Donald Kohn

The current schedule of eight meetings per year evolved in 1981. Its foundation was the greater focus on the monetary aggregates; meetings around the beginning of each quarter allowed a growth rate for the up-coning quarter to be established, and mid-quarter meetings gave an opportunity to consider mid-course corrections. With less emphasis on the aggregates in conducting short-run policy, this schedule could be reconsidered.

To some extent, the desired number of meetings may depend on the Committee's decisions on the focus of policy and discretion for intermeeting adjustments. Reduced scope for adjustments between meetings might call for more frequent meetings to calibrate policy to incoming information, though greater telephone contact might work in the other direction. And concern that greater attention to the federal funds rate could make adjustments more difficult might argue for more frequent meetings to consider policy alternatives. Generally, more frequent meetings have the advantage of more timely opportunity to review new information, but they also involve the inconvenience of more preparation and travel.

Unorthodox monetary policy may work, but it obviously would have to be through channels other than reducing short-term interest rates since they are already at zero. Those channels might include reducing expected short-term rates by tilting down long-term rates, or reducing term or risk premiums in long-term rates. The latter also would tend to reduce long-term rates and exchange rates as well.

Pumping up the monetary base by itself would be unlikely to be effective in doing either of these things, that is, reducing short-term rate expectations or term and risk premiums. Such increases in the base would tend to go into excess reserves and there is no obvious reason why that would change expectations about future rates. Tilting open market operations to a limited degree toward bonds or foreign exchange also is not likely to do much. Studies show that modest changes in the supply of bonds, Operation Twist kinds of things, do not have much effect on bond yields. Sterilized intervention, which is what in effect such foreign exchange buying would be, also does not do much. However, massive purchases of bonds or massive intervention might. The Federal Reserve did set the rate on government bonds during World War II. If a central bank were willing to purchase all the supply of government bonds, it could set the bond rate again, and presumably this would feed through to corporate borrowing rates as well. So, there are extreme policies involving massive purchases that should work in lowering term premiums and risk premiums.

Presented as part of the staff briefing at the June 30-July 1 FOMC meeting in 1998.

As for the level of the natural rate, it is higher than it has been in some of the past forecasts, although as I noted it drifts down over time as the wealth-to-income ratio drifts down. I think the height is a result of the fact that the wealth-to-income ratio is a lot higher than we thought it was--or thought it was going to be a year or two ago--given what has happened to the stock market. Demand has been much stronger. In effect the experience, in terms of the level of the wealth-to-income ratio and the strength of demand at previous interest rates, has led us to think that the natural or equilibrium rate is a lot higher than we used to believe and a lot higher perhaps than it has been in history. If the strength of demand for producers’ durable equipment and so forth persists, the saving rate, even if it is creeping up, is going to be lower than it has been historically, and then the natural real rate will be high relative to history.

Every forecaster must cope with how best to convey not only what he believes to be the most likely outcome in the forecast, but the uncertainty around that forecast. No method is perfect, but the fan chart has a number of favorable characteristics. It encompasses in one picture not only the most likely outcome, but the growing uncertainty about that outcome as one moves into the future, and any sense that the risks around the outcome are skewed more in one direction or the other. And comparing fan charts between Reports can convey shifts in uncertainty and risks over time, as well as changes in the central tendency.

The inflation forecast and the inflation report are key elements in making policy under the inflation target set by the government and in explaining the policy to the public. MPC members agreed that the process of arriving at the forecast has many useful aspects. It has helped the Committee come to some common understandings on a basic framework for analysis of economic developments, the causes of inflation, and the transmission of monetary policy.

In light of these difficulties, the first priority of the MPC might be to improve the clarity and usefulness of its current forecast made under constant interest rates. To further aid the public in forming expectations about future interest rate changes, the Committee might consider extending the forecast beyond two years either formally in the fan chart, or informally in a discussion of tendencies. Such an extension, together with information about the risks to the forecast, should help the public make informed judgments about the likely course of interest rates. In addition, the Committee might encourage research on how it could determine and publish any views it had about the possible future evolution of the policy rate.

In addition, at few key junctures in the past five years, the Federal Reserve exercised a more flexible monetary policy than inflation targeting probably would have suggested or allowed. The first occurred in reaction to the "seizing up" of financial markets that followed the Russian debt default in the late summer of 1998. Although forecasts were marked down at this time, the easing was faster and larger than would have been suggested by Taylor-type rules based on our past pattern of behavior and incorporating an implicit inflation target. In effect, to protect against the potential for a really bad outcome for markets and economic activity, the policymakers raised the most likely outcome for inflation--or at least skewed the risks toward the possibility that inflation would pick up. Similarly, in 2001, easing was unusually aggressive, even before September 11, as the extent of the demand shock gradually revealed itself. To be sure, when one looks back, the outcomes in both instances in terms of stable inflation were not any different than inflation targeting would have sought. At issue, however, is whether the FOMC would have responded so aggressively to these shocks if it had been constrained by an inflation target. It is a matter of how the central bank is likely to weigh the risks and rewards of various courses of action--where it takes its chances. My sense is that, given the stress on hitting inflation objectives, the pressures of an inflation target would have constrained flexibility that in the end turned out to be useful.

 

I do not believe that inflation targeting, in any meaningful sense of that term, describes what the Federal Reserve has been doing over the last twenty years, or even in recent years, when Marvin [Goodfriend] claims that policy has evolved into "implicit" inflation targeting. Instead, the success of U.S. monetary policy has in large part derived from its ability to adapt to changing conditions--a flexibility that likely has benefited from the absence of an inflation target. Nonetheless, the U.S. economy has enjoyed most of the benefits ascribed to inflation targeting in terms of anchoring inflation expectations as well as inflation itself. It is the focus on long-term price stability that has fostered these benefits, and I believe that this focus will not be at risk with a change in personnel at the Federal Reserve. Considering these points, I am skeptical that for the United States the potential benefits of changing to a regime of inflation targeting would outweigh its possible costs.

With respect to the strength of our responses to output gaps and inflation gaps, I think the Committee hasn’t been as gradual or as damped in its responses as the equations say it has. In my view there are a couple of points indicative of biases there. One is that the Committee has been forward-looking, so we’re really looking at forecasts and not at existing output gaps. We can often bring information to bear that says that a particular shock will likely go away and we don’t need to react so strongly to it.

So I think the wrong stuff is on the right-hand side of these Taylor rules; the Committee is doing much more than looking at the current levels of those two gaps. The second point is that these estimates are made on the assumption of a constant inflation target, in this case from 1987 through the present. I don’t want to get into a discussion of whether it should or should not have been constant. But I do believe that, from 1987 at least into the second part of the 1990s, the Committee surely did not have a constant inflation target. A number of the former members of this Committee talked about an opportunistic approach to reducing inflation. Inflation was higher than it needed to be over the long run, but there wasn’t any extraordinary effort to reduce it. The models wanted us to be stronger in reducing inflation because they had a lower inflation target than the Committee and the Committee didn’t react to the model’s target but to its own. I think that biases the results to finding that the Committee didn’t act as aggressively as the models thought it should, when in fact it acted fairly aggressively—and aggressively enough to get some pretty darn good outcomes for the economy over the past twenty years.

Having said that, I think there is a valuable lesson embedded here, and it goes to the discussion you were having about policy mistakes. It’s better generally for policy to act too strongly than too weakly to developing situations. Serious policy errors have been made when policy doesn’t react aggressively enough to a developing situation. Examples are the Federal Reserve in the 1970s or the Bank of Japan in the 1990s.

That is the sort of policy error that allows expectations to get out in front. It allows a spiral to develop that becomes very, very hard to reverse. If we react too aggressively, that also can be a policy mistake. But tightening too much because we’re afraid of inflation or easing too much because we’re concerned about deflation or recession is much more easily reversed without cumulating expectational problems getting built in. So to me the lesson for the Committee from these optimal rules is that we are probably better off being a little too aggressive than being not aggressive enough in terms of the possible consequences for the economy over time.

In standard models, at a given real interest rate, a sustained increase in the growth rate of productivity should boost demand even more than it does potential supply in the long run. Or, to put the same thing another way--market interest rates eventually must rise after an upturn in productivity growth to equate demand and supply. The extra pressure on demand comes from several sources once the long-run growth of supply notches higher and is recognized by economic agents...In the short run, whether demand exceeds or falls short of potential supply and whether interest rates need to rise are ambiguous...This short-run ambiguity presents a challenge to monetary policy. Because of the lags in the response of the economy, policymakers must not only analyze the existing situation but also form a judgment about how demand and supply are likely to evolve over the next several years.

I would note that patience in policy action can take several forms. One form would be to wait before taking any action; another would be a damped trajectory for the funds rate once tightening begins. A more gradual increase that begins sooner might enable the Federal Reserve to better gauge the financial and economic response to its actions and reduce the odds that a sharp tightening tack would be required at some point to prevent the economy's overshooting. However, this approach might also run a larger risk of prematurely truncating the expansion--especially if markets interpret the first tightening move as presaging a rapid return to a so-called neutral policy.

Solid growth in economic activity, higher prices in some sectors, and hints of the stabilization of overall inflation, along with perceptions by businesses that "pricing power" may be returning, are marking a transition from asymmetric risks of additional disinflation to more nearly balanced risks of rising and falling inflation. This transition is another key piece of the backdrop for monetary policy.

Over time, however, foreign producers seem to be absorbing a greater share of the impact of a falling dollar in their profit margins rather than passing it on fully in their prices, and I expect the drop in the dollar to have only a modest effect on U.S. inflation.

I should note that the course of aggregate demand is not independent of the course of potential aggregate supply. Both economic theory and empirical evidence suggest that households and businesses make decisions about spending with an eye to future incomes and sales, so that a rosier long-term outlook tends to raise demand today. Thus, as the FOMC notes frequently in its statements, robust underlying growth in productivity is providing ongoing support to economic activity...

As with the transition in demand, the transition to less-spectacular growth of potential supply involves important risks. We have been persistently surprised by the extent of the pickup in productivity and could be facing a higher level and growth rate of productivity than many expect. If we are so fortunate as to be confronting these circumstances, policymakers will need to be alert to the need for a faster expansion of aggregate demand to match the stepped-up pace of supply. Conversely, perhaps the transitory factors boosting productivity will recede more sharply than most observers anticipate, and the output gap will close more rapidly. It appears to me that uncertainty in our current situation is at least as great for potential output as it is for demand.

Investor confidence seems to have recovered, at least somewhat, from the corporate governance and accounting scandals revealed in 2002 and 2003.

Judging from the results of statistical models incorporating the factors we have been examining, increases in commodity, energy and import prices together might have boosted core consumer inflation on the order of roughly 1/4 to 1/2 percentage point over the past four quarters.

Nonetheless, the high level of business profit margins suggests that, even if unit labor costs begin to rise more quickly than prices, the effect on inflation could be muted for a time because firms would have room to absorb some of the cost increases in the form of reduced profit margins...To be sure, margins cannot shrink forever--just as they cannot grow to the sky. But elevated margins provide some cushion against cost pressures being passed through to prices--so long as the central bank does not allow excess demand to develop in product markets.

Going forward, I anticipate continued strong growth in demand but, given persistent solid gains in productivity and potential output, only a gradual closing of the output gap. Under these circumstances, ongoing competitive pressures in labor and product markets should help to contain cost and price increases. The downward pressure will probably diminish over time, but at least for a while, economic slack should continue to operate as a restraining force on the overall trend in inflation.

In the labor market, the behavior of compensation in recent years has been consistent with standard models of wage dynamics incorporating a natural rate still somewhat below the current unemployment rate. Moreover, one of the surprising developments of the current cycle has been the extent of the decline in labor-force participation. Many analysts have adopted the working hypothesis that this decline reflects a type of "discouraged worker" effect, albeit one that is not captured in the standard statistical series attempting to measure that phenomenon. Presumably, many of the people who exited the workforce in the face of poor employment prospects now stand ready to resume competing for jobs as the market improves. If that is correct, then the current level of the unemployment rate relative to estimates of the natural rate, may, if anything, understate the availability of labor resources.

In that regard, although a weak economy, associated slack in resource utilization, and rapid increases in productivity were undoubtedly reducing inflation last year, core inflation--especially as measured by the core CPI--seems to have fallen by more, and to a lower level, in 2003 than these fundamentals can explain. Typically, such departures from historically normal behavior do not persist, and inflation tends to return to a level more in line with its fundamental determinants. Indeed, the step-up in inflation this year from last year's pace may partly reflect such a return.

Although paying interest on reserves would yield significant benefits, even greater efficiencies and regulatory burden reduction might be realized by substantially reducing, or even eliminating, reserve requirements.

As we have previously testified, unnecessary legal restrictions on the payment of interest on demand deposits at depository institutions and on balances held at Reserve Banks distort market prices and lead to economically wasteful efforts by depository institutions to circumvent these artificial limits. In addition, authorization of interest on all types of balances held at Reserve Banks would enhance the toolkit available for the continued efficient conduct of monetary policy. And the ability to pay interest on a variety of balances, together with increased authority to lower or even eliminate reserve requirements, could allow the Federal Reserve to reduce the regulatory and reporting burden on depository institutions of reserve requirements.

The Federal Reserve Board strongly supports, as its key priorities for regulatory relief, legislative proposals that would authorize the payment of interest on demand deposits and on balances held by depository institutions at Reserve Banks, as well as increased flexibility in the setting of reserve requirements. We believe these steps would improve the efficiency of our financial sector, make a wider variety of interest-bearing accounts available to more bank customers, and better ensure the efficient conduct of monetary policy in the future.

In the past few years, the financial markets have come through an extraordinarily stressful period, but one that was not marked by the sort of financial-sector distress that accompanied and intensified the economic problems in many previous such episodes. I attribute that relatively good record, in no small part, to greater diversification of risk, to the growing sophistication of risk management techniques being applied at more and more institutions, and to stronger capital positions going into the period of stress.

Other instruments to deal with instability--discount window lending, moral suasion, actions to keep open or slowly wind down ailing financial institutions--are much more likely than monetary policy adjustments to have undesirable and distortionary effects on private behavior.

Central bank[s] must incorporate into [their] decisions the risks and consequences of several alternative outcomes. That is, [they need] to assess not only the most likely outcome for a particular course of action but also the probability of the unusual--the tail event. And [they need] to weigh the welfare costs of the possible occurrence of those tail events. This risk-management approach has been articulated by Chairman Greenspan for monetary policy, and it is equally applicable to a central bank’s decisions regarding crisis management.

