more confident that we will see continued improvement in the labor market. Then I would feel comfortable that the time had come to cut the pace of asset purchases.

…

I do believe that we are making progress towards our objectives of maximum sustainable employment in the context of price stability. The economic fundamentals are improving and I expect that the healing process will continue in the coming months and years. At the same time, it is important to recognize that the financial crisis generated significant headwinds that are only slowly abating. We must push against these headwinds forcefully to best achieve our objectives.

My view is that the neutral federal funds rate consistent with trend growth is currently very low. That’s one reason why the economy is not growing very fast despite the current accommodative stance of monetary policy.  Although the neutral rate should gradually normalize over the long-run as economic fundamentals continue to improve and headwinds abate, this process will likely take many years.  In the meantime, the federal funds rate level consistent with the Committee’s objectives of maximum sustainable employment in the context of price stability will likely be well below the long-run level.

There are several reasons motivating our interest in developing {an overnight fixed-rate reverse repo} facility. First, such a facility should enable the Federal Reserve to improve its control over the level of money market rates. .. These reverse repos would be available to an expanded set of counterparties that includes many of the money market lenders who are ineligible to earn the interest on excess reserves (IOER), such as GSEs and a number of money market funds. Depending on the facility rate, these lenders who cannot earn the IOER rate might get a better rate by investing in the overnight RRPs compared to lending to banks or to broker dealers. This competitive effect could, in and of itself, put a stronger floor on money market rates.

Second, this new facility is also likely to reduce the volatility of short-term interest rates. If a lender that cannot earn the IOER rate has an unexpectedly large amount of funds to invest, this lender currently may have to accept an unusually low interest rate. But with the overnight reverse repo facility in place, this lender could lend as much funds as desired to the facility at a fixed rate and this should reduce the downward pressure on money market rates. By tightening control and reducing the volatility of short-term rates, such a facility should reassure investors that the Federal Reserve has sufficient tools to manage monetary policy effectively even with a very large balance sheet.

In coming months we will test the facility with two goals in mind. First, we want to be assured that there are no glitches operationally with somewhat higher transaction volumes than in previous tests, that we can accept cash from a larger array of counterparties, post collateral in the tri-party repo system and reverse the transactions each day smoothly. Second, while the limited size of the operations during this exercise will prevent the operations from having a significant impact on market rates, we will observe how the facility impacts individual investor demand relative to other market rates. Additionally, we can see how sensitive that demand is to changes in market conditions such as quarter-end that increase the demand for safe assets. These observations will give us some insight into how the facility could affect the entire constellation of money market rates. Only by testing and learning will we be able to assess how best to use the facility.

There are several reasons motivating our interest in developing {an overnight fixed-rate reverse repo} facility. First, such a facility should enable the Federal Reserve to improve its control over the level of money market rates. .. These reverse repos would be available to an expanded set of counterparties that includes many of the money market lenders who are ineligible to earn the interest on excess reserves (IOER), such as GSEs and a number of money market funds. Depending on the facility rate, these lenders who cannot earn the IOER rate might get a better rate by investing in the overnight RRPs compared to lending to banks or to broker dealers. This competitive effect could, in and of itself, put a stronger floor on money market rates.

Second, this new facility is also likely to reduce the volatility of short-term interest rates. If a lender that cannot earn the IOER rate has an unexpectedly large amount of funds to invest, this lender currently may have to accept an unusually low interest rate. But with the overnight reverse repo facility in place, this lender could lend as much funds as desired to the facility at a fixed rate and this should reduce the downward pressure on money market rates. By tightening control and reducing the volatility of short-term rates, such a facility should reassure investors that the Federal Reserve has sufficient tools to manage monetary policy effectively even with a very large balance sheet.

…

In coming months we will test the facility with two goals in mind. First, we want to be assured that there are no glitches operationally with somewhat higher transaction volumes than in previous tests, that we can accept cash from a larger array of counterparties, post collateral in the tri-party repo system and reverse the transactions each day smoothly. Second, while the limited size of the operations during this exercise will prevent the operations from having a significant impact on market rates, we will observe how the facility impacts individual investor demand relative to other market rates. Additionally, we can see how sensitive that demand is to changes in market conditions such as quarter-end that increase the demand for safe assets. These observations will give us some insight into how the facility could affect the entire constellation of money market rates. Only by testing and learning will we be able to assess how best to use the facility.

Consistent with the modest pace of economic growth, improvement in labor market conditions has been slow. Even though the unemployment rate has declined by 2.7 percentage points from its peak of 10 percent in October of 2009, there are still many people that want jobs but are not counted as unemployed because they are not actively looking for work. An alternative measure of labor market conditions, the employment to population ratio, which is not influenced by changes in the number of these workers, has shown limited improvement. Job loss rates have fallen, but hiring rates remain depressed at low levels. Taken together, the labor market still cannot be regarded as healthy. Numerous indicators, including the behavior of labor compensation, are all consistent with the view that there remains a great deal of slack in labor markets.

If industry is unable to play its role in achieving a holistic solution {to repo market reform}, regulators may find themselves forced to employ the specific policy tools at their disposal in their respective purviews to address the fire sale risk.

The diversity of participants in the tri-party repo market has made it difficult to move forward quickly with a market solution that addresses the risk I have outlined. Industry leadership is absolutely critical to overcoming these challenges. If industry is unable to play its role in achieving a holistic solution, regulators may find themselves forced to employ the specific policy tools at their disposal in their respective purviews to address the fire sale risk. While such an approach may indeed enhance the overall stability of this market, it could also lead to unintended consequences that include reducing the efficacy of the critical role played by this market in supporting the broader financial system.

[This] form of forward guidance—pre-commitment to a policy rate path—could create more risk for the central bank. In particular, consider a scenario in which the central bank decided to increase monetary accommodation by committing to maintain a low short-term interest rate for a long time even if this commitment resulted in inflation overshooting the central bank’s objective in the future.

This is not a policy that has been adopted by the Federal Reserve. There are implementation challenges with this approach. In particular, it is difficult for a monetary policy committee today to institutionally bind future monetary policy committees to follow actions that could conflict with their objectives in the future. Without such a credible forward commitment, such policies would likely be ineffective in affecting expectations in the manner needed to provide additional monetary policy accommodation.

Today, I will evaluate three broad sets of choices: 1) Building a credible resolution regime and more resiliency in the financial system that together reduce the systemic costs of failure sufficiently so that large, complex firms can be allowed to fail; 2) taking steps, such as tougher prudential standards, that further reduce the probability of failure of such firms; and 3) breaking up the too big to fail firms so that no firm is so large that its failure would threaten financial stability in the first place.

To summarize, I conclude that building a credible resolution regime is necessary but not sufficient… I will argue that at least as much effort should be made to lower the risk of failure of such large, complex firms. Not only does this include higher capital and liquidity requirements, which we are implementing, but also building incentives into the system so that firm managements will act more forcefully and much earlier to put their firms on more solid ground before they encounter greater difficulties.

Finally, I am not yet convinced that breaking up large, complex firms is the right approach. In particular, these firms presumably exist, in large part, because there are scale or network effects that allow these firms to offer certain types of services that have value to their global clients. These benefits might be lost or diminished if such firms were broken up…

A holistic approach is needed that both provides a credible resolution process for large, complex and interconnected banks, uses enhanced prudential standards and initiatives to further reduce the probability of default and the social losses associated with a default, and that incents management to intervene early to address incipient problems before they threaten the viability of the firm. Relying solely on resolution is not sufficient. Until the Title II resolution process is used, there will remain uncertainties regarding how well this approach will work in practice—especially in a time of market stress. For this reason it is also important to continue to pursue a number of alternative approaches.

But, I have to admit that I am getting more hopeful. Not only do we have some better data in hand, but also the fiscal drag, which has been holding the economy back, is likely to abate considerably over the next few years at the same time that the fundamental underpinnings of the economy are improving.