Despite their drawbacks much of the time, conditional statements from the central bank about the near-term course of policy can be useful in certain circumstances. These circumstances might include a situation in which the policymakers and the markets seemed to have substantially conflicting forecasts about the economy and the path of policy; such differences persist despite the central bank's efforts to explain its outlook; and the effect of those divergent views on financial conditions threaten to detract from economic performance.

In fact, economists do not fully understand how markets incorporate information. Herding behavior, information cascades, multiple equilibria, and the amount of investment in financial research all pose puzzles about markets and information. The situation is complicated still more when an important participant is seen as having superior information owing to its investment in research or its understanding of its own behavior. In such circumstances, certain types of central bank talk might actually impinge on welfare-enhancing market pricing by being misunderstood and receiving too much weight relative to private judgments.

What we say is important, but what we do over time will ultimately determine economic outcomes. We should not allow a desire for clarity of expression to deflect our decisions from those that would contribute best to overall economic performance and which may be difficult to explain easily. And we must take care that policy expectations engendered by communication do not unduly constrain policy action. Furthermore, we cannot allow transparency to limit discussion in the Committee out of concern about how its publication will affect markets and the economy.

More is not necessarily always better, and at each step of the way central banks have needed to take account of the potential costs as well as the benefits of greater transparency.

We need to be particularly careful that people understand how limited our knowledge actually is--the uncertainty and conditionality around any statement we make about future developments.

The possibility that discussions of future policy, even nonspecific, could create presumptions about a string of policy actions makes finding a consensus among policymakers on what to say about future interest rates quite difficult--more so than agreeing on the policy today. It is no accident that the Reserve Bank of New Zealand stands out as about the only central bank to publish such a path and as one of the few in which decisions are the responsibility of only one individual.

The possibility that discussions of future policy, even nonspecific, could create presumptions about a string of policy actions makes finding a consensus among policymakers on what to say about future interest rates quite difficult--more so than agreeing on the policy today. It is no accident that the Reserve Bank of New Zealand stands out as about the only central bank to publish such a path and as one of the few in which decisions are the responsibility of only one individual.

In the United States, we have some indirect evidence that crowding out of private views has not increased even as the Federal Reserve has become more talkative. Market interest rates have continued to respond substantially to surprises in economic data.

Early release of the minutes could have costs if Committee members became more guarded in their discussion out of concern about the effects of their remarks when reported or if, over time, the minutes themselves became less comprehensive. In my view, neither of these developments is an inevitable consequence of the new schedule, and I am sure the Committee will resist any temptation to allow them to occur.

Reactions to the minutes could be sizable, as they were last Tuesday, but because the minutes do elaborate on the rationale for the Committee's decisions and outlook, these reactions should help markets anticipate policy actions and price assets in ways that foster economic stability.

Minutes of FOMC meetings necessarily contain elements of both policy inclination and economic outlook. Benefits flow from a more timely release of a fuller, more nuanced explanation of why the policy decision was made than is possible in an announcement.

Because of concern about market interpretation, policymakers often see talk about policy inclination also as having the potential for constraining future decisions in ways that might interfere with the most-effective achievement of policy objectives. The stronger the market expectations about near-term policy actions, the greater the risk of roiling markets and creating confusion in the event the decision differs from those expectations.

Over time, I anticipate further steps toward explaining our views, but at a pace that is likely to be measured.

While import growth does not appear to have been the driving force in labor market developments for the U.S. economy as a whole, it’s certainly the case that some industries and some regions have been affected quite significantly by trade.

The direct contribution of rising commodity, energy, and other import prices to consumer inflation is likely to lessen considerably, however. Commodity price increases have slowed; the dollar has flattened out in recent months, which should damp import price increases; and, if they conform to the expectations implicit in futures markets, oil prices should level off and then drop back a bit.

In the housing market, prices are unlikely to fall on a national basis, but the increases well above the rise in rents and incomes that we have seen in recent years cannot continue indefinitely, and rising interest rates will probably damp these increases even more. Home building should cool a bit as a result, but perhaps more consequentially, as capital gains on housing slow, households will likely turn to reducing the growth of their consumption out of current income as a way of building assets to finance their children's education, their retirement, and so forth.

The path of interest rates is not an end in itself--it is a means to an end, which is fulfilling our mandate for maximum employment and stable prices. A measured pace of rate increases is our best guess, for now, of what will accomplish these objectives. But that guess is conditional and contingent on our expectations [on how] the economy will evolve.

Over time, both inflation and inflation expectations will be determined not by adjustments of particular prices but by fundamental factors--the competitive environment in labor and product markets that in turn reflects the extent of resource utilization, and the pace of productivity growth and its effect on costs. The recent news on both fronts suggests that inflation pressures will remain contained, but substantial uncertainty surrounds that outlook.

Market participants should understand the nature of the chances they are taking. Markets price best if they take account not only of the most likely outcome but also of the risks of alternative developments.

Communicating our expectations for policy has been unusual for us. In my view, when it is possible, such communication should help to align expectations better with reality and thereby improve pricing in asset markets and the effectiveness of policy. Some observers have objected because they think our words have removed too much uncertainty from markets, encouraging people to take financial positions that they will regret eventually and, by holding down long-term interest rates, work at cross purposes with firming policy. I believe the performance of the economy, rather than our words, has shaped expectations beyond the very near term.

In this environment, the economy is likely to remain on a path of solid growth, strong enough to continue to gradually reduce unemployment and raise operating rates in industry for a while.

At this time, the odds are that inflation pressures are contained and will remain so.

A limited slowdown in productivity growth would not be a major concern. The margin of prices over unit labor costs is high by historical standards, and firms should be able to absorb some increases in labor costs without passing them on in prices...However, a more substantial and permanent slowdown in productivity growth would put continuing upward pressure on costs that firms eventually would need to recover by raising prices more quickly.

In the latter half of last year, the growth of output per hour slowed, giving a boost to unit labor costs after two years of declines. Those increases were not large, however, and productivity growth seems to have increased at a good clip in the first quarter of this year.

A number of factors have contributed to the unusually low long-term interest rates that we have seen, but one of them has been the changing attitude of savers toward risk...As people have become increasingly confident that good economic performance will last for a while, they have asked for less extra compensation for taking the risks of lending for longer periods and to borrowers whose odds on default are usually viewed as high. These changing attitudes have helped produce an unusual phenomenon--the failure of longer-term interest rates to move higher in an expanding economy with rising short-term interest rates; for many businesses, longer-term borrowing costs have actually fallen since last summer.

Our view has been that we could probably remove our accommodative policy gradually--"at a measured pace" in our jargon. But that expectation has depended on an outlook for inflation remaining contained and growth only moderately exceeding that of the economy's potential.

Judging from aggregate measures of wages and labor compensation, the economy is still operating a little below its long-run sustainable level of production.

The behavior of labor compensation, the height of profit margins, and still-strong productivity growth all suggest that workers and businesses continue to face very competitive market conditions and that cost increases will remain in check. But in the current circumstances, we need to be vigilant for signs of persistent upward pressure on costs, a marked tightening of labor and product markets, a reduction in global discipline on domestic pricing decisions, or increases in inflation expectations--especially expectations of price increases over the longer run.

The FOMC has said that it believes it can remove policy accommodation gradually. That strategy should be successful if...growth ahead is moderate and inflation pressures are contained. Such a strategy has advantages. Importantly, the gradual approach should enable us to better gauge the ongoing effects of our actions in an uncertain world--give us more opportunities to assess the effects of past increases in rates when we know that those effects can vary and will occur with a lag--and hence to calibrate our actions better to the needs of the economy. Moreover, to date, announcing that we expect to remove accommodation at a measured pace has not materially impeded market participants from responding meaningfully to incoming data, primarily by extending the anticipated series of gradual rate increases when these data suggested the potential for greater inflation pressures.

Economic activity has shown a good bit of forward momentum as businesses have stepped up their purchases of capital equipment and households have continued to increase their spending on consumer goods and services and on houses. As a result, economic growth has been sufficient to continue eroding slack in labor and product markets.

Inflation has picked up over the past year or so, but from very low levels and with much of the overall acceleration attributable to an increase in energy prices that should not be repeated any time soon.

We are struggling to understand a major surprise. Despite the recent improvements in job prospects, the percentage of the population either working or looking for work--that is the labor force participation rate--has not yet risen from its recessionary lows. Apparently, the demand for workers has been strong enough to allow many of those actively looking for jobs to find them but not strong enough to pull people back into the labor force who may have dropped out--perhaps for early retirement or additional schooling...The unusual behavior of labor force participation will present a challenge to policymakers.

Monetary policy is still accommodative...But, over time, this policy stance will not be consistent with keeping inflation down. Interest rates need to rise to forestall a buildup of imbalances between aggregate demand and potential supply that would threaten to raise inflation and undermine stability.

Investors seem to expect short-term interest rates to remain on the low side of historical averages for some time. These subdued expectations may reflect a belief that underlying global demand will remain damped and that the world will continue to be willing to invest heavily in the United States.

[The FOMC] should not hesitate to raise interest rates to contain inflation pressures just because it might set off a retrenchment in housing prices, just as we were willing to keep rates unusually low as house prices rose rapidly. Nor should we hesitate to raise rates because higher rates mean higher debt-servicing burdens for the current account, the fiscal authority, or households.

To the extent that current spending behavior is built on realistic expectations--in particular, for future short-term interest rates, the exchange rate, rates of return on capital investments in the United States relative to those abroad, and housing price appreciation--the transition should be relatively orderly: Asset prices should adjust gradually to changing developments, as should the spending patterns of households and firms. But if current expectations are badly distorted, then the way forward may not be so smooth. Eventually, reality always asserts itself over wishful thinking, and such realignments are sometimes abrupt, as illustrated by the collapse of the high-tech bubble a few years ago. In such circumstances, asset prices can adjust sharply, and private spending may also respond quickly, making it difficult for monetary and fiscal policy actions to provide a timely enough counterweight to keep the economy continuously on track.

The federal funds rate appears to be below the level that we would expect to be consistent with the maintenance of stable inflation and full employment over the medium run, and, if growth is sustained and inflation remains contained, we are likely to raise rates further at a measured pace.

To the extent that current spending behavior is built on realistic expectations--in particular, for future short-term interest rates, the exchange rate, rates of return on capital investments in the United States relative to those abroad, and housing price appreciation--the transition should be relatively orderly: Asset prices should adjust gradually to changing developments, as should the spending patterns of households and firms. But if current expectations are badly distorted, then the way forward may not be so smooth...In such circumstances, asset prices can adjust sharply, and private spending may also respond quickly, making it difficult for monetary and fiscal policy actions to provide a timely enough counterweight to keep the economy continuously on track.

Core inflation has been running somewhat faster more recently, in part because of the increases in the prices of energy, commodities, and imports that began last year. Nevertheless, barring further sizable increases in the prices of oil and natural gas, both core and headline inflation rates should moderate later this year. Buttressing this view, long-run inflation expectations have been, on balance, fairly stable in the face of these price gyrations.

In all likelihood, adjustments toward reduced imbalances in the United States and globally will be handled well by markets without, by themselves, disrupting the good, overall performance of the U.S. economy - provided, of course, that the Federal Reserve reacts appropriately to foster price and economic stability. Still, complacency would be ill-advised.

By increasing the return to saving and by damping the upward momentum in housing prices, rising interest rates should induce an increase in the personal savings rate, and thereby lessen one of the significant spending imbalances.

Strong financial institutions are especially important at this time when asset prices could move by large amounts unexpectedly. By ensuring that financial institutions are adequately capitalized and well prepared in general to deal with major changes in asset prices, prudential regulation decreases the risk that the actions of impaired financial institutions could disrupt the flow of credit and thereby intensify what might already be difficult adjustments. In addition, strong institutions should be positioned to weather any necessary changes in short-term interest rates as policy is adjusted.

I do not anticipate a marked and persistent downshift in U.S. productivity growth that would greatly reduce the expected returns from holding dollar-denominated assets. 

Although the overall state of the economy is favorable, some aspects of the current situation might be viewed as worrisome. In particular, beneath this placid surface are what appear to be a number of spending imbalances and unusual asset-price configurations.

One might have thought that, with probably limited economic slack remaining, such a pronounced imbalance between national saving and domestic investment would have placed substantial upward pressure on interest rates. One also might have expected real interest rates to be high at a time when we are experiencing rapid productivity growth. But, as you know, nominal and real yields on both short-term and long-term Treasury securities are low by historical standards...suggesting that investors are sanguine about default risk and other types of uncertainty.

Low interest rates have, in turn, been a major force driving the phenomenal run-up in residential real estate prices over the past few years, and the resultant boost to net worth must be one of the reasons households have felt comfortable directing so little of their current income to saving.

A second observation concerns the housing market, which you have already discussed. A couple of years ago I was fairly confident that the rise in real estate prices primarily reflected low interest rates, good growth in disposable income, and favorable demographics. Prices have gone up far enough since then relative to interest rates, rents, and incomes to raise questions; recent reports from professionals in the housing market suggest an increasing volume of transactions by investors, who (along with homeowners more generally) may be expecting the recent trend of price increases to continue. Even so, such a distortion would most likely unwind through a slow erosion of real house prices, rather than a sudden crash.

A permanent correction to the spending imbalances must involve the restoration of fiscal discipline and long-run solutions to the financing problems of Social Security, Medicare, and Medicaid.

To a great extent, continuation of the current account deficit depends on the willingness of investors to provide financing...We can speculate that unless a persistently large current account deficit in the United States is accompanied by further and continuous shifts in the world's willingness to increase holdings of dollar-denominated assets in their total portfolios, investors will ultimately require higher ex ante rates of return on their U.S. assets relative to those available on foreign assets.

Now that we are in the neighborhood of price stability, we can be faced with looking at the possibility that inflation will fall too low as well as rise too high. Moreover, so long as inflation expectations are well anchored, we can tolerate limited changes in inflation, but we need to know that a rise or fall is not the beginning of a more extended trend. Consequently, we focus closely on the reasons for any changes in inflation and their implications for the outlook.

Changing [inflation] expectations are a principal avenue by which short-term perturbations in price levels are propagated into more persistent changes in inflation rates.

[Inflation expectation] readings from the financial markets are helpful, but they are also muddied by changing premiums for inflation risk and liquidity, and they are not necessarily representative of the attitudes of households or businesses.

A better understanding of the motivation and dynamics of how compensation is determined between firms and individuals or small groups of workers would help unravel a number of the inflation puzzles I think we face, including those involving productivity growth, globalization, markups, and expectations formation.

The degree to which core inflation picked up in 2004 and 2005 also caught many economists, including this one on the FOMC, by surprise.

Shifts in relative prices, such as crude oil and import prices...can feed through fairly directly to the measures of core inflation through their effect on business costs, though their influence on inflation should be temporary unless they get built into labor costs or inflation expectations.

Surprises are inevitable; aggregate supply and demand curves shift for reasons that cannot be anticipated. But improvement should be possible in several dimensions. We could identify shocks sooner and get a better understanding of their likely effects on inflation. And we could attempt to narrow the definition of "shock." I suspect that much of what we consider to be exogenous is the working out of endogenous events that we do not understand very well.

I do not believe that our understanding of the economics of intraday credit is at this point sufficient to provide quantitative guidance on the optimal pricing of daylight credit, even apart from moral hazard considerations.

Some significant disturbances in the past decade have challenged market participants’ and regulators’ understanding of risk and revealed weaknesses in risk-management tools and practices.

The evolution of financial markets and institutions has greatly affected the process of risk management. The means of managing risk have broadened dramatically, but the resulting systems could well be challenged by developments over coming years.

This is not a time for complacency. Financial-market innovations, some of which have not yet been rigorously stress tested, along with a macroeconomic environment that, while most likely stable and constructive, contains significant uncertainty, suggest that vigilance and adaptation by both market participants and regulators will be necessary to improve the odds of sustaining this era of damped economic cycles and supporting the orderly evolution of financial markets.

Although the most likely outcome for the overall economy is good, a number of characteristics of the current situation suggest some greater-than-usual risks around that central tendency, and, in particular, raise questions about the pattern of asset price movements that might accompany even favorable overall economic performance. That caution flows from the existence of some unusual imbalances in the U.S. economy today.

Stable economic environments encourage innovation; indeed fostering a stable economic environment is an important way in which central banks can contribute to public welfare.

The risk of rapid adjustments and unusual configurations of asset price movements is higher than normal.

Since the fall of 1998, we have not seen the kind of widespread uncertainty about the health of major players in financial markets that has in the past tended to intensify and spread the economic effect of adverse events [such as, excesses of the stock market bubble, including not only the overvaluation of many stocks, but also the lapses in corporate governance.] In my view, two basic reasons account for this relatively favorable outcome. First, risks probably are in fact better diversified and better allocated to those who are prepared to absorb them or to those whose financial distress is less likely to have feed-through effects on the economy. Second, monetary policy in the United States responded very aggressively to incipient declines in activity and inflation that resulted from the emerging problems.

I do not anticipate any break in the pattern of generally favorable economic performance over coming years. Most economic forecasts are for moderate growth and low inflation in the United States for the foreseeable future.

In our risk-management approach to monetary policy, we attempt to reduce the odds that our nation will experience damaging macroeconomic tail events, that is, asset price movements that are much more extreme than our usual experience. But our capabilities are limited; ultimately, we are working with only the overnight interest rate and we concentrate on the price level more generally, which may not always be compatible with the stability of the prices of particular assets. And, like you, we cannot reliably anticipate what will occur. All the more reason for both private parties and regulators to pay particular attention to possible sources of risk and stress over coming years.

You need to keep in mind that our economy is in unexplored territory in many respects. Historic patterns of movements in interest rates, exchange rates, and house prices may not be very good guides to future relationships.

These phenomena [the growing current account deficit, dwindling household savings, low level long-term interest rates and the rapid pace of house price increases] could well continue for some time longer, but they are not sustainable indefinitely. At some point, global investors will require higher expected rates of return as their portfolios become increasingly concentrated in dollar assets; house price increases will encounter resistance as they rise relative to income and rents; as housing prices level out, households will recognize that they must increase saving out of income to have adequate resources for retirement; and the Federal Reserve already has been raising short-term interest rates as demand recovers from the shocks of recent years.

Although the Federal Reserve sees no need to pay interest on excess reserves in the near future, the ability to do so nevertheless would be a potentially useful addition to the monetary toolkit of the Federal Reserve.

Some have asserted that our accommodative policy stance in recent years, made necessary by the macroeconomic situation, itself has tended to drive down risk premiums as investors "reached for yield." Notably, however, most risk spreads have remained narrow even as we have been removing policy accommodation.

I am intrigued by efforts to separate the extent to which the decline in risk premiums in recent decades is due to a reduction in inflation versus a reduction in real output volatility. In that regard, does the fact that most of the decline occurred by the end of the 1980s suggest that inflation control played a more important role than the damping of business cycles, which might reveal itself more gradually over time?

Risk premiums are certainly relevant for monetary policy deliberations, and we do pay attention to our best estimates of them…Neglecting or grossly misestimating risk premiums will lead to misperceptions of the market's outlook and thus potentially to market moves that we did not anticipate…We are also interested in risk premiums as indicators of uncertainty and not solely as inputs into accurate readings of investors' mean economic outlook.

An effective monetary policy may well have been one factor in the great moderation of inflation and business cycles that I mentioned earlier. And our efforts in recent years to make the policymaking process more transparent may, almost by definition, have reduced uncertainty and thus compressed risk premiums.

To separate signal from noise, we try to look not only at the persistence of movements but also at their correlation across markets.

[T]he actions of private parties to protect themselves--what Chairman Greenspan has called private regulation--are generally quite effective.

Despite their historical importance for aggregate inflation, energy prices, for example are controlled for in only one of the structural [inflation] models discussed at this conference.  And this importance is not necessarily a concern of the past: Prices for oil and natural gas have soared since 2003, directly boosting the energy component of the consumer price index as well as raising the production costs, and ultimately to at least some degree the prices, of non-energy goods and services.  As a policymaker, I can assure you that any model of inflation that did not take account of these effects, and how they might or might not affect ongoing rates of inflation, would have been or little practical use to the FOMC over the past few years.

Luck as well as structural changes in the economy may have had a lot to do with the current low level and apparent stability of US inflation.  If so, and if our luck turns and we experience a series of adverse shocks, our ability to formulate policies that deliver sound performance may depend upon a much better understanding of the inflation process and of expectations formation.

To be sure, the integration of newly industrializing economies into the global trading system is exerting downward pressure on costs and prices. But the effect on inflation--the rate of change in prices--has probably not been large to date, and the extent and duration of its damping influence on inflation in the future are open questions.

Hurricanes are obviously the very embodiments of unexpected developments...   Economic activity and prices will be affected for some time and discerning underlying trends will be difficult.  It is not obvious that this form of uncertainty has implications for monetary policy, however.  Pausing or slowing down a rise in policy interest rates would not itself help to reduce uncertainty because the way in which policy might affect spending or inflation is not in question.  Rather this is a situation in which a central bank generally is well advised to make its best forecast, to evaluate the risks around that forecast as well as it can, and to act on that forecast and associated evaluation of risks.

Measures of labor compensation have given somewhat mixed signals about how tight labor markets have become. The rate of increase in the measure of compensation per hour derived from the national income and product accounts moved up appreciably over the four quarters ended in mid-2005 compared with the preceding year. This rise was apparently due in part to bonuses and stock options that may be only loosely related to labor market slack, however. Moreover, according to the employment cost index, which is based on a survey of firms, and to the growth in average hourly earnings in the payroll employment report, compensation pressures remained quite subdued. On balance, I do not believe conditions in labor markets have become excessively taut, but experience suggests remaining humble in making any such assessment.

The effects on economic activity of a deceleration in consumption spending are likely to be offset to some extent by a pickup in demand from other sectors. In addition to the boost to construction spending from rebuilding efforts, the growth of business capital spending more broadly should strengthen....   Looking ahead, some of the restraining influences on investment spending appear likely to wane. Production and the demand for capital likely will strengthen with the turn in inventory investment; several foreign economies, such as Japan, seem to be experiencing more robust demand; and any tendency toward more-settled conditions in energy markets would help to alleviate uncertainty about both foreign and domestic demand.

With regard to economic activity, my best guess is that the economy retains a good deal of forward momentum and that the evolution over time of the balance between aggregate demand and potential supply may not be greatly affected by the hurricanes and further rise in retail energy prices. In particular, the factors that were supporting the growth of activity through the first two-thirds of the year are still in place: Market interest rates remain relatively low and credit spreads narrow; underlying growth of productivity--the ultimate source of long-run gains in incomes and living standards--appears to be appreciable; and the rapid rise in house prices, which persisted through at least the first half of the year, has given households a reservoir of housing wealth that they can draw on to support spending.

In this regard, I think the policy tactics followed by the FOMC over recent years will be helpful. We have moved rates higher gradually and announced our intentions in a manner that underscores that these intentions depend on the economic outlook. The announcement should enable market participants to get a more accurate view of our intentions sooner and build them into financial market conditions, which then feed back on spending. This transparency, together with the gradual trajectory of policy actions, should help us to get a better and more timely fix on the effects of our actions than in the past.

In sum, I see risks on both sides of my expectations that the growth of economic activity will slow modestly on balance over the next year or so, leaving the economy producing at about its sustainable potential. But unless activity slows unexpectedly, and after the rise in retail energy prices, the risks may be skewed a little toward the upside on inflation. Because the economy is producing at a reasonably high level and activity is most likely on a solid upward track, my focus at this time is naturally on keeping inflation contained.

Economists, including those at central banks, simply are not very good at understanding, much less predicting, the dynamics of asset price adjustments; and I would guess that our ignorance is especially profound when those dynamics may be in the process of shifting.

The FDIC does not have the authority to supervise the corporate owners of ILCs and their affiliates in the same manner that bank holding companies and their nonbank affiliates are supervised under the BHC Act. The GAO recently concluded that, due to these differences in authority, exempt ILCs may pose more risk to the deposit insurance funds than banks operating in a bank holding company structure.

Conventional policy as practiced by the Federal Reserve has not insulated investors from downside risk. Whatever might have once been thought about the existence of a "Greenspan put," stock market investors could not have endured the experience of the last five years in the United States and concluded that they were hedged on the downside by asymmetric monetary policy.

Rather than demonstrating the need for preemptive extra action to restrain emerging bubbles, these examples [of the Great Depression and the recent Japanese deflation experience] are object lessons concerning the wisdom of central banks' easing promptly and aggressively following market slumps when inflation is already low, so as to head off the threat posed by the zero lower bound. By doing so, policymakers should be able to avoid the severe nonlinear dynamics of deflation.

If we can identify bubbles quickly and accurately, are reasonably confident that tighter policy would materially check their expansion, and believe that severe market corrections have significant non-linear adverse effects on the economy, then extra action may well be merited. But if even one of these tough conditions is not met, then extra action would be more likely to lead to worse macroeconomic performance over time than that achievable with conventional policies that deal expeditiously with the effects of the unwinding of the bubbles when they occur. For my part, I am dubious that any central banker knows enough about the economy to overcome these hurdles. However, I would not want to rule out the possibility that in some circumstances, or perhaps at some point in the future when our understanding of asset markets and the economy has increased, such a course of action would be appropriate.

Accordingly, for me, the critical indicators in the time ahead will be the ones that signal whether growth is indeed likely to proceed at a sustainable pace and whether inflation remains on a favorable track. This is a judgment my colleagues and I will need to make meeting by meeting as the incoming information--both the data and, critically, the timely feel for developments that we get from the Reserve Banks' contacts in the community--help us assess the paths for the economy and price pressures.

A rough estimate puts the reduction in real GDP growth from the increases in energy prices since late 2003 at between 1/2 percent and 1 percent per year.

[Fed officials] are trying to pick up early signs that the rate of economic growth might be cooling off, and we are also very alert to what is happening to price inflation...  Overshooting is something we are very aware of as a risk in policy today. 

Moreover, increases in compensation costs have generally been modest. To be sure, average hourly earnings of production and nonsupervisory workers have been accelerating in recent quarters. However, the broadest measures of compensation have not picked up, suggesting that competition in labor markets has been intense. Nonetheless, with labor markets tightening, some pickup in compensation increases for the broad measures would not be surprising. Nor would a pickup necessarily be inflationary, given the very good growth in labor productivity that we have experienced in recent years.

Despite the relatively moderate increases in prices and costs that we have observed lately, the capacity utilization rate and the unemployment rate have recently reached zones that on occasion in the past have been associated with the beginnings of upward pressure on inflation. Of course, the past is not always a good guide to the future, in part because a great deal of uncertainty surrounds the relationship of resource utilization and inflation. For instance, we cannot directly observe full capacity of either labor or production resources; consequently, we can never be certain what level of activity represents the full utilization of capacity.

In addition, measurement issues aside, the empirical evidence of the past half-century suggests that the relationship between utilization and inflation can shift over time. Unfortunately, we typically are only imperfectly aware of the changes and their magnitudes in real time. In the 1990s, that relationship was affected by, among other things, changing trends in the growth rate of productivity and innovations in the structure of labor markets, such as increased use of temporary help supply.

These uncertainties mean that we, as policymakers, need to keep not only an open mind about estimates of the economy's potential but also a close eye on the various indicators of costs and prices so that we can recognize incipient price developments and react to them as early as possible. But we also must recognize that, by the time evidence of accelerating prices becomes definitive, containing inflation pressures could entail disruptive economic adjustments. So despite the uncertainties, we must evaluate all the evidence and make our best judgments about the oncoming risks to sustained good economic performance. In the current circumstances, as the Federal Open Market Committee has said, the economic climate appears to be one in which further increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures.

The available evidence suggests that the pace of economic expansion may moderate a little from its average over recent quarters, keeping resource utilization in line with recent levels.

We cannot say exactly why the level of investment has remained low for the past few years, so we certainly cannot rule out a return to previous higher trends. In that regard, we do seem to be seeing a strengthening in global demand, which could signal a more pervasive change in attitudes and expectations.

The latest reads on business spending and intentions point to continued solid growth in capital spending, supported by favorable fundamentals of steady increases in final demand and a relatively damped cost of capital.

During 2001 and 2002, anecdotal reports suggested that many firms saw no need to upgrade equipment because no compelling new technology or application had been released, which would have tended to lengthen the replacement cycle. If replacement cycles since then have remained longer than in previous decades, firms would respond with a lower level of gross investment.

Businesses were unusually cautious after the most recent recession in expanding their productive capacity. Both hiring and capital investment lagged the usual recovery pace. One possible source of this caution was said to be questions about the strength and sustainability of the recovery, accentuated by concerns about terrorism and other geopolitical uncertainties.