But there is much more work to do. In particular, I think we have just scratched the surface in understanding how developments in one area, such as capital and liquidity requirements for large, complex financial institutions, affect other areas, such as effective monetary policy implementation. We still don't have well developed macro-models that incorporate a realistic financial sector. We don't understand fully how large-scale asset purchase programs work to ease financial market conditionsis it the effect of the purchases on the portfolios of private investors, or alternatively is the major channel one of signaling?

The 6 ½% is already a little bit obsolete in the sense that we’re really close to it. Most people think that the Fed is not going to raise rates until the unemployment rate is considerably below 6 ½%. So my personal opinion is 6 ½% is not providing a lot of value right now in terms of our communications. So my personal view is this is probably a reasonable time to revamp the statement to take out that 6 ½% threshold because it’s not really providing any great value…

Generally, I think the Bank of England’s approach, I think, is a very good approach. It was qualitative rather than quantitative in that they weren’t putting in specific numerical targets. I think that’s appropriate in the U.S. We are going to have to look at a broad set of labor market conditions rather than one single indicator. The labor market in the U.S. is difficult to interpret right now…We don’t really have a really good sense of how much this fits in which category, how much the decline in participation is demographics versus how much the decline is participation is discouraged workers. So I think that tells you you have to look at a broad array of indicators rather than just focusing on the unemployment rate.

The other thing I liked about the Bank of England’s approach is that they did talk about the longer term, not just focusing on the timing of liftoff, but also what happens after that. And as you recall, the Bank of England made it clear they’ve thought the rate at which rates would rise would be gradual, and that rates would not rise to particularly high levels, because I think their view was that there are going to be persistent headwinds restraining the economy. A neutral interest rate in the current environment is going to be lower than a neutral interest rate has been historically. That same rational applies here in the U.S. I think that the equilibrium real interest rate associated with a neutral monetary policy regime today is considerably lower than it was historically. To me, you want to stretch our your expectations of the whole forward path of short rates, not because you have certainty about that, obviously the world’s going to change and you’re going to get new information, but your expectations about forward path of short term interest rates gets embodied into stock prices. That’s an important component in terms of how financial conditions get set. And financial conditions are very, very important because that’s really the transmission mechanism through which monetary policy works. So the more information the Fed can give about what we’re thinking about, the better market participants can assess us. Therefore, financial conditions can be set at an appropriate level.

I think that fundamentally if you look at the U.S. economic outlook, fiscal drag, which has been a big factor, especially last year, has definitely lessened. Number two, the fundamentals for the household sector are definitely improved. The deleveraging process is far along and real incomes seem like they’re starting to improve. The corporate sector is awash in cash. Profits are high and stock prices are very high. And so it looks like the economy—and monetary policy is very accommodative, so you are still getting quite a bit of support from monetary policy. So it seems to us the economy should do better in 2014 than in 2013. The question mark is the weather. The weather is going to make reading the data more difficult over the near term because it’s been unusually cold and snowy. And that’s going to depress economic activity in the first quarter. I think that it’s hard to know exactly how big an impact that is. Certainly it’s going to have a significant impact in housing and construction. The weather feeds into other areas like consumer spending, like auto sales. I think that’s a little bit harder to determine. For myself personally, a working assumption is that the weather is going to take half to one percent off the annualized growth rate in the first quarter. So the first quarter is probably going to be less than 2% in terms of annualized growth. I would expect as you get close to the spring, we’ll see some of these weather effects dissipate.

Federal Reserve Bank of New York President William Dudley said Friday the U.S. dollar faces little threat from the upstart private currency called Bitcoin. “On a whole bunch of metrics, the U.S. dollar wins” over Bitcoin, he said while answering questions after a speech in Brooklyn. “The U.S. dollar is a pretty stable store of value” and so far, the same can’t be said about Bitcoin, he said.

“I think we have a really good currency here in the U.S. called the dollar,” Mr. Dudley said.

Turning first to economic activity, the trajectory of economic growth continues to disappoint… This performance reflects three major factors—the significant headwinds resulting from the bursting of the housing bubble, the shift of fiscal policy from expansion toward restraint, especially in 2012 and 2013, and a series of shocks from abroad—most notably the European crisis.
The good news is that all three of these factors have abated. With respect to the headwinds resulting from the financial crisis, they are gradually becoming less severe. In particular, the sharp decline in household wealth due to the decline in housing prices and the weakness in equity prices has been largely reversed…[T]he financial obligation ratio, which measures the debt servicing cost of households, has declined from a peak of 18.1 percent of disposable income in the fourth quarter of 2007 to 15.4 percent in the fourth quarter of 2013. This is a level not seen since the early 1980s.
On the fiscal side, the amount of restraint has diminished sharply. For 2014, the projected drag is about ½ percent of GDP, roughly half the level of 2013. Moreover, much of this restraint was frontloaded into the beginning of the year, with the cessation of long-term unemployment compensation, the expiration of the bonus depreciation provisions and the higher tax rates that applied to final tax settlements for the 2013 tax year. For the remainder of this year and next, the degree of fiscal restraint should be very modest.
In terms of the outlook abroad, the circumstances are more mixed… When all these cross-currents are considered, the impetus to growth from abroad appears little changed from last year.

I think there is some confusion as to whether the FOMC’s 2 percent inflation objective is a ceiling or not. My own view is that 2 percent is definitely not a ceiling. Once we reach 2 percent, I would expect that we would spend as much time slightly above 2 percent as below it, recognizing that we will hardly ever be exactly at 2 percent because of the inherent volatility in prices. If inflation were to drift above 2 percent, all else equal, then we would tend to resist such a rise. But, if inflation were slightly above 2 percent even as unemployment remained far above levels consistent with maximum employment, then the unemployment consideration would dominate because we would be further from the unemployment objective than we are from the inflation objective. This should not surprise anyone. This is what our “balanced approach” implies.

With respect to the trajectory of rates after lift-off, this also is highly dependent on how the economy evolves. My current thinking is that the pace of tightening will probably be relatively slow. This depends, however, in large part, not only on the economy’s performance, but also on how financial conditions respond to tightening. After all, monetary policy works through financial conditions to affect aggregate demand and supply. If the response of financial conditions to tightening is very mild—say similar to how the bond and equity markets have responded to the tapering of asset purchases since last December—this might encourage a somewhat faster pace. In contrast, if bond yields were to move sharply higher, as was the case last spring, then a more cautious approach might be warranted.
In terms of the level of rates over the longer-term, I would expect them to be lower than historical averages for three reasons. First, economic headwinds seem likely to persist for several more years. While the wealth loss following the financial crisis has largely been reversed, the Great Recession has scarred households and businesses­—this is likely to lead to greater precautionary saving and less investment for a long time. Also, as noted earlier, headwinds in the housing area seem likely to dissipate only slowly.
Second, slower growth of the labor force due to the aging of the population and moderate productivity growth imply a lower potential real GDP growth rate as compared to the 1990s and 2000s. Because the level of real equilibrium interest rates appears to be positively related to potential real GDP growth, this slower trend implies lower real equilibrium interest rates even after all the current headwinds fully dissipate.
Third, changes in bank regulation may also imply a somewhat lower long-term equilibrium rate. Consider that, all else equal, higher capital requirements for banks imply somewhat wider intermediation margins. While higher capital requirements are essential in order to make the financial system more robust, this is likely to push down the long-term equilibrium federal funds rate somewhat.
Putting all these factors together, I expect that the level of the federal funds rate consistent with 2 percent PCE inflation over the long run is likely to be well below the 4¼ percent average level that has applied historically when inflation was around 2 percent. Precisely how much lower is difficult to say at this point in time.

Two issues with the overnight reverse repo rate warrant careful consideration. The first is how big a footprint the facility should have in terms of volume. To the extent that the overnight RRP rate were set very close or equal to the interest rate on excess reserves (IOER) without caps, then this might result in a large amount of disintermediation out of banks through money market funds and other financial intermediaries into the facility. This could encourage further development of the shadow banking system. If this were deemed undesirable, this would argue for a wider spread between the overnight RRP and the IOER in order to reduce the volume of flows into the facility.