Another possibility is that business investment has been held down in recent years because relative prices of capital goods are no longer falling at the same pace at which they declined in the late 1990s.

The Federal Reserve will continue to play an important role in fostering a smoothly functioning payments system that is safe, efficient, and accessible. We also need to be flexible in carrying out our traditional functions within the payments system--as a provider of payment services, regulator, and catalyst for change--in this rapidly changing environment.

Counterparty discipline, sound risk management, and strong and resilient clearing and settlement are all in the interest of private parties. Nonetheless, government has a role to play, especially when it senses moral hazard is weakening market discipline on risk taking and leaving the broader interests of society inadequately protected. Regulators may need to insist on minimal capital levels and on actions to strengthen private systems.

The Federal Reserve has been working with other regulatory agencies and the private sector both here and abroad to strengthen the financial system in order to lower the odds that a sharp change in prices or questions about a major market participant would lead to a systemic financial crisis. Our collective efforts have been in three areas: enhancing market discipline; encouraging sound risk management; and strengthening clearing and settlement systems.

To date, demands from these [emerging market] economies appear to have contributed to the rise in energy and other commodity prices, which is boosting overall inflation here, while their supply of low-cost exports seems to have been placing some limited downward pressure on our underlying inflation rate.  But that latter result may not persist; it stems in part from the imbalance of production over spending in some of those economies and the constraints some have placed on the appreciation of their currencies, neither of which is likely to be sustained indefinitely.

I believe it is improtant to monitor a range of inflation measures in conducting monetary policy.  No single measure can, by itself, provide enough information with which to form a well-founded judgment about the prospects for inflation and economic growth.  Among the many inflation measures I consider are indexes of consumer prices (including the Personal Consumption Expenditure price index and the Consumer Price Index)--both the headline indexes and the indexes that exclude the eratic prices of food and energy; the price indez for gross domestic purchases (the broadest price measure of domestically purchased goods and services); and the price index for Gross Domestic Product (the broadest price measure of domestically produced goods and services)...Similarly, I find it useful to look at a variety of forward-looking measures of inflation when considering the economic outlook.

Empirical estimates of the lag between a change in the funds rate and its full effect on aggregate output range from as short as one quarter to as long as a year and a half; the estimated lag in the response of inflation is also variable but tends to be somewhat more drawn out.  Some of this variability reflects differences across time in the extent to which financial markets anticipate future policy actions.  In the current episode, Federal Reserve communications have enabled investors to anticipate much of the rise in the funds rate that has occurred over the past two years and incorporate those expectations into prices in financial markets, speeding up the response fo real activity and inflation relative to a situation in which policy actions are less well anticipated.  Actual and expected increases in short-term interest rates have likely already contributed to damping some forms of interest-sensitive spending, most notably in the housing sector.

In particular, the entry of China, India, and others into the global trading system probably has exerted a modest disinflationary force on prices in the United States in recent years. Moreover, we should recognize that these disinflationary effects could dissipate or even be reversed in coming years. They reflect, at least in part, the global imbalances that are the subject of this conference, rather than just the integration of emerging-market economies into the global trading system

But we are also subject to inflationary forces from abroad, including those that might accompany a shift to a more sustainable pattern of global spending and production, or those that might emanate from rising cost and price pressures.

In the end, however, policymakers here and abroad cannot lose sight of a fundamental truth:  In a world of separate currencies that can fluctuate against each other over time, each country’s central bank determines its inflation rate.

Experience with current account adjustments by industrialized economies--for example, by the United States in the 1980s--suggests that the transition to a more sustainable configuration is not likely to be disruptive. But we cannot be sure, particularly because the U.S. experience is unique given the dollar’s role as a reserve currency and Americans’ relatively favorable returns on assets held abroad. The world economy is in uncharted territory with regard to the size of the imbalances.

While we can point to types of goods for which prices are restrained by forces from abroad, the net effects of globalization on domestic inflation of all goods and services need not even be negative, especially in today’s environment of strong global growth.

Although private and government demands for dollar assets have allowed the U.S. current account deficit and foreign surpluses to persist, these imbalances are not sustainable indefinitely. In the United States, both public and private saving will need to rise to meet the oncoming needs of an aging population. At some point, risk-adjusted returns on investments in the rest of the world will begin to look favorable relative to holding dollar assets. Dollar assets are becoming an increasing proportion of non-U.S. portfolios; this can continue for a time, but not forever. At some point, the United States is going to need to finance its imports with the proceeds of its exports, not with foreign saving.

Continued strong demand for dollar assets will be critical to keeping that unwinding [of current account imbalances] smooth and not disruptive. The Federal Reserve can contribute by being sure the public remains confident that the purchasing power of their dollar assets will not erode unexpectedly. As long as inflation expectations remain contained, relatively faster growth of the prices of imported goods for a time would be associated with only a temporary bulge in inflation and would result in a needed change in relative prices.

Because of these differences, it is incumbent on us from time to time to reexamine our operational role in the payments system.

These assessments have focused in the past, and should continue to focus in the future, on the Federal Reserve’s role as a provider of retail payment services. Large-value payments systems, such as Fedwire, are typically viewed as core, systemically important services, and they are commonly provided by other central banks around the globe. A rationale for the participation of a government-related entity, such as the Federal Reserve, in the retail payments system is harder to formulate.

The pass-through turns out to be harder to find either econometrically or in the price data themselves than any savvy consumer might think… [T]he small acceleration in many other {non-energy-intensive} nonshelter portions of the index, while consistent with a small pass-through of energy costs, could also be attributable to non-energy factors.

In the final analysis, I think we probably saw some pass-through of higher energy costs into core inflation once price and wage setters came to believe that the rise in energy prices would not soon be reversed. But the magnitude of the effect has been small--perhaps on the order of a cumulative 1/2 percentage point or less since the end of 2003. If crude oil prices hold at close to current levels over the next few years, the resulting absence or even partial reversal of these energy cost shocks should, all else equal, put some modest downward pressure on core inflation.

The adjustment in {residential} markets has proven to have been more rapid and deeper than many economists had predicted, and we have yet to see signs that indicate just how the process will work itself out.

[C]alculations about the sustainable level of housing starts based on demographic factors, such as population growth and household formations, suggest that starts may be closer to their trough than to their peak. Although such calculations are, in general, not particularly useful for near-term forecasting, they do suggest that any overbuilding in 2004 and 2005 was small enough to be worked off over coming quarters at close to the current level of housing starts.

[T]he Federal Reserve has returned short-term interest rates only to more-normal levels and long-term rates are unusually low relative to those short-term rates. This situation stands in sharp contrast to some past downturns in the housing market that followed actions by the Federal Reserve to tighten credit conditions significantly.

One potential pitfall in this {soft landing} argument is that, in the past, a noticeable and sustained shortfall of growth from its potential and an accompanying decrease in resource utilization have often cumulated into a full-fledged recession. Several features of the current financial situation, however, support my contention that "this time will be different." These recessions have often been triggered by a highly restrictive stance of policy and a generalized tightening of credit conditions through high long-term rates, wide risk spreads, and a pull-back of bank lending. Obviously, these conditions are not present today. Although one cannot rule out the possibility that a withdrawal from risk-taking could impinge on credit supplies and intensify downward pressure on activity, the preconditions for such a response do not seem to be in place. Business balance sheets are in very good shape and financial institutions are quite well capitalized.

When we try to model energy pass-through econometrically, the results indicate that a break occurred in pricing patterns in the early 1980s: Pass-through is clearly evident before 1980 but it is difficult to find thereafter. I suspect this pattern has something to do with the monetary policy reaction to those shocks and its effect on inflation expectations. In the 1970s, monetary policy not only accommodated the initial shocks but also allowed second-round effects to become embedded in more persistent increases in inflation. Since the early 1980s, the pass-through to core prices has been limited or non-existent, at least in part because households and firms have expected the Federal Reserve to counter any lasting inflationary impulse that they might produce. This result reinforces the need today to keep inflation expectations well anchored. In addition, movements in relative oil prices were more persistent before 1980 and less persistent after--until recently. After 1980, households and firms probably expected deviations of energy prices from long-run averages to be largely reversed and saw less reason to try to adjust wages and prices in response to what they viewed as transitory changes in energy costs.

Looking ahead, policy adjustments will depend on the implications of incoming data for the projected paths of economic activity and inflation. I must admit I am surprised at how little market participants seem to share my sense that the uncertainties around these paths and their implications for the stance of policy are fairly sizable at this point, judging by the very low level of implied volatilities in the interest rate markets.

I think that the risks to my outlook for economic activity may be skewed a bit to the downside, while those to my forecast of gradually declining inflation are tilted to the upside. In my view, in the current circumstances, the upside risks to inflation are of greater concern.

Don't sell the Fed's inflation concern short.

During the Q&A session.

In response to greater demand, the supply of rental housing should increase over time, in part by drawing from the overhang of owner-occupied units; hence, I do not expect rents to be a major influence on core inflation a year or two from now, the horizon that is the focus of monetary policymaking.

 

Some of the divergence {between hourly compensation in the productivity estimates and the ECI} appears to be the result of an increased volume of stock option exercises in early 2006--an occurrence captured by the compensation per hour measure but not by the ECI--and these option exercises should not represent costs that firms actually internalize when calculating their marginal cost of production. Thus, in my own thinking, I have tended to discount, though not dismiss, the latest readings on labor costs. However, I acknowledge that rising labor costs are an upside risk to my inflation outlook, especially if they occur under product-market conditions in which firms can readily pass costs through.

Based on the data we now have, the growth of real GDP in the third quarter appears to have remained as subdued as it was in the second quarter and may well have slowed further.

As a result of these trends, the Reserve Banks' check-collection volume has declined. Since 1999, the number of checks collected through the Reserve Banks has fallen by about 30 percent. Consequently, the Reserve Banks have taken major steps to reduce check costs, including reducing the resources devoted to this service by transferring check-processing operations from some offices to more centralized locations. Today, twenty-two offices offer check processing, down from forty-five just three years ago.

Other Reserve Bank services have been undergoing consolidation as well... The Reserve Banks have found it more efficient to have a few central offices perform certain internal support and back-office services--such as managing information technology and payroll--rather than having each Bank conduct them individually. This trend toward consolidation of operations has precipitated significant structural changes at the Reserve Banks. Staff levels have been reduced throughout the System. Several Reserve Bank Branch offices now have, or soon will have, no remaining financial services operations...

The contributions of the Reserve Banks are perhaps most visible to the public in the sphere of monetary policy. All twelve presidents attend and participate actively in the meetings of the Federal Open Market Committee. What they tell the Committee about what they are hearing from their contacts helps us recognize shifting economic conditions before they are evident in the data. Their reports often illuminate the reasons for the data we are receiving, thereby helping us anticipate what will come next. Their policy perspectives are informed by the research and analysis of outstanding staffs.

...Reserve Banks also play an increasingly important role in reaching out to convey information to the community. Through extensive education efforts, speeches by their presidents and other officers, and discussions with their boards of directors and other groups, Reserve Banks foster understanding about the System, its policies, and its objectives, as well as about matters of general economic interest.

 

 

[T]he compensation figures in the national accounts are subject to significant revision, as illustrated by the release of new data this week that suggests hourly compensation rose only 4-1/2 percent, not 7 percent, over the past year. Changes such as this make real-time estimates of unit labor costs and labor’s share of total income much less useful in our analyses than studies based on revised data might suggest. Finally, the existing wage data are not well suited for measuring certain concepts important to modeling and policymaking, such as marginal labor costs. For example, hourly compensation in the national accounts includes stock options at their exercise value rather than at their value at the time of issuance.

For example, a significant portion of the personal consumption expenditures (PCE) price index is based on imputations of prices for important categories of household purchases, such as banking services, rather than on direct observations of market prices.  This "nonmarket" component of the index is hard to replicate, tends to move in an erratic manner from month to month, and is subject to considerable revision--factors that reduce the usefulness of the overall index as a short-run indicator of price pressures.

Market-based PCE

Brainard’s analysis showed that if policymakers are uncertain about how real activity and inflation will be affected over time by monetary actions, they should be less aggressive in responding to changes in economic conditions than would be the case if they knew the true model of the economy...  [C]entral banks should be cautious about boldly acting on the predictions and policy prescriptions of any one model, especially given that policymakers usually are unsure about the nature and persistence of the shocks hitting the economy.

Central bankers around the world certainly seem receptive to taking a gradualist and cautious approach to policy under most circumstances, as indicated by (among other things) their apparent tendency to smooth interest rates.  The behavior of the Federal Reserve during the second half of the 1990s illustrates this approach to policy...  Staff analysis at the time supported Brainard’s conclusion that the appropriate response to heightened uncertainty about the economy’s true productive potential would be to reduce the importance of the estimated output gap in setting policy.  Whatever the persuasiveness of this analysis, the FOMC did respond in a restrained manner to unusually robust real economic activity--as I believe was appropriate in light of the low and stable inflation that followed.

Of course, gradualism and model averaging may not be appropriate in all circumstances.  For example, it may be necessary for monetary policy to respond to what might be called "tail events," along the lines suggested by recent work on "robust control."  To simplify greatly, this approach often amounts to choosing policy settings to minimize the maximum possible loss across different models of the economy, in contrast to the standard Bayesian approach, which (loosely speaking) seeks to minimize the average loss across models.  Much of the research on robust control has been a bit technical and esoteric.  But the notion that policymakers may at times base policy settings on especially pernicious risks has an important ring of truth. 

For example, in 2003 the FOMC noted that a continued fall in inflation would be unwelcome largely because such an eventuality might potentially lead to persistently weak real activity with interest rates stuck at zero.  Partly in response, the FOMC reduced the federal funds rate to an unusually low level and kept it there for an extended period, in a manner that perhaps would not have occurred in the absence of concerns about the "worst case" effects of deflation.  This type of risk management--in which the central bank takes out some insurance against a bad but improbable event--has been an aspect of policymaking for some time and does seem to respond to extreme risks in a way reminiscent of the literature on robust control.

Thus policymakers and the public at large live in an uncertain world.  For example, most of you are probably wondering when this speech will end.  I thought about gradually drawing to a close at, say, a measured pace, but my risk-management instincts tell me just to stop.  Thank you.

{At the} last meeting of the FOMC, with the minutes released and the announcement and the speech that Chairman Bernanke gave just earlier this week, we suggested that that trend seems to be shifting, and our expectation is that it will shift towards a gradual decrease. But the risk around that expectation is still tilted to the upside.

From the Q& A session, as reported by Bloomberg News

    "We already enjoy considerable credibility. And I just mentioned that we've had huge fluctuations in oil prices showing barely a ripple in long-term inflation expectations. So the benefits are probably, I'm sure, are much smaller in the U.S. than they would be in many other countries.
     ``And then we do have to worry about the costs, about whether anchoring expectations a little bit better -- that expectations are already very well-anchored, but having that marginal influence, what are the tradeoffs, both in terms of the flexibility and in terms of making people understand what we're doing, how it's consistent with our dual mandate, etc.
     ``So this is the nature of the discussion that's going on.  But I think it's less clear-cut in the U.S.''

From the Q& A session, as reported by Bloomberg News

Measures of inflation compensation derived from nominal and indexed Treasury yields provide information that addresses some of the weaknesses in survey measures... Even here, however, we encounter important technical difficulties:  These inflation compensation measures are "contaminated" both by an inflation risk premium and by differences in liquidity between the markets for nominal and indexed Treasury securities.  More fundamentally, even a "rational" forecast of inflation from financial markets provides only part of the information needed to form monetary policy because it gives only a sense of where inflation is expected to go, not why it is going there.  The latter question is often important for assessing the appropriate stance of policy.

Most central banks also strive to follow at least the spirit of Bayesian thinking by taking an eclectic approach to forecasting and to policy analysis.  To see this, consider the range of material that the staff supplies to the FOMC.  In the case of the economic projections contained in the briefing document we call the Greenbook, the staff consults a variety of indicators and models and then judgmentally pools this information to produce the baseline outlook.  The staff then supplements this analysis with various alternative scenarios intended to illustrate the primary risks to the outlook.  Although these scenarios are usually constructed using a single model (FRB/US), the simulations actually encompass a wider range of views about the nature of the economy.  For example, the simulations routinely consider alternative characterizations of such key aspects of the economy as the expectations formation process, wealth effects, and the sensitivity of inflation to changes in resource utilization and monetary policy.  Finally, the staff provides the FOMC with estimated confidence intervals for the forecast and produces studies addressing such questions as the optimal design of policy under different types of uncertainty. 

In addition, the structure of the FOMC, like that of a number of foreign monetary authorities, may also provide Bayesian-like benefits in attempting to deal with uncertainty.  Many of the individuals who participate in policymaking at the Fed have different views about the structure of the economy.  These differences enter our discussions and, through the Committee’s deliberations, affect the course of policy, although, I admit, how we weigh these competing views to arrive at a decision can appear to be murky.  Certainly, the process is one that a good Bayesian might find hard to recognize.  Nevertheless, studies suggest that the decisions reached by committees are usually superior to those produced by individuals.

Perhaps the most intractable problems surround the measurement of such key concepts as the equilibrium real interest rate, trend productivity, and potential output.  We never observe these variables, which often figure prominently in our deliberations, but can only infer them from the behavior of other variables that are themselves subject to mismeasurement...

These revisions may or may not also have implications for the level of the real federal funds rate consistent with longer-run macroeconomic stability.

In my own judgment, housing starts may be not very far from their trough, but the risks around this outlook still are largely to the downside. Although house prices nationally have decelerated noticeably and appear to have fallen in some markets, they are still high relative to rents and interest rates. Building permits decreased substantially again in November, and inventories of unsold homes have only started to edge lower. We also do not know whether the possible stabilization that seems to be taking hold would be immune to a rise in longer-term interest rates should term premiums increase or the federal funds rate fail to follow the downward path currently built into market expectations. Even if starts stabilize at close to current levels, those levels are sufficiently low that overall construction activity would remain a negative for the growth of economic activity in the first half of this year.

In my view, however, what we are seeing in the recent information on factory output and capital spending is not the leading edge of general economic weakness but instead an adjustment to a sustained pace of expansion that, necessarily, is less rapid than that from mid-2003 to mid-2006...

...

So, despite the recent favorable price data, I believe it is still too early to relax our concerns about whether the run-up in price pressures in the spring and summer of last year is truly unwinding and whether it is unwinding rapidly enough to forestall a pickup in inflation expectations.

"I don't think there's a strong message {in the inverted yield curve} for the Federal Reserve or economic policy makers," Kohn said. "It's something we pay attention to" but the bond market "is not sending a traditional signal," he said, explaining that yields can be understood as resulting from strong demand for long term assets and confidence among market participants the conomy will do well and inflation will not be a problem.

Even with the opening of some slack in the manufacturing sector and in homebuilding, labor markets generally seem to have stayed fairly tight, with the unemployment rate at only 4-1/2 percent. Although recent data indicate that labor costs were not rising as rapidly in 2006 as first estimated, labor compensation does appear to have increased more quickly over 2006 than over 2005. Last year's increase in compensation also appears to have outpaced overall consumer price inflation. That development in and of itself does not necessarily indicate an increase in inflationary pressures, especially if it represents a process in which real compensation begins to catch up with the rapid increases in labor productivity earlier this decade. What would be problematic would be a pickup in the growth of nominal hourly labor compensation that was passed through to prices over the next several quarters, or one that was not matched, over a sustained period, by a comparable pickup in the growth of productivity. Eventually, the resulting faster growth of unit labor costs would pose a serious threat to price stability.

Certainly, the recent data on consumer prices have been encouragingly consistent with the downward tilt to inflation that the FOMC has been expecting. However, we need to be cautious about extrapolating trends from a couple of months of data. The data themselves are noisy--subject to month-to-month variations that are unrelated to more-persistent developments. And we need to recognize that some of the very recent disinflation may represent one-time influences. Energy costs have moved down markedly in recent months, and those declines have fed through to prices for a number of intermediate goods and probably for some final goods as well. But futures markets anticipate that prices of crude oil will increase gradually, which suggests that, once the adjustment to the current level plays out, energy prices will no longer work to restrain total and core inflation. And if a portion of the weakness in goods prices reflects efforts by producers to forestall or correct inventory imbalances, that restraint on pricing will dissipate as firms' corrective actions take effect.

I am a central banker to my core, so I know that somewhere, somehow, something will go wrong...

Uncertainty about where we stand in the housing cycle remains considerable. In part, that is because this housing downturn has differed from some of those in the past in important ways. It was not triggered by a restrictive monetary policy and high interest rates; indeed, relatively low intermediate and long-term interest rates are helping to support the stabilization of this sector. But the current contraction in housing did follow an unusually large run-up in sales and construction and, even more so, in prices relative to the returns on other financial and real assets. Our uncertainty about what pushed home prices and sales to those elevated levels raises questions about how the market will adjust now that expectations of the rate of house price appreciation are being trimmed. And changes in the organization of the construction industry, with activity more concentrated in the hands of large, publicly traded corporations, may also affect the dynamics of prices and activity in response to the inventory overhang.

Adequate liquidity has two aspects: First, we must meet any extra demands for liquidity that might arise from a flight to safety; if such demands are not satisfied, financial markets will tighten at exactly the wrong moment. This was, for example, an important consideration after the stock market crash of 1987, when demand for liquid deposits raised the demand for reserves held at the Fed; and again after 9/11, when the loss of life and destruction of infrastructure impeded the flow of credit and liquidity.

Second, we must determine whether the stance of monetary policy should be adjusted to counteract the effects on the economy of tighter credit supplies and other knock-on effects of financial instability. As a result, meetings of the Federal Open Market Committee (FOMC), often in conference calls if the situation is developing rapidly, have been an element in almost every crisis response. Those meetings allow us to gather and share information about the extent of financial instability and its effects on markets and the economy as we discuss the appropriate policy response.

[T]he Federal Deposit Insurance Corporation Improvement Act of 1991, or FDICIA, took major steps toward reducing moral hazard in the banking system and limiting taxpayer losses by reinforcing the importance of strong capital.  Among the mechanisms in the act is the requirement that bank supervisors take prompt corrective action when depositories show signs of becoming troubled.  This step was reinforced by the least-cost requirements of FDICIA, which generally require the FDIC to resolve a failing institution in the manner least costly to the deposit insurance fund.

But other forces have also led central banks and other financial supervisors around the world to increase their emphasis on financial stability. Perhaps most important, the financial system, once essentially bank-centered, has become more market-centered. Of course, banks continue to be core participants in the financial system and to provide an indispensable window on market activities. But the development of a relatively market-oriented system has been accompanied by a large number of new participants, many with global reach, and a much larger array of financial instruments. This vastly expanded web of participants and instruments has increased the number of potential channels for the creation and transmission of financial shocks.

The degree of potential moral hazard created will depend on the instrument chosen. Policy actions that work through the overall market rather than through individual firms create a lower probability of distorting risk taking. Thus, a first resort in managing a crisis is to use open market operations to make sure aggregate liquidity is adequate. Adequate liquidity has two aspects: First, we must meet any extra demands for liquidity that might arise from a flight to safety; if such demands are not satisfied, financial markets will tighten at exactly the wrong moment. This was, for example, an important consideration after the stock market crash of 1987, when demand for liquid deposits raised the demand for reserves held at the Fed; and again after 9/11, when the loss of life and destruction of infrastructure impeded the flow of credit and liquidity.

Second, we must determine whether the stance of monetary policy should be adjusted to counteract the effects on the economy of tighter credit supplies and other knock-on effects of financial instability...

Other policy instruments that can be used to deal with financial instability--discount window lending, moral suasion aimed at convincing private parties to keep credit flowing, actions to keep open or slowly wind down troubled institutions--are, in my judgment, more likely than open market operations or monetary policy adjustments to have undesirable and distortionary effects. Hence, they should be, and are, used only after a finding that broader instruments, like open market operations, are unlikely to prevent significant economic disruption.

The degree of potential moral hazard created will depend on the instrument chosen. Policy actions that work through the overall market rather than through individual firms create a lower probability of distorting risk taking. Thus, a first resort in managing a crisis is to use open market operations to make sure aggregate liquidity is adequate. Adequate liquidity has two aspects: First, we must meet any extra demands for liquidity that might arise from a flight to safety; if such demands are not satisfied, financial markets will tighten at exactly the wrong moment. This was, for example, an important consideration after the stock market crash of 1987, when demand for liquid deposits raised the demand for reserves held at the Fed; and again after 9/11, when the loss of life and destruction of infrastructure impeded the flow of credit and liquidity.

Second, we must determine whether the stance of monetary policy should be adjusted to counteract the effects on the economy of tighter credit supplies and other knock-on effects of financial instability...

Other policy instruments that can be used to deal with financial instability--discount window lending, moral suasion aimed at convincing private parties to keep credit flowing, actions to keep open or slowly wind down troubled institutions--are, in my judgment, more likely than open market operations or monetary policy adjustments to have undesirable and distortionary effects. Hence, they should be, and are, used only after a finding that broader instruments, like open market operations, are unlikely to prevent significant economic disruption.

In every step we take to deter or manage financial crises, it is important that we recognize that we impose costs, and that our efforts can be most effective if we both enhance and are supported by market discipline. Institutions and investors must be allowed to take risks and must be prepared to accept the consequences of their actions. For its part, the government should limit its intervention to those circumstances that could lead to placing the system in serious danger and could spill over to the economy. Otherwise, even the most well-intentioned government intervention can actually weaken the system by undermining the incentives for market participants to limit the risks they undertake.

FDICIA allowed for the relaxation of its least-cost mandate in situations posing a true systemic crisis. But the conditions under which least-cost resolution can be relaxed are quite strict. First, a least-cost resolution would have to create "serious adverse effects on economic conditions or financial stability." Second, any action under the exception must be recommended by at least two-thirds majorities of the boards of both the FDIC and the Federal Reserve and ultimately approved by the Secretary of the Treasury in consultation with the President.

The systemic-risk exception has never been invoked, and efforts are currently underway to lower the chances that it ever will be.

Finally, in today's global economy, very settled financial market conditions--narrow risk spreads and low expected market volatility--coexist with unprecedented current account imbalances among nations and interest rates that are low by historical standards.  In such a world, it would be imprudent to rule out sharp movements in asset prices and a deterioration in market liquidity that would test the resiliency of market infrastructure and financial institutions.  

[S]upervisory authority in a number of countries abroad has been consolidated and separated from central banks; these moves have forced the new regulators and their central bank colleagues to learn how to operate not only in a new financial landscape but also in a new regulatory environment.

A rise in saving can achieve that shift because the extra savings would be used to increase the nation’s stock of capital and increase our net holdings of foreign assets.  Increasing the amount of productive assets owned by Americans increases the amount of consumption that future generations will be able to enjoy.  Determining the best way to distribute the burden associated with the aging of the population should be high on society’s list of priorities. 

Economists at the Federal Reserve have developed a model that combines information on the decline in labor force participation at older ages...with information on the changes in labor force participation across generations.  Exhibit 4 shows the actual participation rate, the model’s estimate of the underlying trend in the total participation rate between 1995 and 2006, and--under a specific set of assumptions--a projection of the trend out to 2015... Currently, actual participation is again above the estimate of the long-run trend, according to this model, largely because of the current strength of the labor market.

I was not entirely persuaded by the authors’ arguments ... that rely on “new estimates of real-time output gaps,” a bit of an oxymoron given that you cannot really produce a new real-time estimate of a constructed series like the output gap.  Perhaps the gap series produced by the Council of Economic Advisers was viewed skeptically by some contemporary observers, but it was the “official” series published by the Commerce Department, and it was referred to by the Federal Open Market Committee (FOMC) in its policy deliberations.  It does not surprise me that forecasters took several years to catch up to the adverse developments in trend productivity and the demographic factors that boosted the NAIRU; in the 1990s, we took a while to realize the implications of favorable movements in both variables even though we were aware from the experience of the 1970s that such changes were possible.

Policymakers in the 1970s--the Federal Reserve among them--were dealt a very bad hand that, for a variety of reasons, they played poorly.

...

Not only were the output costs of disinflation seen to be high but also the monetary policy needed to bring inflation down was consistently miscalculated--economists during the 1970s persistently overestimated both the speed and magnitude of the slowdown in real activity and inflation that would result from a given rise in the federal funds rate. Part of this miscalculation reflected a judgment that the economy and financial markets were fragile and that small changes in market interest rates would have major effects on aggregate spending (for example, as a result of disintermediation induced by ceilings on the interest rates that banks and thrifts could pay).