The second issue is the facility’s potential impact on financial stability. In particular, would such a facility make financial instability less likely? And, when financial stress did occur, would such a facility amplify or dampen financial strains?

On the first point, it seems that such a facility would tend to make financial instability less likely. The overnight RRP facility allows us to make a short-term safe asset more widely available to a broad range of financial market participants. The provision of short-term safe assets by the official sector might crowd out the private creation of runnable money-like liquid assets. This might enhance financial stability by reducing the likelihood of a financial crisis.

However, if a financial crisis were to occur, the existence of a full allotment, overnight, RRP facility might exacerbate instability by encouraging runs out of more risky assets into the facility. That is because the supply of a full allotment facility would be completely elastic at the given fixed rate. Money market mutual funds and other providers of short-term financing could rapidly shift funds into the facility away from assets such as commercial paper that support the private sector. In contrast, in the current regime, when financial crises lead to flows into less risky assets, their interest rates fall, limiting the appetite for these less risky assets. Consequently, under a full allotment setup, runs could be larger and these runs could exacerbate the fall in the prices of riskier assets. Note that the risk here is how quickly financial flows could reverse from one day to the next, not the average level of take-up of the facility over time.

Recently, some economists have argued that the amount of slack in the labor market may be smaller than suggested by the official unemployment rate of 6.3 percent. They focus on the level of short-term unemployment—those workers unemployed for less than 27 weeks—which has returned close to its average long-term level—and argue that it is the short-term unemployed that are critical in driving compensation trends.
My own reading of this research suggests that one should not jump to such a conclusion. Instead, I conclude:
The relative impact of each type of unemployment on wages depends on whether long-term unemployment reflects primarily structural or cyclical force. I suspect that a much greater proportion of those who are currently long-term unemployed have simply been very unlucky compared to historical averages. This blunts somewhat the distinction between being short- versus long-term unemployed.
If the long-term unemployed are simply unlucky as opposed to not having the appropriate skills, then their impact on wages presumably depends on whether or not there is an excess supply of short-term unemployed. If there are plentiful short-term unemployed, they may get the best job opportunities first… But, once the short-term unemployed pool is depleted, then the long-term unemployed will become more relevant to the labor market supply, so their impact on wages and the labor market will likely increase as the labor market tightens.

The weakening demand during recessions forces firms to look for new ways to be more efficient to cope with hard times. These adjustments do not affect all workers equally. Indeed, its what we typically think of as middle-skilled workersfor example, construction workers, machine operators and administrative support personnelthat are hardest hit during recessions. Further, a feature of the Great Recession and indeed the prior two recessions, is that the middle-skill jobs that were lost dont all come back during the recoveries that follow. Instead, job opportunities have tended to shift toward higher- and lower-skilled workers.

Market expectations are that the Federal Reserve will start to raise short-term interest rates around the middle of 2015... That sounds to me like a reasonable forecast, but forecasts often go astray, so I wouldnt put too much weight on that particular set of forecasts.

The world is highly uncertain. In the current environment its still very, very appropriate to continue to follow very accommodative monetary policy.

What was new prior to the crisis was the extent to which maturity transformation and financial intermediation had migrated outside of commercial banks. The growth of what we call the shadow banking system occurred largely without the types of safeguards—robust prudential regulation, deposit insurance, lender of last resort—that have safeguarded the commercial banking system from the types of widespread panics and runs that are capable of destabilizing the financial system. The systemic risk created by this gap in coverage was not well recognized by regulators or the private sector prior to the global financial crisis. Market participants had little incentive to internalize the negative externality of the run-risk created by their collective choice of finance, and they made erroneous assumptions about the liquidity of asset markets and the capacity and willingness of banks to distribute central bank liquidity to the wider financial system during periods of stress. 

Short-term funding of longer-term assets is inherently unstable, especially in the presence of information and coordination problems.

WINKLER: Five-year bond yields suggested for expected inflation have turned positive for the first time in more than three years. Is the Fed ready to accept this tightening of financial conditions?

DUDLEY: Well I think we evaluate what the economic outlook is and what's happening to financial conditions. And obviously we don't control financial conditions. It also depends on what's happening in the global economy. But we definitely take that on board. I think when I - the dollar it has appreciated a bit over the last few months, not by a significantly (inaudible), but obviously that does factor in terms of our economic forecast. If the dollar were to strengthen a lot it would have consequences for growth. We would have poorer trade performance, less exports, more imports. And if the dollar were to appreciate a lot it would tend to dampen inflation. So it would make it harder to achieve our two objectives. So obviously we would take that into account.

...

I think that the dollar partly reflects the relative performance of the U.S. economy relative to performances in other countries, and in that case that you could sort of understand what we're seeing. I think from our perspective we don't care about the dollar per se. In other words that's not a goal, independent goal of policy. Our goal policy is maximum sustainable employment and two percent inflation. Obviously as the dollar moves that affects the appropriateness of a given monetary policy to achieve those objectives. And we certainly take it on board just like we take on board what's happening to the stock market, what's happening to the bond market, what's happening to credit spreads, what's happening to credit availability. All those factors sort of drive our assessment of what's happening to financial conditions. And then that influences our economic outlook. And then that in turn then influences the monetary policy response.

Obviously as the dollar moves that affects the appropriateness of a given monetary policy to achieve those objectives. And we certainly take it on board just like we take on board what's happening to the stock market, what's happening to the bond market, what's happening to credit spreads, what's happening to credit availability. All those factors sort of drive our assessment of what's happening to financial conditions. And then that influences our economic outlook. And then that in turn then influences the monetary policy response.

WINKLER: Five-year bond yields suggested for expected inflation have turned positive for the first time in more than three years. Is the Fed ready to accept this tightening of financial conditions?

DUDLEY: Well I think we evaluate what the economic outlook is and what's happening to financial conditions. And obviously we don't control financial conditions. It also depends on what's happening in the global economy. But we definitely take that on board. I think when I - the dollar it has appreciated a bit over the last few months, not by a significantly (inaudible), but obviously that does factor in terms of our economic forecast. If the dollar were to strengthen a lot it would have consequences for growth. We would have poorer trade performance, less exports, more imports. And if the dollar were to appreciate a lot it would tend to dampen inflation. So it would make it harder to achieve our two objectives. So obviously we would take that into account.

...

I think that the dollar partly reflects the relative performance of the U.S. economy relative to performances in other countries, and in that case that you could sort of understand what we're seeing. I think from our perspective we don't care about the dollar per se. In other words that's not a goal, independent goal of policy. Our goal policy is maximum sustainable employment and two percent inflation. Obviously as the dollar moves that affects the appropriateness of a given monetary policy to achieve those objectives. And we certainly take it on board just like we take on board what's happening to the stock market, what's happening to the bond market, what's happening to credit spreads, what's happening to credit availability. All those factors sort of drive our assessment of what's happening to financial conditions. And then that influences our economic outlook. And then that in turn then influences the monetary policy response.

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.

DUDLEY: Well I think the idea is a very simple one. If I'm compensated in stock, and especially if I'm compensated in stock options I'm basically being given incentives to take a lot of risk relative to debt holders in the company. Well that obviously has potential implications for financial stability, so why not have part of compensation be in the form of debt, in fact I would argue in the form of deferred debt so that if the company gets in trouble the senior management actually bear the consequences. We think this would lead to sort of more conservatism in terms of how people run these companies. So we think it's an interesting idea worth exploring.

 We're having a culture conference in a couple weeks at the New York Fed. And we'll be talking a little bit more about this I think going forward.

WINKLER: And this has made you undoubtedly very popular I'm sure.

DUDLEY: Well I don't really see why this should be problematic. We're not talking about people not getting paid. We're talking about the form of the compensation. I think that you go back and look at the old partnership forms. The partnership typically got paid a very small current payment and then the rest of their compensation was deferred as capital in the firm. And they didn't get that capital back until they actually retired from the firm. And I think if you look at the history of those partnerships that those partnerships were, one, quite successful and, two, actually quite stable. So I think that using the lessons of that kind of model I think would be useful.

WINKLER: So you mentioned the balance sheet earlier in this discussion, which is now more than $4 trillion. The Fed has said that in the long run it should be reduced to the smallest level consistent with, "the efficient implementation of monetary policy." So what would say is the new normal for the balance sheet post crisis?

  DUDLEY: Well that statement was I think is a little bit deliberately vague because I don't think we really know what monetary policy regime for sure is going to be the right monetary regime in the long run. We're going to get a lot of information over the next few years conducting monetary policy with a large balance sheet, relying on the interest on excess reserves as the main tool of monetary policy. If that turns out to be fabulously successful it's possible that we could run monetary policy with what's called a floor system where we set an interest rate that actually has essentially the magnet-setting rates in money markets broadly. Or we could decide that this isn't so - this doesn't work so well, and we want to go back to the system that we had before the crisis, which was just a very small amount of reserves in the system with the federal funds rate balanced by the Federal Reserve adding and subtracting reserves to keep things in balance. I think my own view is it's too soon to make that call. That call will be made by future committees.

And my own personal opinion is let's see how things go. Let's learn. And as we learn then we can figure out what regime is right. And then that will determine the size of the balance sheet. Now what the principals are basically saying though, whatever regime we pick we're going to want to keep this balance sheet as small as possible, consistent with that regime being effective.

Well you could try to present baseline and alternative {fed funds} forecasts, but I think again I think the problem with that is that it overstates the degree of certainty about that path relative to that forecast. I think that the reality is one of the problems of the summary of economic projections is that it's really focused on modes, what's people's modal outlook for interest rates. And the reality is highly likely that the modes will not actually be realized.

So I think the second problem of course you have is that and we have 17 members right now of the - of participants of the FOMC. A lot of them are all over the country. And so the ability to get all this group together to agree on a precise path of interest rates under the baseline versus on other forecasts I think that would be actually quite difficult to do in a very timely way.

So I think central banks around the world that have actually published forecasts typically they have a monetary policy committee that's quite small. And usually it's located in one place.

One thing that we have right now is the so-called dot-plot. So there's interest rate projections from all the 17 participants on the FOMC for 2014, '15, '16, '17. And people are interested in those numbers as a guide to when the Fed is actually likely to lift off.

My own personal opinion is that I think people shouldn't overweight the value of those dots, especially as you get out further in terms of the time horizon. I have a dot for '15, '16 and '17, but if I told you what my confidence and around that dot was you would probably not put a lot of weight on where that dot is precisely located. So I think the subcommittee I think will look at the issue.

Are there improvements that can be made in terms of how we communicate the summary of economics projections information? Obviously if it was obvious that there was a better way of doing it I'm sure we would be doing it already. So I don't think that people should be sort of waiting for big changes, but if we can find ways to that improve the communication process then certainly we'll go forward with that.

Well I think being at the zero lower bound is not a very comfortable place to be because, one, the tools of monetary policy at the zero lower bound are more limited.

Number two, you also have some consequences for the economy. I think one of the things that makes me less happy is the fact that the crisis was really about debtors. And then the monetary policy response has really been hard on savers. So getting out of the zero lower bound would also be a good thing for savers. So I think my view is I want to get off the zero lower bound as soon as I think it's appropriate because I think being there is just uncomfortable. And I think it's also it would be nice to actually for savers actually to get a positive return.

Reference rates have become a ubiquitous but largely hidden fiber in the fabric of financial markets. They play a critical role in making financial markets more efficient by reducing information frictions, lowering transactions costs and mitigating the moral hazard. The FSB report10 was released in July and Governor Powell11 has recently described the Federal Reserves plans to support the two primary components of the reform of LIBOR. First, we are considering, in cooperation with the LIBOR administrator and other members of the official sector, ways to broaden the definition of LIBOR to more adequately represent current patterns of bank funding and to anchor it more firmly in observable transactions. Second, we believe it is important for market participants to have access to a range of appropriately created and governed reference rates that best suit their particular business needs. For example, some activities such as interest rate derivatives might be better served with a risk-free or near risk-free reference rate, rather than one that embeds a bank credit risk component. I would like to emphasize three points in support of the FSB recommendations and our own efforts. First, the FSB recommendations make clear that there is not one single path for all jurisdictions to achieve the common objective of more robust and resilient reference rates. Rather, each jurisdiction must take into account its own specific institutional, legal and market practices and arrive at its own best solution. In the U.S., I believe it is important to identify alternative reference rates that are grounded in a strong governance framework as laid out in the IOSCO principles and that are supported by market transactions. This brings me to my second pointgiven a set of robust reference rates that meet IOSCO standards, the choice among these reference rates should be left to market participants who can best identify the specific rate that is most appropriate for a specific business need. Third, the Federal Reserve is committed to working with market participants of all kindsdealers, end users, legal and accounting expertsto help develop robust reference rates that meet the needs of all types of market participants. In addition to these specific efforts around improving and finding alternative benchmarks, the New York Fed is sponsoring other efforts related to the reform of market practices and benchmark rates. The Foreign Exchange Committee (FXC) and Treasury Market Practices Group (TMPG), for example, are two groups of senior market practitioners sponsored by the New York Fed that are working within their markets to identify best practices for trading and behavior related to benchmark rates. Both groups also have published broader sets of best practices for the foreign exchange markets, and for Treasury, agency debt and agency MBS markets. I would ask all market participants to ensure that these and other best practices guide the behavior that we should expect from participants in financial markets.

A wide array of economic indicators now suggest that growth in the U.S. has picked up and is widely expected to be around 3 percent during the second half of 2014 and in 2015 While I believe that the risks around this consensus forecast are reasonably well balanced, I also believe that the likelihood that growth will be substantially stronger than the point forecast is probably relatively low.

There is a great deal of uncertainty about the resulting path of the unemployment rate, with some forecasters expecting a fairly steep decline to around 5 percent by the end of 2015, while others anticipate a much more gradual decline.

Because it looks very likely that the program will have fulfilled its objectives, I expect to support a decision to end the asset purchase program at the end of this month.

In recent years, there have been ongoing occurrences of serious professional misbehavior, ethical lapses and compliance failures at financial institutions. This has resulted in a long list of large fines and penalties, and, to a lesser degree than I would have desired employee dismissals and punishment.

I reject the narrative that the current state of affairs is simply the result of the actions of isolated rogue traders or a few bad actors within these firms. As James OToole and Warren Bennis observed in their Harvard Business Review article about corporate culture: Ethical problems in organizations originate not with a few bad apples but with the barrel makers. That is, the problems originate from the culture of the firms, and this culture is largely shaped by the firms leadership. This means that the solution needs to originate from within the firms, from their leaders.

For the economy to achieve its long-term growth potential, we need a sound and vibrant financial sector. Financial firms exist, in part, to benefit the public, not simply their shareholders, employees and corporate clients. Unless the financial industry can rebuild the public trust, it cannot effectively perform its essential functions. For this reason alone, the industry must do much better.

In conclusion, if those of you here today as stewards of these large financial institutions do not do your part in pushing forcefully for change across the industry, then bad behavior will undoubtedly persist. If that were to occur, the inevitable conclusion will be reached that your firms are too big and complex to manage effectively. In that case, financial stability concerns would dictate that your firms need to be dramatically downsized and simplified so they can be managed effectively.

[G]iven the dollars role as the global reserve currency, the Federal Reserve has a special responsibility to manage U.S. monetary policy in a way that helps promote global financial stability.