The issue of expectations illustrates our ignorance.  As I have already indicated, inflation expectations are among the most important variables policymakers monitor, but we do not have answers to our most basic questions about them:  Are available measures suitable indicators of true inflation expectations by households and businesses?  How are expectations formed--and in particular what are the respective roles of central bank talk, central bank actions, and actual inflation outcomes?  And how do expectations influence price and wage setting?  In short, although I believe that inflation expectations are critical to assessing the inflation outlook, I cannot be sure (particularly in real time) that our expectational measures are accurate and so cannot know what precise role expectations play in wage and price dynamics.  

Expectations are critical to understanding the economy and developments in the financial system.  Of course, we look at a great deal of data from the nonfinancial side of the economy, such as gross domestic product (GDP) growth, the unemployment rate, and changes in the prices of goods and services.  These data certainly reflect expectations but not always in a transparent way.  And, these data take some time to compile and so are never available in real time.

Because financial asset prices embody expectations about the future, they also contain forward-looking information about prospective developments, and many are available continuously and instantaneously.  We pay attention to an extensive range of asset prices, including those of Treasury securities (both nominal and real), corporate debt and equities, and derivatives.  Although it is not easy, we use these asset prices to tease out information about expectations that help us to interpret and predict the pace of economic activity and prices.

Although we use a variety of techniques for extracting information from asset prices, what we can learn has limits.  First, asset prices are tough to work with.  They change rapidly and are subject to short-run technical factors--swings in prices that are not related to fundamental and persistent shifts in supply and demand.  Second, and perhaps even more important, how asset prices embody risk and investors’ risk attitudes is complicated and varies over time.  We must use models to extract information on risk and risk preferences from prices, and because all models are simplifications of reality, we have to recognize that the results are only approximations of the underlying attitudes and circumstances and thus are subject to error.

We believe it is critical for Congress to consider and address the important public policy implications raised by the ILC exception, particularly in light of the dramatic recent growth and potential future expansion of banks operating under this special exception. If left unchecked, this recent and potential future growth of firms operating under the exception threatens to undermine the decisions that Congress has made concerning the separation of banking and commerce in the American economy and the proper supervisory framework for companies that own a federally insured bank. The ILC exception also creates an unlevel competitive playing field by allowing both financial and commercial firms to own an insured bank but avoid the prudential limitations, supervisory framework and restrictions on affiliations that apply to corporate owners of other insured banks.

There are good reasons to think that these developments have made the financial system more resilient to shocks originating in the real economy and have made the economy less vulnerable to shocks that start in the financial system. Borrowers have a greater variety of credit sources and are less vulnerable to the disruption of any one credit channel; risk is dispersed more broadly to people who are most willing to hold and manage it. One can see the effects of these changes in the reduced incidence of financial crises in recent years. From the 1970s through the early 1990s, we seemed to be in almost continuous crisis mode. These crises were centered on depository institutions, and because borrowers were so dependent on depository institutions for credit availability, problems at depository institutions meant problems for the financial system and for the economy more generally.

...

But we certainly should not read this experience as meaning that we are free of systemic risk--the risk of financial-sector problems spilling into the real sector or aggravating already difficult economic circumstances. Indeed, I see several reasons for carefully considering the potential for such problems to emerge.

New players and new instruments have become important since 2002, when the last adverse credit cycle peaked. New and already existing market participants are maneuvering for greater shares in a rapidly evolving market structure. Although leverage has declined in the nonfinancial businesses whose credit is being priced and traded, it may well have increased in the structure of intermediary finance. In any event, the growth of tranched CDOs and other structured credit products with substantial embedded leverage has made it more difficult to assess the degree of leverage of individual institutions or of the financial system as a whole.

In addition, the extraordinarily rapid growth of credit derivatives markets in the past few years has occurred against the backdrop of relatively benign macroeconomic performance--good global growth, low inflation, historically high corporate profits and low business failures, and reasonably predictable monetary policies. Partly as a consequence, the prices of financial assets seem to embody relatively low expected volatilities and relatively little reward for taking credit risk or for extending the duration of investor portfolios.

With more risk traded in markets and more participants managing that risk through portfolio adjustments made in markets, the importance of market liquidity has increased and the potential knock-on effects from an erosion of liquidity have multiplied. We could face situations in which asset price movements are exacerbated by the actions of market participants, including dynamic hedging strategies or forced liquidations of assets to meet margin calls, and those asset price movements could feed back onto the economy.

There are good reasons to think that financial innovation over the past few decades, including the emergence and growth of the credit derivatives markets, has made the financial system and the economy more resilient. But it would be foolish to think that these innovations have eliminated systemic risk.

Both market participants and public authorities should understand that, despite our best efforts, crises are inevitable, and so we need to work on crisis management as well. Here, too, cooperation among authorities here and abroad is critical. We must understand the market structures and vulnerabilities and the objectives and constraints under which authorities with different jurisdictions would be working in those circumstances.

Inevitably, uncertainty on the part of market participants and public authorities will be heightened in the event of market turmoil, and that uncertainty can feed on itself. Both authorities and participants need to think through how they will handle such crises. For the authorities, that process includes considering how to resolve any failures of large institutions in ways that impose costs on shareholders and uninsured liability holders while preserving orderly markets. Such a resolution will be necessary to limit the moral hazard of any interventions that we are forced to undertake. Market participants need to consider how they would settle contracts and work with troubled borrowers in a distress situation. More planning will reduce the rise in uncertainty in a crisis and the likelihood that fear will lead to precipitous actions that are in no one's best interest.

Systemic events in market-based financial systems are perhaps more likely to involve price fluctuations and abrupt changes in market liquidity than are systemic events in depository-based financial systems. But that is not really bad news because such events can more readily be countered by macroeconomic policy instruments than could old-fashioned crises of depository intermediation. Supplying additional liquidity and reducing borrowing costs can greatly ameliorate the effects of market events on the economy, and those types of macroeconomic interventions will carry less potential for increasing moral hazard than would the discount window lending that was a prominent feature of crisis management when depositories funded more credit.

Market-intermediated finance also requires us to live with less control and less knowledge than we had when banks were dominant. Greater uncertainty about where risks are lodged is the flip side of better dispersion of those risks, especially to less regulated sectors, and of more resilience of the whole system. Gathering additional information about the risk profiles of currently less regulated institutions is unlikely to yield insights that can be acted upon and may create a false sense of comfort among market participants, which could make the system substantially more risky. We need to have confidence in the invisible hand. But confidence does not mean blind faith, a thought that brings me to what we can productively do to reduce systemic risks within the boundaries that I just described.

We need to accept that accidents will happen--that asset prices will fluctuate, often over wide ranges, and those fluctuations will be driven in part by trading strategies, by the cycles of greed and fear that have always been with us, and by the ebb and flow of competition for market share. The fluctuations will result in redistributions of wealth and, on occasion, will confront us with financial crises. But we cannot and should not try to prevent this process through a monetary policy that puts special emphasis on stabilizing asset prices or through regulatory policies that limit access to markets by qualified participants or that attempt to restrain competition materially. Monetary policy that proactively leans against asset price movements runs a considerable risk of yielding macroeconomic results that fall short of maximum sustainable growth and price stability. Regulatory policies that try to prevent failures of core participants or others under all conceivable circumstances will tend to stifle innovation and reduce our economy's potential for long-run growth.

David suggests that monetarism failed when its proponents got too prescriptive by advocating rigid rules for money growth.  Among the lessons he takes from the failed monetarist experiment are that central banking is an applied science and that our imperfect understanding of how economies and markets function implies that a good dose of humility is required--and I agree. 

Anchored inflation expectations damp the pass-through of supply-related price shocks.  They also permit central banks to respond more forcefully to output fluctuations.  Most significantly, the improved inflation performance has come with, not at the expense of, output stability.  Although a consensus has not formed on how much of the "Great Moderation" in the growth of real output can be attributed to monetary policy, everyone agrees that at least a portion of it can.

Before anyone jumps to the conclusion that Frankfurt is a stop on my road to Damascus, let this Saul state that for me the case remains open.  Inflation has come down worldwide, in countries without, as well as with, inflation targets.  Moreover, I share David's puzzlement about why an explicit inflation goal should make a substantial difference in performance given the paucity of evidence showing that choosing a target directly affects the level of the public's inflation expectations.  That said, I am relatively more persuaded that inflation targeting helps reduce the variance of inflation expectations.

 I suspect that... the causes of the swing in house prices will be seen as less a consequence of monetary policy and more a result of the emotions of excessive optimism followed by fear experienced every so often in the marketplace through the ages.   

In addition, I thought that economic performance would be better served by the Federal Reserve taking its chances on responding too much, or too rapidly, to the turmoil in financial markets rather than acting too little, or too slowly.  Sluggish or inadequate easing risked a weaker real economy that might cause lenders to pull back even more, leading to a deteriorating situation that could prove difficult to reverse.  With the news on inflation relatively favorable of late and with inflation expectations seemingly well anchored, I believed that we would be able to offset the cut in the federal funds rate--if it turned out to be larger than needed--in time to preserve price stability.

Most notably, investors' concerns about exposures to subprime mortgage credit risk caused them to shun commercial paper that might be backed by such assets, in both Europe and the United States.  This aversion, in turn, meant that commercial banks that had written backup liquidity lines for commercial paper programs or had other connections with these programs might have to make good on their actual or implied support by extending credit.  With leveraged buyout credit and some mortgage originations also possibly staying on the balance sheet unexpectedly, the banks faced substantial, but uncertain, calls on their liquidity and capital.  All this uncertainty led the banks and other short-term lenders to turn very cautious; interest rates on bank deposits and other sources of credit beyond just a few days rose steeply, funding in money markets became concentrated in the very short term, and concerned and uncertain lenders generally became much less willing to extend the credit needed for liquid and efficient financial markets. 

Many people had expected the Federal Reserve to follow a gradual path of rate reductions in response to financial market developments--say, 25 basis points in September and another 25 basis points in October.  Such a path would be in keeping with how we have often approached our policy choices, as it has the advantage of allowing us to calibrate our policy as we see how the economic situation is evolving and responding to earlier policy moves.  However, given the circumstances at the time of the September FOMC meeting, there were strong arguments in favor of the larger action of a 50 basis point decrease in the federal funds rate.  

In the business sector, balance sheets are in good shape, and most firms are not likely to face an appreciable tightening of credit availability.  As a result, I anticipate that they will expand their investment spending to keep pace with rising household demands and with strength in export markets.  In sum, once we get through the near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment.

Of course, we would not have eased policy if the outlook for inflation had not been favorable. 

But you should view these forecasts even more skeptically than usual...   We will need to be nimble in adjusting policy to promote growth and price stability.

Our policy easing was aimed at helping to offset the effects of those tighter credit conditions and thereby to encourage moderate economic growth over time.  It was not intended to, nor should it, short circuit a more realistic pricing of risk and the gains and losses that the repricing will entail for market participants.

The last item on my list of limitations was that simple rules do not take account of risk-management considerations.  As shown in Figure 2A, the core CPI inflation rate for 2003 was falling toward 1 percent.  The real-time reading of the core PCE inflation rate (not shown) was on average even lower than the comparable CPI figure.  Given these rates, the possibility of deflation could not be ruled out.  We had carefully analyzed the Japanese experience of the early 1990s; our conclusion was that aggressively moving against the risk of deflation would pay dividends by reducing the odds on needing to deal with the zero bound on nominal interest rates should the economy be hit with another negative shock.  This factor is not captured by simple policy rules.

[T]he increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October.  Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses.  Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses as well.

The underlying causes of the persistence of relatively wide-term funding spreads are not yet clear.  Several factors probably have been contributing.  One may be potential counterparty risk while the ultimate size and location of credit losses on subprime mortgages and other lending are yet to be determined.  Another probably is balance sheet risk or capital risk--that is, caution about retaining greater control over the size of balance sheets and capital ratios given uncertainty about the ultimate demands for bank credit to meet liquidity backstop and other obligations.  Favoring overnight or very short-term loans to other depositories and limiting term loans give banks the flexibility to reduce one type of asset if others grow or to reduce the entire size of the balance sheet to maintain capital leverage ratios if losses unexpectedly subtract from capital.  Finally, banks may be worried about access to liquidity in turbulent markets.  Such a concern would lead to increased demands and reduced supplies of term funding, which would put upward pressure on rates.

...Finally, banks may be worried about access to liquidity in turbulent markets...

This last concern is one that central banks should be able to address.  The Federal Reserve attempted to deal with it when, as I already noted, we reduced the penalty for discount window borrowing 50 basis points in August and made term loans available.  The success of such a program lies not in loans extended but rather in the extent to which the existence of this facility helps reassure market participants.  In that regard, I think we had some success, at least for a time.  But the usefulness of the discount window as a source of liquidity has been limited in part by banks' fears that their borrowing might be mistaken for accessing emergency loans for troubled institutions.  This "stigma" problem is not peculiar to the United States, and central banks, including the Federal Reserve, need to give some thought to how all their liquidity facilities can remain effective when financial markets are under stress. 

Central banks seek to promote financial stability while avoiding the creation of moral hazard.  People should bear the consequences of their decisions about lending, borrowing, and managing their portfolios, both when those decisions turn out to be wise and when they turn out to be ill advised.  At the same time, however, in my view, when the decisions do go poorly, innocent bystanders should not have to bear the cost. 

...

To be sure, lowering interest rates to keep the economy on an even keel when adverse financial market developments occur will reduce the penalty incurred by some people who exercised poor judgment.  But these people are still bearing the costs of their decisions and we should not hold the economy hostage to teach a small segment of the population a lesson.

 

 In practice, policy decisions are likely to depend on more than the modal forecast used by the authors, such as the degree of uncertainty, the risks around the central tendency, and a weighting of the costs to public welfare from missing the forecast on one side or another. 

To be sure, the Committee looks to the Chairman to provide strong leadership.  The Chairman's special role is partly legal and structural--as the chair of the Board and the Committee and as the Committee's representative in front of Congress where the FOMC is held accountable for its actions... But in my experience, the other members of the Committee are also important for good policy.  Effective Chairmen cannot operate independently of the sentiment on the Committee; ultimately, the authority of the Chairman rests on his ability to persuade the other members of the Committee that the choices they are making under his leadership will accomplish their objectives.  The better the collection of individuals he needs to persuade, the better the policy is likely to be. 

...

Could the functioning of the FOMC be improved?  Certainly, and Chairman Bernanke has moved to further utilize the diverse views of the FOMC members, while maintaining the leadership necessary to keep this diverse group headed in the appropriate direction. 