Like other central banks, our monetary policy mandate has a domestic focus. But, our actions often have global implications that feed back into the U.S. economy and financial markets, and we need to always keep this in mind. For most of us, the market volatility that we saw during the so-called taper tantrum in the spring and summer of 2013 still remains fresh in our minds. EME financial markets were hit hardest, with declines in equity prices, a widening in sovereign debt spreads and a sharp increase in foreign exchange rate volatility. In the U.S., we saw a spike in Treasury yields, with the 10-year rate rising by more than 100 basis points from early May before peaking in early September.

Most commentary about this period has focused on the shift in expectations with respect to U.S. monetary policyand, in particular, to uncertainty about the timing and implications of Fed taperingas the catalyst for these moves. This focus seems generally right to me.

Looking ahead, it seems likely that markets will remain focused on vulnerabilities that they might have ignored prior to the taper tantrum in 2013. The greater premium on strong fundamentals, policy coherence and predictability will likely remain. There will be no one right answer in managing the trade-offs that come with the changed environment, and adjustment will sometimes be difficult. Moreover, we will undoubtedly experience further bumps in the road. The renewed volatility we saw last month is evidence enough of that. Yet, I think we can remain generally optimistic on the outlook so long as market participants continue to appropriately discriminate across countries, rather than treating EMEs as a homogenous group.

Furthermore, many EMEs generally appear to be better equipped today to handle the Fed's prospective exit from its exceptional policy accommodation than they were in past tightening cycles

The impact that changes in Fed policy can have beyond our borders has led to calls for us to do more to internalize those impacts, or even further, to internationally coordinate policymaking. As Ive already noted, Fed policies have significant effects internationally, given the central place of U.S. markets in the global financial system and the dollars status as the global reserve currency. In pursuing our policy responsibilities, we seek to conduct policy transparently and based on clear principles. We are mindful of the global effects of Fed policy. Promoting growth and stability in the U.S., I believe, is the most important contribution we can make to growth and stability worldwide.

The largest problems that countries create for others often emanate from getting policy wrong domestically. Recession or instability at home is often quickly exported. Equally important, growth and stability abroad makes all our jobs easier. This means that there are externalities in the work we do, so that more effective fulfillment of our domestic mandates helps to bring us to a better place collectively. Ensuring global growth and stability is and will remain our joint and common endeavor.

In considering the appropriate timing of lift-off, there are three important reasons to be patient. First, the Committee is still undershooting both its employment and inflation objectives. Unemployment is too high and inflation is too low. Thus, monetary policy needs to be very accommodative in order to close these gaps relative to the Committees objectives. Second, when interest rates are at the zero lower bound, the risks of tightening a bit too early seem considerably greater than the risks of tightening a bit too late. A premature tightening might lead to financial conditions that are too tight, resulting in a weaker economy and an aborted lift-off. This would be problematic in that it would harm the Feds credibility and, more importantly, would be difficult to rectify. The U.S. experience during the Great Depression and the Japanese experience over the past two decades illustrate the risks of raising interest rates too soon, especially when inflation is running below the central banks objective. Finally, given the still high level of long-term unemployment, there could be a significant benefit to allowing the economy to run slightly hot for a while in order to get these people employed again. If they are not employed relatively soon, their job skills will erode further, reducing their long-term prospects for employment and, therefore, the productive capacity of the U.S. economy.

Furthermore, many EMEs generally appear to be better equipped today to handle the Fed's prospective exit from its exceptional policy accommodation than they were during past tightening cycles. This reflects the fundamental reforms that EMEs have put in place over the past 15 years, as well as the hard lessons learned from past periods of market stress. Among the positives are: The absence of pegged exchange rate regimes that often came undone violently during periods of acute stress; Improved debt service ratios and generally moderate external debt levels; Larger foreign exchange reserve cushions; Clearer and more coherent monetary policy frameworks, supporting what are now generally low to moderate inflation rates; Generally improved fiscal discipline; and Better capitalized banking systems, supported by strengthened regulatory and supervisory frameworks.

In assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures. Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored. However, market-based measures, such as those based on breakeven inflation derived from the difference between yields on nominal versus Treasury Inflation-Protected Securities (TIPS), have registered declines over the past few months, even on a 5-years forward basis. Research done by my staff suggests that much of this decline in market-based measures of inflation compensation reflects a fall in the inflation risk premiumthat is, what investors are willing to pay to protect themselves against inflation risk. Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.

The Dodd-Frank Act mandates supervisory stress tests that assess whether large bank holding companies have a sufficient level of capital to absorb losses during adverse economic conditions.4 The Federal Reserve also conducts a capital planning exercise, called the Comprehensive Capital Analysis and Review or CCAR. This evaluation combines the quantitative results from the Dodd-Frank Act stress tests with a qualitative assessment of whether the largest bank holding companies have vigorous, forward-looking capital planning processes that account for their unique risks. The criteria for both sets of stress tests are dynamic and change in response to evolving risks. For example, past tests have assumed a sharp, sudden, and widespread drop in markets triggered by, say, a large Eurozone shock. The tests also evaluate market interconnectedness, including the risk of major counterparty default.

As part of this effort, I have proposed four specific reforms to curb incentives for illegal and unduly risky conduct at banks. First, banks should extend the deferral period for compensation to match the timeframe for legal liabilities to materializeperhaps as long as a decade. Second, banks should create de facto performance bonds wherein deferred compensation for senior managers and material risk takers could be used to satisfy fines against the firm for banker misbehavior. Third, I have urged Congress to enact new federal legislation creating a database that tracks employees dismissed for illegal or unethical behavior. Fourth, I have requested that Congress amend the Federal Deposit Insurance Act to impose a mandatory ban from the financial systemthat is, both the regulated and shadow banking sectorsfor any person convicted of a crime of dishonesty while employed at a financial institution.

For starters, the Federal Reserve now makes its most consequential supervisory decisions on a system-wide level through the Large Institution Supervision Coordinating Committee or LISCC. The committee comprises representatives across professional disciplines from several Reserve Banks and the Board of Governors. The New York Fed supplies only three of its 16 members. LISCC sets supervisory policy for the 15 largest, most systemically important financial institutions in our country and develops innovative, objective, and quantitative methods for assessing these firms on a comparative basis.

Second, consumers are in better financial shape. Households are carrying less debt, with total household liabilities roughly $500 billion below their cyclical peak in 2008.

Third, the fiscal restraint that has held back growth in recent years has ended, with the federal budget deficit now at a level consistent with a stable to slowly declining federal debt-to-GDP ratio.

Now that these headwinds have subsided, buoyant financial market conditions spurred, in part, by a very accommodative monetary policy should do more to support economic activity. In particular, compared to historical patterns, the current household net worth-to-income ratio is high relative to the personal saving rate.

Another positive development for both the U.S. and the global economy is the sharp decline in energy prices. Lets start with the U.S. perspective. Despite the impressive recent gains in natural gas and crude oil production, the U.S. still is a net importer of energy.

More broadly, the decline in energy prices also will be supportive to the global growth outlook in two other ways. First, by pulling down inflation in many countries it will spur more expansive monetary policy.

Market expectations that lift-off will occur around mid-2015 seem reasonable to me. Although that could change depending on how the economy evolves, my views on when do not differ appreciably from the most recent primary dealer and buy-side surveys undertaken by the New York Fed prior to the October FOMC meeting.

Will these forecasts once again turn out to be too optimistic? Subject to a few caveats that I discuss later, my view is that the likelihood of another disappointment has lessened. The consensus forecast seems like a reasonable expectation, in part, because several of the headwinds restraining U.S. economic activity in recent years have subsided. First, the housing sector is currently in much better balance

Another positive development for both the U.S. and the global economy is the sharp decline in energy prices. Lets start with the U.S. perspective. Despite the impressive recent gains in natural gas and crude oil production, the U.S. still is a net importer of energy. As a result, falling energy prices are beneficial for our economy. In economist parlance, falling energy prices are a positive terms of trade shock for the U.S. Over the near-term, this will lead to a significant rise in real income growth for households and should be a strong spur to consumer spending.

More broadly, the decline in energy prices also will be supportive to the global growth outlook in two other ways. First, by pulling down inflation in many countries it will spur more expansive monetary policy. We are already seeing this response in Europe and Japan. Second, the decline in energy prices is also likely to ease the global fiscal stance. Over the near-term, for oil exporting governments, falling revenue will not be fully offset by reduced expenditures. This will cause major oil exporters to run either smaller budget surpluses or bigger budget deficits.

The second major implication is to be cautious about overreliance on simple monetary policy rules, such as the Taylor Rule, that do not include measures of financial market conditions in their formulation.

As I have noted elsewhere, the Taylor Rule formulation has a number of characteristics that make it a useful input into the policy-setting process

Despite these attractive features, I do not believe that simple policy rules can take the place of in-depth analysis of economic and financial market conditions. While simple policy rules provide useful benchmarks to policymakers, their very virtuetheir simplicityis also a significant shortcoming. Policy rules cannot capture all of the information that is relevant for policymaking. In particular, such rules do not capture the fact that the linkage between the federal funds rate and financial market conditions can be very loose.

With respect to how fast the normalization process will proceed, that depends on two factorshow the economy evolves, and how financial market conditions respond to movements in the federal funds rate target. Financial market conditions mainly include, but are not necessarily limited to, the level of short- and long-term interest rates, credit spreads and availability, equity prices and the foreign exchange value of the dollar.

Over time, financial market conditions have become a much more important factor in evaluating the appropriate setting of monetary policy and the level of short-term interest rates.

So, if the effect of short-term rate changes on financial market conditions has become less predictable and more variable over time, what implications does this have for U.S. monetary policy?

[W]hen lift-off occurs, the pace of monetary policy normalization will depend, in part, on how financial market conditions react to the initial and subsequent tightening moves. If the reaction is relatively largethink of the response of financial market conditions during the so-called taper tantrum during the spring and summer of 2013then this would likely prompt a slower and more cautious approach. In contrast, if the reaction were relatively small or even in the wrong direction, with financial market conditions easingthink of the response of long-term bond yields and the equity market as the asset purchase program was gradually phased out over the past yearthen this would imply a more aggressive approach.

Inflation has been running below the Federal Reserves objective of a 2 percent annualized rate for the personal consumption expenditures (PCE) deflator... Nevertheless, I expect inflation will begin to move back towards our 2 percent objective in 2015. As the economy expands and the labor market continues to tighten, resource slack should decline and this should gradually exert some upward pressure on prices. Also, despite some softness in market-based measures of inflation compensation, inflation expectations still seem well-anchored and this should also work to pull inflation gradually higher.

As an example, one significant conundrum in financial markets currently is the recent decline of forward short-term rates at long time horizons to extremely low levelsfor example, the 1-year nominal rate, 9 years forward is about 3 percent currently. My staffs analysis attributes this decline almost entirely to lower term premia. In this case, the fact that market participants have set forward rates so low has presumably led to a more accommodative set of financial market conditions, such as the level of bond yields and the equity markets valuation, that are more supportive to economic growth. If such compression in expected forward short-term rates were to persist even after the FOMC begins to raise short-term interest rates, then, all else equal, it would be appropriate to choose a more aggressive path of monetary policy normalization as compared to a scenario in which forward short-term rates rose significantly, pushing bond yields significantly higher.

In my view, the paper reaches five major conclusions---conclusions that I find myself broadly in agreement with:

There are many factors that influence the level of the equilibrium real short-term interest rate. Real potential GDP growth may be one factor, but the real equilibrium rate is also affected by financial conditions, uncertainty and risk aversion, financial market performance (e.g., bubbles and busts) and the degree of restraint exerted by the stringency of banking and financial market regulation.

There is little evidence supporting the so-called secular stagnation view that the equilibrium real short-term rate will persistently remain near or below zero.

The equilibrium real short-term rate is non-stationary. Thus, it will not necessarily revert back to some long-run average value.

U.S. and global markets are integrated to a significant degree. As a result, the equilibrium real short-term rates both here and abroad will tend to move together. This seems especially germane in the current environment in which very low long-term government bond yields in Europe and Japan appear to have been an important factor in pulling U.S. long-term yields lower over the past year or so.

Given the uncertainties about the current and future levels of the equilibrium real short-term rate, an inertial policy rule may lead to better outcomes. As a consequence, the process of normalization of monetary policy should proceed cautiously, with short-term interest rates more likely to rise only gradually toward the equilibrium real short-term rate.
...
My point estimate is that the longer-run value of the federal funds rate is 3 percent, well below its long-run historical level of 4 percent. At the same time, I also have little confidence about the accuracy of this specific estimate. So you see that I come out in a very similar place as the authors of this years Monetary Policy Forum paper. They suggest that the long-run equilibrium real federal funds rate might be in the range of 1 to 2 percent. Add on 2 percent inflation, you end up in just about the same place as my current long-term 3 percent nominal federal funds rate point estimate.

I will argue that in the U.S. context, a Taylor-type ruleeven an inertial oneis an incomplete guide for policy because it does not explicitly include financial variables that are important factors in the transmission of monetary policy to the real economy. Finally, I will briefly comment on the issue of secular stagnation and my views on the long-term equilibrium real federal funds rate.
...
While simple policy rules provide useful benchmarks for policymakers, their very virtuetheir simplicityis also a significant shortcoming.

If the labor market continues to improve and inflation expectations remain well-anchored, then I would expect -- in the absence of some dark cloud gathering over the growth outlook -- to support a decision to begin normalizing monetary policy later this year.

With the benefit of hindsight, one could argue that the Federal Reserve should have raised short-term interest rates more aggressively over [the 2004-07] period.

“If we hit 2.5 per cent growth in the second quarter and it looks like the third quarter is shaping up for something similar, then I think you are on a firm enough track that you would imagine you would have made sufficient progress in our two tests [for a rate hike], certainly by the end of the year,” he said.
“It would not shock me if we decided to lift off in September, or it wouldn’t shock me if the data were a little softer and it caused us to wait.”

...

The Fed has been guiding investors that its rate hikes will come at a “gradual” pace as it seeks to avoid a repeat of the 2013 “taper tantrum”, in which yields spiked sharply on the back of signals of reduced stimulus from former Fed chairman Ben Bernanke.
Mr Dudley suggested his definition of “gradual” was lifting rates at around half the pace in the Fed’s 2004-07 hiking cycle, when they rose a quarter point at every meeting — but he stressed that the statement was not a “commitment in any way” by the Fed. “Our expectations will evolve in light of the incoming economic information.”

Our colleague Sam Fleming recently interviewed New York Fed president Bill Dudley and asked him about the possibility of the Fed’s maintaining a larger balance sheet indefinitely in conjunction with the use of its reverse repo facility. His answer suggested that the central bank remained undecided:

Q: Do you think in the longer-term, the new normal for the Fed balance sheet in 2020 onwards would be a larger balance sheet than in the past?

A: It is really premature to say. We are going to learn a lot about running monetary policy with a large balance sheet, using the overnight RRP and interest on excess reserves as our primary tools to affect the federal funds rate target.

As we learn that that will probably affect our judgment about whether it would be better to go back to a corridor system, with a very small amount of reserves in the system, or whether it would be better to have a greater amount of reserves and rely on these interest rate instruments to guide the stance of monetary policy.

My personal opinion — not the committee’s opinion — is jury’s out. We are going to learn a lot. Let’s learn and then decide and not make any judgments today.

Q: I think it was Ben Bernanke who argued for sticking with the RRP and having a bigger balance sheet.

A: There are some benefits of having more excess reserves in the system. It is a supply of liquidity, of safe assets to the system, it probably provides a little bit more lubrication to make the system work more easily. But we also have to see how well this works in practice, not just in theory . . .

And the other question is how big is big enough. I would be shocked if we wanted to run a $4.5 trillion balance sheet . . . The question is how much excess reserves would you want in the system if you wanted to run with a system based on interest rates being your primary instrument of policy.