Presidents have tended to dissent a little more than Governors.  The greater number of dissents by presidents might reflect a number of factors.  For one, presidents have their own staffs, which can help support alternative views in preparing for a meeting.  Board members share a common staff with the Chairman, and, being in the same building, perhaps have a greater opportunity to influence and be influenced by the Chairman.  In this regard, Bank presidents may act like "outsiders" more readily than Board members.  At the same time, Bank presidents tend to be longer tenured than Board members, and can contribute the institutional memory one might expect from "insiders" when Board membership turns over rapidly. 

Presidents have tended to dissent a little more than Governors.  The greater number of dissents by presidents might reflect a number of factors.  For one, presidents have their own staffs, which can help support alternative views in preparing for a meeting.  Board members share a common staff with the Chairman, and, being in the same building, perhaps have a greater opportunity to influence and be influenced by the Chairman.  In this regard, Bank presidents may act like "outsiders" more readily than Board members.  At the same time, Bank presidents tend to be longer tenured than Board members, and can contribute the institutional memory one might expect from "insiders" when Board membership turns over rapidly. 

...

FOMC members recognize the degree of uncertainty around their judgments.  Unless they perceive that a serious misjudgment is being made, they expect, given common objectives, that when they prefer another policy and their analysis later proves correct, the Committee is likely to move in their direction in time to forestall problems developing.  And they may see their influence on policy as greater over time if they are usually part of the consensus. 

Good communication is essential to successful central banking.  It is critical to preserving the democratic accountability and public legitimacy of central banks that, for good reasons, have been granted a high degree of insulation from short-run political pressures.  And good communication strengthens the effectiveness of good policy, largely because expectations are so important to the choices that households and businesses make about spending and saving and about prices and wages, as well as to the asset prices that help shape those choices.  Private decisions are more likely to reinforce the achievement of central bank objectives if decisionmakers understand the goals of the central bank, its evaluation of the forces bearing on the economy, and its possible responses to economic shocks. 

Among the most important criteria for judging the effectiveness of communications and transparency, then, is whether or not they impede making the best possible policy decisions.  Transparency should not be allowed to inhibit the free give and take and the testing of ideas at meetings that are so important to reaching good decisions.  And communication must deal with the diversity of views on the policy committee; that diversity is a strength of policy committees, but it can make it challenging to arrive at a clear, consistent public explanation of a policy decision, because policymakers can arrive at the same policy position based on different rationales.  Good communication must also take into account uncertainty.  Understandably, market participants want to know what is going to happen next--to the economy and to policy.  But we cannot say more than we know, and we should strive to avoid giving people the impression that we know more than we do. 

Because the situation has been so fluid and so uncertain in its effects, the speeches of individual FOMC participants have given varied interpretations of the developments and their implications for policy.  The resulting dispersion of messages has bothered market participants seeking clear, unambiguous guidance about the views of the central bank.  The public should understand that the FOMC members do not coordinate schedules and messages, and that members' views are likely to be especially diverse when, as in the current situation, circumstances are changing quickly and are subject to many different analyses.  The diversity of views on the Committee is one of its strengths and vital to arriving at sound decisions.  

The credit rating agencies got it wrong. Badly. I think some of the investors didn't understand that a triple-A (rating) for a corporate bond really has a different meaning. A corporate bond that's triple-A will act in a different way than a triple-A tranche of subprime mortgages will act, and so when markets moved and markets changed, people got surprised by the extent to which there was downgrading.

From audience Q&A, as reported by Market News International

The originate-to-distribute model for loans has been a successful model for some time; I think that's a very successful thing; it's worked very well in a number of areas -- consumer loans, auto loans, all kinds of things for a long time. In the case of mortgages, it just got too complicated. People made wrong assumptions. I think these instruments need to be simpler, more transparent. People need to be able to look through and make a judgment about whether the credit rating agency has done the right job or not.

From audience Q&A as reported by Market News International 

Kohn also addressed the question of sovereign wealth funds and the risks associated with their investments. 

In general, he said, the U.S. benefits from the "recycling" of U.S. dollars back into the U.S. economy, through these funds and other mechanisms. However, the process would benefit from more transparency, he said, adding that the U.S. Treasury and the International Monetary Fund are studying the issue. 

"We should welcome that recycling," Kohn said.

From audience Q&A as reported by Market News International

Even as we respond to forces currently weighing on real activity, we must also set policy to resist any tendency for inflation to increase on a sustained basis. Allowing elevated rates of inflation to become entrenched in inflation expectations would be costly to reverse, constrain our ability to cushion further downward shocks to spending, and result over time in lower and less stable economic expansion. Inflation expectations generally have appeared reasonably well anchored, giving the FOMC room to focus on supporting economic growth

I do not expect the recent elevated inflation rates to persist.  In my view, the adverse dynamics of the financial markets and the economy have presented the greater threat to economic welfare in the United States.  But the recent information on prices underlines the need to continue to monitor the inflation situation very carefully.

...

I expect the run-up in headline inflation to be reversed and core inflation to edge lower over the next few years.  This projection assumes that energy and other commodity prices will level out, as suggested by the futures markets.  Moreover, greater slack in the economy should reduce pressure on prices and wages.  Despite high resource utilization over the past couple of years and periods of elevated headline inflation, labor cost increases have remained quite moderate, and inflation expectations remain reasonably well anchored.

Even in a more favorable economic environment, some time is likely to be required to restore the functioning and liquidity of a number of markets...    In the end, we will have a safer system, but one with more bank intermediation, less leverage, and higher financing costs for many borrowers.

The Federal Reserve was created in large part to supply liquidity and calm markets in such situations, importantly by assuring banks of a backup source of funding through the discount window.  To enhance the utility of the discount window and encourage its use, the Federal Reserve reduced the spread between the discount rate and the federal funds rate last August, and we made lending available explicitly on a term basis, rather than only overnight.  However, banks were reluctant to use even this more attractive discount facility because they feared that their counterparties would see it as a sign of weakness, and pressures in term funding markets increased.

In December we introduced a new method for banks to borrow from the Federal Reserve against a broad range of collateral--the term auction facility (TAF).  The TAF is an auction through which a fixed amount of lending is offered to the banking system, and it seems to have been successful in avoiding the "stigma" problem and in helping funding markets return to more normal functioning.  Markets were also aided by coordinated efforts to supply liquidity by several other central banks at the same time.

Our job at the Federal Reserve is to put in place those policies that will promote both price stability and growth over time.  We have the tools.  As Chairman Bernanke often emphasizes: We will do what is needed.

Although a firming in the growth of economic activity after midyear now appears the most likely scenario, the outlook is subject to a number of important risks.  Further substantial declines in house prices could cut more deeply into household wealth and intensify the problems in mortgage markets and for those intermediaries holding mortgage loans.  Financial markets could remain quite fragile, delaying the restoration of more normal credit flows.  As observed in the minutes of its most recent meeting, the FOMC has expressed a broad concern about the possibility of adverse interactions among weaker economic activity, stress in financial markets, and credit constraints.

Thus far, the quality of other consumer loans has remained satisfactory. However, the delinquency rates on credit cards and consumer installment loans at banking organizations increased over the second half of the year. Moreover, although household bankruptcy filings remained below the levels seen before the changes in bankruptcy law implemented in late 2005, the bankruptcy rate rose modestly over the first nine months of 2007 and could be a harbinger of increasing delinquency rates on other consumer loans. In view of this risk, Federal Reserve supervisors are monitoring these consumer loan segments for signs of spillover from residential mortgage problems, particularly in regions showing homeowner distress, and are paying particular attention to the securitization market for credit card loans.

No, no, Oh no. ...  Some banks did not take adequate steps. Now, we are doing a study, as I noted in my testimony, of lessons learned. We did not perform flawlessly. I absolutely agree with that.

Response to question from Sen. Richard Shelby whether the Fed was reluctant to ise its power to rein in banks. As reported by Market News International.

Commercial real estate is another area that requires close supervisory attention.  The delinquency rate on commercial mortgages held by banking organizations almost doubled over the course of 2007 to over two percent.  The loan performance problems were the most striking for construction and land development loans--especially for those that finance residential development--but some increase in delinquency rates was also apparent for loans backed by nonfarm, nonresidential properties and multifamily properties.

As the nation's central bank, the Federal Reserve is acutely aware of conditions in the economy and financial markets and the challenges those conditions pose to the safety and soundness of banking organizations. Accordingly, we have been focusing supervisory efforts on those institutions most exposed to residential and commercial real estate or other sectors that have come under pressure. We are also attentive to those institutions that would suffer most from a prolonged period of deterioration in economic conditions. We continue to focus our examinations on the financial condition of banking organizations--including the adequacy of their liquidity, capital, and loan loss reserves and their consequent ability to recognize additional losses. We are also evaluating risk management practices very closely, including scrutinizing governance and controls, given some of the risk management lapses in those areas revealed by recent events

During times of systemwide stress, such as the one we are currently experiencing, significant liquidity demands can emanate from both the asset and the liability side of a bank's balance sheet.  For example, we have recently seen how unanticipated draws on liquidity facilities by structured investment vehicles, commercial paper conduits, and others can lead to significant growth in bank assets.  Moreover, some organizations have also encountered difficulty in selling whole loans or securitizing assets as planned.  There were also cases in which reputational concerns have prompted banks or their affiliates to provide liquidity support to a vehicle or to incorporate some of the vehicle's assets onto the bank's balance sheet, even when the bank had no legal obligation to do so.  In a few cases, these unexpected increases in the balance sheet created some pressures on capital ratios, even when capital levels remained unchanged. 

I don't know the answer to whether we did our own independent evaluation of those things. I know that we valued the risk management systems and whether things were being marked to market and whether there was collateral behind the change in values, whether the banks were protecting themselves if the value of the CDS changed, and they were collecting the margin for that, and I believe they are. As long as the risk management systems were in place, it probably was not necessary [to test the valuations themselves].

When asked whether the Fed or other regulators performed independent analysis on bank valuations of complex financial instruments. As reported by Market News International

I do think we have tried to position ourselves with the extra push from fiscal policy that you folks and the House and the President put together for the second half of the year that the economy is in a position to rebound later this year. I think at the same time, as Chairman Bernanke pointed out, there are downside risks to this forecast and a lot of it comes from the financial market dynamics that we're talking about today.

From Q&A as reported by Market News International

Looking at your dividend policy ought to be an essential component of looking at all the sources of capital...

Dividend policies definitely should be on the table, as they have been for a number of institutions already.

From the Q&A session, as reported by Reuters

I think progress is being made in the financial markets. It looks very shaky everyday there is some more bad news, I don't know what's happen today other than this set of testimony and I hope that's not bad news, but I think there are some signs out there that we're working through the problem. There is greater transparency by firms with problems on their banks. There is capital coming into the system that several of my colleagues have mentioned on the panel. So people are raising capital, they are being much more open about what the issues are. I think part of this problem is about uncertainty so increased transparency by lenders and others with problems on their books is going to be very helpful to letting people know what the downside risks are, how to price them in. I do think the markets have gotten to a point that they are anticipating some pretty adverse kinds of outcomes in the housing market and in the economy to a certain extent.

From Q&A as reported by Market News International

I do think there is an issue with credit rating agencies. I've spoken on this recently. I wouldn't go far as to say banks have outsourced it lock, stock and barrel but I think in the recent rounds that we've seen that the very high credit ratings for a certain class of securities, the collaterized debt obligations based on a prime asset backed securities which were not only rated triple-A but were considered senior to Triple-A securities. I think there was an over reliance generally on that rating, but even with the banks - with some of the most sophisticated banks, as they packaged these there was an undue reliance on the credit ratings and that shouldn't happen, particularly with larger institutions that have the where with all and are in the business of making credit assessment. And I think there is a very fundamental lessons that has come out of this.

From Q&A as reported by Market News International

I think I would be a fool not to say that when we get through this and when this mess is cleaned up, I'll have to think about what we went through.

From Q&A as reported by Market News International, on the relationship between monetary policy and asset prices.

Still, a leveling out in oil prices seems the more likely scenario. Surprised as we have been by the rapid, extended run-up in energy costs over the past few years, one would think that the price of a storable commodity such as oil should already embody expectations of continued rapid growth in the developing economies. However, the large run-up in spot and futures prices in recent weeks indicates that market participants are still revising their views of long-term demand-supply conditions. In these circumstances, policymakers must be mindful of the uncertainties surrounding the outlook for commodity prices and the risk that past or future increases in these goods could yet embed themselves in higher long-run inflation expectations and a persistently faster rate of overall price increases. 

Successful coordination in the provision of liquidity raises the question of whether appreciable gains might be had from coordination of monetary policies more generally. John is skeptical, and so am I. Gains from formal policy coordination never seemed large, and it is not clear that globalization has increased them appreciably. Policies agreed to under one set of circumstances may no longer be appropriate when circumstances change, as they inevitably will. Monetary policy should be able to adjust quickly to such changes; agreements that must be renegotiated can tie policymakers' hands. That does not mean that no circumstances exist in which coordinated monetary policy actions would be beneficial, but such circumstances are probably quite rare. Ultimately, global stability depends on good performance in individual countries, and the record of recent decades suggests that, in general, good performance is most readily achieved when central banks focus on their own mandates for domestic price stability and growth.

The market is still adjusting, the turmoil has not yet settled down ... It's still a fragile situation out there.

As reported by Bloomberg News

The repeal of Glass-Steagall didn't contribute to financial turmoil in a way that we should roll it back.

From audience Q&A as reported by Market News International and Bloomberg News

"Credit default swaps are a good example of a market that has huge potential for helping people manage risks," said Kohn, but he added that those who use the swaps "need to be aware of the risks they're taking."

Kohn said "good progress" has been made in improving the infrastructure of the credit default swaps market, so that "counterparties are not assigned arbitrarily." But he said swaps purchasers still need to "be very careful about where their exposures are in that market."

From Q&A as reported by Market News International

Part of our work list for regulations is to reexamine the extent to which we ourselves rely on rating agencies (to measure) the risks that you guys are taking.

There was far too much reliance on credit rating agencies all around.

From Q&A as reported by Market News International 

I believe it is fair to say that the creation of new, innovative financial products outstripped banks' risk-management capabilities. As I noted earlier, some banks that chose to hold super senior CDO securities did so because they trusted in an external triple-A credit rating. Because some banks did not fully understand all aspects of these exposures, once the risks crystallized last year in a weak house price environment, compounded by widespread liquidity pressures in many markets, banks had to scramble to measure and hedge these risks.