Taken together, we have made considerable progress in terms of the global regulatory regime to reflect the growing importance of FMIs and central counterparties (CCPs) within the financial system.

Let me briefly list a few of the accomplishments of the PFMI:
• They are now being globally adopted and implemented as mandatory, and the specific requirements themselves have been raised substantially. For example, there is a new, explicit liquidity standard to ensure that payments are made on time and in the right currency, and the cover 2 requirement for complex CCPs is much tougher than what came before it.
• They also provide greater detail and scope, including more detailed guidance with respect to CCPs and trade repositories (TRs).
• They are underpinned by a detailed disclosure framework, an agreed assessment methodology and a rigorous monitoring program to both promote consistency in how authorities have adopted and implemented the PFMI as well as, importantly, to promote consistency in outcomes.
• They provide greater harmonization to avoid regulatory arbitrage and race to the bottom behaviors.
• They include requirements and guidance for FMIs to implement their own viable recovery and orderly wind-down plans.

As I see it, great progress has been made, but there is more work to do in a number of areas:
• Greater harmonization and better cross-border mutual recognition practices;
• CCP recovery and resilience as well as coordination with other authorities to ensure incentives are aligned;
• Appropriate incentives for CCPs so that the profit motive does not conflict with having a safe system that can absorb large shocks without destabilizing the financial system; and
• Availability of data in TRs on a cross-border basis to facilitate the development of a more complete picture of market activities and emerging risks.

[A]t this moment the decision to begin the normalization process at the September FOMC meeting seems less compelling to me than it was a few weeks ago. But normalization could become more compelling by the time of the meeting as we get additional information on how the U.S. economy is performing and more information on international and financial market developments, all of which are important in shaping the U.S. economic outlook.

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I'm far away from thinking about quantitative easing... The U.S. economy is performing quite well.

“If the economy continues on the same trajectory it’s on...and everything else suggests that’s likely to continue...then there is a pretty strong case for lifting off” before 2015 ends, he said in a Wall Street Journal interview.

"The interesting question is what happens when the Fed starts to shrink our balance sheet," Dudley said. "We have said in our exit principles that we intend to end the process of investment only after we begin the process of raising short-term interest rates."

And, he added, the Fed has said "we expect the interest rate to be the primary tool of monetary policy, and the balance sheet will be in the background."

The Fed "will be doing the balance sheet shrinkage at some future point in time," Dudley added. "But we will be probably doing it in a way that we have some focus on market function and make sure that our activities don't have bigger consequences for the financial markets. So we will definitely have to take that into consideration in terms of how we shrink our balance sheet over time."

Dudley, who is vice chair of the policy-setting Federal Open Market Committee, said the committee does not intend "at this time to actually engage in asset sales."

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.

What is important for attaining the Federal Reserve’s mandated objectives is not that monetary policy is described in terms of a formal prescriptive rule, but rather that the FOMC’s intentions and strategy are well understood by the public. This argues for clear communication through the FOMC meeting statements and minutes, the FOMC’s statement concerning its longer-term goals and monetary policy strategy, the Chair’s FOMC press conferences and testimonies before Congress, and speeches by the Chair and other FOMC participants. But it also is important that the strategy be the “right” reaction function. This means a policy approach that responds appropriately to important factors beyond the two parameters of the Taylor Rule—the output gap estimate and the rate of inflation.

I don’t think [negative interest rates are] a question that’s on the table right now because I think the economy is growing above trend and the issue is really a question of when are we likely to raise short term interest rates, not whether we are going to lower short term interest rates below zero. Now the one thing that we have seen over the last year or so is other countries have moved to negative short term interest rates and I would say that on balance the unintended consequences of moving to those negative short term interest rates is it’s probably been less than what people had feared, but they’re doing it in a totally different institutional set up than we have in the United States and so it’s not obvious that just because it’s working relatively okay there that you would necessarily want to import it here.

We have a very different system in terms of how our money markets work and I think you’d have to ask yourself the question is the benefit of going to negative interest rates -- obviously in a very different environment than we are in today -- is that does that outweigh the potential cost in terms of unintended consequences. Obviously, as we went through the financial crisis that was an option and we decided not to pursue that option because of fears that the benefits were not sufficient to outweigh the potential costs.

New York Fed President William Dudley, addressing reporters, said he would "completely agree" with Fed Chair Janet Yellen who had earlier said December is in play for a policy tightening if the economic data points to further improvement in the labor market and to a rebound in inflation.

After lift-off the upward trajectory of the short-term rates is likely to be quite shallow.

As a Fed policymaker, I strive to be clear in my communications. But I can’t tell you today precisely what I’d favor doing in the future, because that future remains uncertain.

Dudley said that liftoff won’t come as any surprise to investors when it happens, though he did not rule out some market response when the Fed decides to move.

"The good news is that this is probably the most well advertised, discussed, thought about, mused-over prospect of beginning a normalization of monetary policy in history," he said. "I’m not looking for a big reaction."

"We hope that relatively soon we will become reasonably confident that inflation will return to our 2 percent objective," he said at Hofstra University. Dudley said it was "very logical" to expect that the Fed's inflation and employment conditions would be met "soon," allowing policymakers to "start thinking about raising the short-term interest rates."

[W]e expect that the normalization of monetary policy will be quite gradual. But, there is no commitment here. The flow of the data—broadly defined―will drive our actions as it influences our assessment of the economic outlook and our view of the stance of monetary policy best suited to achieve our dual mandate objectives of maximum sustainable employment and price stability.

In terms of the economic outlook, the situation does not appear to have changed much since the last FOMC meeting. Some recent activity indicators have been on the softer side, pointing to a relatively weak fourth quarter for real GDP growth. But this needs to be weighed against the strength evident in the U.S. labor market. I continue to expect that the economy will expand at a pace slightly above its long-term trend in 2016. In other words, I anticipate sufficient economic strength to push the unemployment rate down a bit further and to more fully utilize the nation’s labor resources.

I continue to expect that the economy will expand at a pace slightly above its long-term trend in 2016...
Putting these positives and negatives together, the most likely outlook seems to be more of what we have experienced in this expansion—an economy that grows at slightly above a 2 percent annual rate this year.

While it has a short history, I put more weight on the New York Fed’s survey because its methodology should be more robust in accurately assessing consumer inflation expectations. Compared to the more widely followed University of Michigan survey, for example, the New York Fed survey has several advantages. The sample size is larger, most of the people that are interviewed are the same each month, and the inflation expectations question is posed differently to focus the respondent’s attention on inflation rather than on prices. We believe that all these factors lead to a more reliable estimate of inflation expectations.

I felt that the likelihood of a substantial tightening in financial market conditions due to lift-off was relatively low, in part, because the rate hike was widely anticipated. Market conditions had adjusted quite smoothly—except for some strains observed in the high-yield debt market—as market participants placed higher odds of tightening in the weeks preceding the December FOMC meeting. This reinforced that conclusion. A large market reaction would have been a surprise given that this was one of the most anticipated monetary policy events in history. Also, the policy action needs to be viewed in context. While this decision was the first upward adjustment to short-term rates in nearly 10 years, the actual move was small—only 25 basis points—which, by itself, should have only a very mild impact on the overall trajectory of the economy. As we noted in the FOMC statement and as Chair Yellen pointed out in her December press conference, even after this rate hike, the stance of monetary policy remains accommodative.

Even though this path is shallow relative to previous tightening cycles, the median federal funds rate path of FOMC participants in the December Summary of Economic Projections (SEP) is well above the path implied by the federal funds futures market. Should this be a concern? Does this imply that there is a significant risk of an abrupt future spike in short- and long-term interest rates as market rates realign to levels more consistent with the median FOMC participants’ projections?

I don’t think so for several reasons. First, the SEP projections are modal forecasts—that is, what the participants believe is most likely to happen—whereas those embodied in market prices are a mean—that is, an average across all possible outcomes. One might reasonably expect these modal forecasts to be above the mean when inflation is low and the economic outlook is uncertain. Second, the median federal funds rate forecasts for primary dealers and for buyside participants surveyed just prior to the December FOMC meeting differed only marginally from the December SEP median projections of FOMC participants. This reinforces my judgment that the difference between means and modes is the main factor for the gap between the federal funds futures market and the SEP paths. Third, the differences between the interest rates implied by futures markets and the SEP have been quite small at shorter-term time horizons, such as the end of 2016, and grow much larger as the time horizon lengthens. I think this is noteworthy because the confidence one has at longer horizons should be much lower than at shorter horizons.

I also believe that continuing reinvestment until the federal funds rate reaches a higher level makes sense. We want to ensure that we have the ability to respond to adverse shocks by easing monetary policy by lowering the policy rate. Having more “dry powder” in the form of higher short-term interest rates seems more desirable than less dry powder and a smaller balance sheet.

Now the words “well underway” in the FOMC statement are vague—what does that mean in terms of the level of the federal funds rate? Reiterating the disclaimer that I am speaking for myself, my view is that we should not set a numerical tripwire for ending reinvestment. If the economy were growing very quickly and the risks of an early return to the zero lower bound for the federal funds rate were deemed to be low, then I could see ending reinvestment at a relatively low federal funds rate. In contrast, if the economy lacked forward momentum and the risks of a return to the zero lower bound were judged to be considerably higher, I would want to continue reinvestment until the federal funds rate was higher. Consistent with the general principles I mentioned before, the evolution of the overall monetary policy stance—both interest rate decisions and balance sheet developments—should be data dependent.

"One thing I think we can say with more confidence is that financial conditions are considerably tighter than they were at the time of the December meeting," said Dudley, a permanent voter on the Federal Open Market Committee, the Fed's monetary policy arm.

"So if those financial conditions were to remain in place by the time we get to the March meeting, we would have to take that into consideration in terms of that monetary policy decision," he said.

Inflation is probably going to take a little bit longer to get back to our 2 percent objective, everything equal, than maybe what you thought a few months ago.

I still anticipate that the combination of decreasing resource slack and anchored longer-term inflation expectations will contribute to inflation rising to our 2 percent objective over the medium term. Even so, because of the more persistent effects of energy and commodity price declines and U.S. dollar appreciation, the return of inflation to that goal may be slower than I earlier anticipated. This does not deny the possibility of some upside surprise―such as a sharp upswing in wage growth triggered by low unemployment. But, on balance, I am somewhat less confident than I was before.

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I judge that the balance of risks to my growth and inflation outlooks may be starting to tilt slightly to the downside.

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

The ultimate responsibility for risk identification and risk management remains with the supervised institution. The Federal Reserve’s role is to ensure that the institution has the necessary strong processes in place to achieve this objective. As risks emerge, supervisors intervene, within the realms of their safety and soundness mandates, to require that banks take corrective actions as necessary. Supervision can reduce the chance that a financial firm fails, but it can never provide a guarantee against failure.

In terms of transparency, I do think it is a fair critique that, in the past, the Federal Reserve has not always been sufficiently transparent... During the crisis, I also believe we could have done more to explain the motivations for our extraordinary interventions. At times, while the motivations and objectives might have been obvious to us, they weren’t always as readily apparent to Congress or to the public. I think this created uncertainty about what we were trying to accomplish, and made it more difficult for outside observers to assess the appropriateness of our actions and our motives.

Given my outlook and risk assessment, I judge that a cautious and gradual approach to policy normalization is appropriate. Moreover, caution is also called for because of our limited ability to reduce the policy rate to respond to adverse developments, recognizing that we could also use forward guidance and balance sheet policies to provide additional accommodation if that proved warranted.

The recent rise in inflation and in measures of inflation expectations have increased my confidence around this outlook compared to earlier in the year, but it is still possible that the return of inflation to our objective could take longer than I anticipate... Although the downside risks have diminished since earlier in the year, I still judge the balance of risks to my inflation and growth outlooks to be tilted slightly to the downside.

I expect real GDP growth of about 2 percent in 2016, slightly below the average pace of growth in this expansion, but a bit above my estimate of the potential growth of the U.S. economy. If this materializes, then we should see some further reduction in the unemployment rate to around 4¾ percent—my estimate of the rate that I view as consistent with stable inflation over the long term.

After years at the effective lower bound for short-term interest rates, economic conditions have finally warranted the start of U.S. monetary policy normalization. But these monetary policy adjustments are likely to be gradual and cautious, as we continue to face significant uncertainties and the headwinds to growth from the financial crisis have not fully abated.

The expectations that were shown in the March summary of economic projections, the median of two rate hikes, seems like a reasonable expectation. But it depends on how the economy evolves. Two seems like a reasonable number sitting here today, but it could be more if the economy is stronger and inflation comes back more quickly, or it could be less if the economy disappoints.

I would never say never to any potential policy tool. But when the U.S. economy was weak several years ago and we were far away from our unemployment and inflation objectives, we did not pursue a negative-rate policy, so I would take some signal from that.

Will more reserve currencies strengthen the international monetary system? My answer can be summed up in one word: “yes.”

So it’s not just about is the economy evolving in line with your forecast, but how confident you are about that continuing in the future. I think it’s important to emphasize, it’s not just how the economic data comes in, but how that economic data then influences your expectations about the future outlook. So data that affects the outlook is what really matters.

To reiterate what some of my colleagues have said, June is definitely a live meeting, but obviously what we do depends on how the economy is going to evolve... A few days ago I think there was a pretty strong sense among the FOMC membership ... that the market was not putting in a sufficient probability mass on the notion of tightening at either the June or July meeting. So I’m actually quite pleased to see that that possibility has moved up.

To reiterate what some of my colleagues have said, June is definitely a live meeting, but obviously what we do depends on how the economy is going to evolve. Looking at the market expectations, I think it looks like June is roughly one in three and a tightening through the July meeting looks like about 60% if you look at the federal funds futures market. I don’t know if that’s precisely the right probability, I would have to go around and talk to all of my colleagues, but clearly looking back a few days ago I think there was a pretty strong sense among the FOMC membership, and you can see this in their commentary, that the market was not putting in a sufficient probability mass on the notion of tightening at either the June or July meeting. So I’m actually quite pleased to see that that possibility has moved up.
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If I get convinced that my own forecast is sort of on track, then I think tightening in the summer, with a June/July timeframe, is really a reasonable timeframe.

In terms of the Brexit issue, obviously that is another variable in the mix. The meeting concludes a week before the Brexit vote, and so there’s a possibility of an event a week later that could potentially have consequences for financial market conditions. We’ll have to think about that in terms of waiting, whether it makes sense to go in June or wait a little bit later. My own view is that, in thinking about Brexit, I wouldn’t want to say that it is determinative, that whether you go or wait. It depends a bit on (1) the probability of an adverse vote in the UK, a “leave” vote, what’s our assessment of the likelihood of that, (2) what’s our assessment of what the likely impact on financial conditions would be if there was such a vote and (3) viewing at that in the context of how strong the economy looks at the time.

I’m becoming more confident that inflation is likely to return back to our 2% objective. Namely, if you look at core inflation in particular, it has been pretty stable over the last year despite the weakness in energy prices and despite the strength in the dollar. ... The fact that core inflation was pretty flat in the period ... should make you a little more confident that inflation will return over the medium term to our 2%.
In response to a question about the downtick in the year-over-year growth rate of the core PCE price index:
The core PCE deflator on a year-over-year basis has been bouncing around a little bit. It ticked up a little bit in the first quarter and it looks like it will tick back down a little bit in the second quarter, and I would view that as mostly noise – I wouldn’t take a lot of signal from that.

Typically, when you see data that doesn’t fit what you anticipate, and when you don’t have a good explanation for it, even ex-post, you probably want to discount that information a little bit.