So we must worry about excessive leverage and susceptibility to runs not only at banks but also at securities firms. To be sure, investment banks are still different in many ways from commercial banks. Among other things, their assets are mostly marketable and their borrowing mostly secured. Ordinarily, this should protect them from liquidity concerns. But we learned that short-term securities markets can suddenly seize up because of a loss of investor confidence, such as in the unusual circumstances building over the past six months or so. And investment banks had no safety net to discourage runs or to fall back on if runs occurred. Securities firms have been traditionally managed to a standard of surviving for one year without access to unsecured funding. The recent market turmoil has taught us that this is not adequate, because short-term secured funding, which these firms heavily rely upon, also can become impaired.

With many securities markets not functioning well, with the funding of investment banks threatened, and with commercial banks unable and unwilling to fill the gap, the Federal Reserve exercised emergency powers to extend the liquidity safety net of the discount window to the primary dealers.³ Our goal was to forestall substantial damage to the financial markets and the economy. Given the changes to financial markets and banking that we've been discussing this morning, a pressing public policy issue is what kind of liquidity backstop the central bank ought to supply to these institutions. And, assuming that some backstop is considered necessary because under some circumstances a run on an investment bank can threaten financial and economic stability, an associated issue is what sorts of regulations are required to make the financial system more resilient and to avoid excessive reliance on any such facility and the erosion of private-sector discipline.

...

Whatever type of backstop is put in place, in my view greater regulatory attention will need to be devoted to the liquidity risk-management policies and practices of major investment banks. In particular, these firms will need to have robust contingency plans for situations in which their access to short-term secured funding also becomes impaired. Commercial banks should meet the same requirement. Implementation of such plans is likely to entail substitution of longer-term secured or unsecured financing for overnight secured financing. Because those longer-term funding sources will tend to be more costly, both investment banks and commercial banks are likely to conclude that it is more profitable to operate with less leverage than heretofore. No doubt their internalization of the costs of potential liquidity shocks will be costly to their shareholders, and a portion of the costs likely will be passed on to other borrowers and lenders. But a financial system with less leverage at its core will be a more stable and resilient system, and recent experience has driven home the very real costs of financial instability.

At the Federal Reserve and at other bank regulatory agencies, our job is to reinforce the incentives and actions that are building a more resilient financial system. We need to make sure that regulatory minimum capital requirements and liquidity management plans protect reasonably well against shocks becoming systemic. Our supervisory guidance needs to be in place to prevent backsliding when, over the coming years, the memories and lessons of the current market turmoil fade, as they certainly will.

To these ends, we are reexamining a host of things ranging from Basel II to liquidity to transparency. Working with our domestic and international colleagues, we are looking to raise the Basel II capital requirements on specific exposures that have been troublesome, such as super senior CDOs of asset-backed securities and off-balance-sheet commitments. We are looking to the Basel Committee on Banking Supervision to update its guidance on liquidity management in light of the recent experience. And we and our supervisory colleagues are looking to require better disclosures of off-balance-sheet commitments and of valuations of complex structured products.

All banks--large and small--need to consider whether they need greater capital cushions. The largest banks should consider whether their changing business model means that they need to hold more capital against some of the newer risks I discussed earlier. It is especially concerning that so many of these newer risks have arisen at the same time. Smaller banks must make sure their capital is sufficient to protect against the risk associated with the greater concentrations that have seemed to accompany the increased competition from securities markets.

Banks might find the current circumstances to be especially favorable for raising new capital. Not only would more capital provide a cushion against the sorts of unexpected declines in creditworthiness and asset values that have marked recent months, it would also position banks well for expansion.

 

To protect their capital and liquidity, banks and other financial market participants are addressing the weaknesses revealed by market developments by becoming much more careful about the risks they are taking. This is a necessary process, but it has been a difficult one as well; it is reducing the values of some assets and tightening credit cost and availability across a wide range of instruments and counterparties, despite considerable easing in the stance of monetary policy. It is this tightening that is accentuating the downside risks for the economy as a whole. And in some sectors, as lenders seek protection against perceived downside risks, it is probably going further than is necessary to foster financial stability in the long run.

Liquidity risk is a familiar risk to banks, but it has appeared in somewhat new forms recently. While the originate-to-distribute model aims to move exposures off of banks' balance sheets, the risk remains that a sudden closing of securitization markets can force a bank to hold and fund exposures that it had originated with the intent to distribute. ...

Concentration risk is another familiar risk that is appearing in a new form. Banks have always had to worry about lending too much to one borrower, one industry, or one geographic region. But as smaller banks hold more of their balance sheet in types of loans that are difficult to securitize, concentration risks can develop. Concentrations of commercial real estate exposures are currently quite high at some smaller banks. This has the potential to make the banking sector much more sensitive to a downturn in the commercial real estate market.

The changing business of the largest commercial banks means that threats to financial stability do not necessarily come from traditional sources such as a deposit run or a deterioration in a bank's portfolio of business loans. The largest banks' capital markets businesses have given rise to new threats to financial stability. These threats stem from banks' securitization activity, from the complexity of banks' capital markets activity, and from the services that banks provide to the asset-management industry, including hedge funds. And risks that are more traditional to banking, such as liquidity risk and concentration risk, have appeared in new forms.

As with any forecast, mine is subject to a number of uncertainties. One is the extent of the housing correction ahead of us. If the retrenchment in house prices becomes deeper than anticipated, its effect on lenders and financial markets could further damp overall economic activity. We are in uncharted waters when the financial system becomes so disrupted, though we should consider ourselves fortunate that we have very few similar historical episodes on which to base our judgments. In such circumstances, uncertainty about how credit conditions will evolve and how businesses and households will react to changing terms and conditions means that we can have even less confidence than usual in our economic forecasts.

Still, the persistence of relatively wide spreads in many markets suggests that investors continue to be worried about credit quality; the issuance of speculative-grade bonds has been scant this year; and securitization markets for many types of mortgages continue to be impaired. In addition, term bank funding markets remain under pressure as banks and other lenders in these markets conserve capital and liquidity and limit risk-taking. Banks have further tightened lending standards across a wide range of business and consumer loans.

These findings generally suggest that market participants remain wary, and in that environment, improvements in financial markets are vulnerable to negative news on the economy or the extent of credit losses. I expect further, but gradual, improvement in financial markets.

In the near term, headline inflation is likely to continue to be boosted by the direct effects of the recent increases in the prices of energy and food. If, as futures markets suggest, those prices level off later this year, prospects seem reasonably good for headline inflation to move back in line over time with core inflation. And I expect core inflation to ease off slowly as commodity prices level out and as economic slack creates competitive conditions that inhibit increases in labor costs and prices

The demand for housing is not likely to rebound substantially for a while after this episode, but the drag on growth from declining activity and prices in the housing market will ebb as excess inventories are worked off and affordability improves.

Although the current financial and economic situation remains quite difficult, I believe that the most likely scenario over the next year or so is one in which economic activity firms during the second half of this year and then gathers some strength in 2009. In the near term, consumer spending is likely to receive a boost from the rebates that are now flowing to taxpayers. Although the timing and the magnitude of the spending response are uncertain, economic studies of the previous experience suggest that a noticeable proportion of households respond reasonably quickly to temporary cash flows. Of course, the stimulus to domestic production will depend on the extent to which the additional demand is met by a temporary drawdown of inventories or an increase in imports rather than by an expansion in domestic output. But to date, businesses appear to be keeping tight control on inventories, and a reasonable assumption is that we will see a temporary lift to the economy in coming months.

To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.

The rise in commodity prices presents particular challenges for monetary policy because such increases both add to near-term inflationary pressures and damp demand. A tendency for increases in commodity prices to become a factor in ongoing pricing and wage-setting more generally would be a worrisome development that would over time tend to undermine economic welfare.

My expectations for moderating inflation and limited spillover effects from commodity price increases depend critically on the continued stability of inflation expectations. In that regard, year-ahead inflation expectations of households have increased this year in response to the jump in headline inflation. Of greater concern, some measures of longer-term inflation expectations appear to have edged up. If longer-term inflation expectations were to become unmoored--whether because of a protracted period of elevated headline inflation or because the public misinterpreted the recent substantial policy easing as suggesting that monetary policy makers had a greater tolerance for inflation than previously thought--then I believe that we would be facing a more serious situation.

The Federal Open Market Committee will be monitoring inflation developments closely for any sign that our longer-run objective of promoting price stability is threatened.

With the information now in hand, it is my judgment that monetary policy appears to be appropriately calibrated for now to promote both rising employment and moderating inflation over the medium term. But a large measure of uncertainty surrounds that judgment and as the economy evolves, so will the appropriate stance of policy.  

I start from the premise that central banks should not allocate credit or be market makers on a permanent basis. That should be left to the market--or if externalities or other market failures are important, to other governmental programs. The Federal Reserve should return to adjusting reserves mainly through purchases and sales of the safest and most liquid assets as soon as that would be consistent with stable, well-functioning markets. In fact, several of the Federal Reserve's new programs are designed to be self-liquidating as markets improve. Minimum bid rates and collateral requirements have been set to be effective when markets are disrupted but to make participation uneconomic when markets are functioning well. Under current law, our facilities for investment banks that don't involve securities eligible for open market operations (OMO-eligible paper) will necessarily be wound down when circumstances are no longer "unusual and exigent"; I'll come back to questions about these facilities in a minute.

However, the Federal Reserve's auction facilities have been an important innovation that we should not lose. They have been successful at reducing the stigma that can impede borrowing at the discount window in a crisis environment and might be very useful in dealing with future episodes of illiquidity in money markets. The new auction facilities required planning and changes in existing systems, and we should consider retaining the new facilities for the purposes of bank discount window borrowing and securities lending against OMO-eligible paper, either on a standby basis or operating at a very low level when markets are functioning well in order to keep the new facilities in good working order. The latter might require that we allow the auction to set the price without a constraining minimum, but a small auction should not distort the allocation decisions of private participants.

Our experience in recent months has underlined the global interdependencies of financial markets. Globally active banks manage their positions on an integrated basis around the world, and pressures originating in one market are quickly transmitted elsewhere. Central banks should consider how to adapt their facilities to help these institutions mobilize their global liquidity in stressed market conditions and apply it to where it is most needed. That approach will require the consideration of arrangements with sound institutions in which central banks would accept foreign collateral denominated in foreign currencies. Those arrangements are under active study and a number of issues need to be resolved. It is possible that over time, major central banks could perhaps agree to accept a common pool of very safe collateral, facilitating the liquidity management of global banks.

Another instrument of liquidity provision that central banks are examining is currency swaps to facilitate granting liquidity in other currencies. The central banks found currency swaps useful because the impediments to intermediation in money markets naturally extended to transactions across currencies as well as across maturities and counterparties...

For the United States, of course, perhaps the most difficult and important question involves access to central bank credit facilities by U.S. broker-dealers, including the primary dealers... Financial markets in most other countries are dominated by universal banks; in those circumstances, securities activities are carried out in organizations that have access to the discount window and other aspects of the safety net we associate with commercial banks...

We gave the primary dealers access to central bank credit under the unusual and exigent circumstances prevailing in mid-March. Their counterparties and creditors will presume that such access would again be granted if the health of the financial system is again threatened by loss of liquidity at the primary dealers. The public authorities need to consider several difficult issues with respect to access to the discount window. One is the circumstances under which broker-dealers should be permitted to borrow in the future...

The question has implications for the appropriate regulatory regime for broker-dealers and their parent companies. As I've already noted, the existence of liquidity facilities at the central bank can undermine normal incentives for maintaining liquidity buffers, and the more extensive the access, the greater the degree to which market discipline will be loosened and prudential regulation will need to be tightened...

[A shortage of Treasury securities] is not one of the things I'm worried about.

From audience Q&A as reported by Bloomberg News.

Normally, most central banks supply and absorb reserves primarily in the safest and most liquid parts of the money markets.  In these segments of the markets they can operate in size without distorting prices, and without preferential treatment for certain private borrowers or forms of collateral. The private sector then distributes the reserves around the markets--across counterparties, maturities, and degrees of creditworthiness. The resulting transactions enhance market liquidity and allow private market participants to allocate credit and determine the appropriate compensation for taking risk.

In principle, prudential regulation of institutions with access to central bank credit can limit moral hazard and induce institutions to hold amounts of longer-term assets and liquid assets that are socially desirable. In practice, however, this requires difficult and necessarily somewhat arbitrary judgments about the types of liquidity stress scenarios that institutions should plan to confront without access to central bank credit and, correspondingly, those scenarios in which institutions in sound financial condition can appropriately rely on central bank credit.

Another instrument of liquidity provision that central banks are examining is currency swaps to facilitate granting liquidity in other currencies. The central banks found currency swaps useful because the impediments to intermediation in money markets naturally extended to transactions across currencies as well as across maturities and counterparties. Supplying credit in dollars to banks in the euro area and Switzerland helped relieve pressure on those banks and in our markets. In recent months, the Fed was able to make currency swap arrangements on short notice but our reaction time could be even shorter if we keep such arrangements in place or on standby. Thinking carefully about which circumstances in the future would warrant the activation of such arrangements will be a useful form of contingency planning.

In particular, the public authorities must address a difficult yet very important question: To what degree should entities with access to central bank credit be permitted to rely on that access to meet potential liquidity demands? Central bank liquidity facilities are intended to permit those with access to hold smaller liquidity buffers, which allows them to fund more longer-term assets and thereby promotes capital formation and economic growth. At the same time, however, the existence of central bank credit facilities can so undermine incentives for maintaining liquidity buffers that institutions hold more longer-term assets than is socially desirable and thereby pose excessive risk to themselves and the financial system.

In view of this uncertain outlook, additional capital injections and the consideration of dividend cuts are still warranted for some of these companies and we have strongly encouraged supervised bank holding companies to enhance their capital positions.  Stronger capital positions also will allow banking institutions to participate in and support the rebound in lending that will accompany the strengthening of the U.S. economy.

The Federal Reserve is nearing completion of enhancements to its supervisory guidance to clarify our role as consolidated supervisor of bank and financial holding companies--often known as our "umbrella supervisor" role... Again, from a financial stability perspective the Federal Reserve has an interest not just in identifying the risks within an individual organization, but also understanding the broader set of risks affecting all key market participants. 

Some institutions took an excessively narrow perspective on risk with insufficient appreciation of the need for a range of risk measures, including both quantitative and qualitative metrics.  For example, some firms placed too much emphasis on the mechanical application of value-at-risk or similar model-based indicators. Sophisticated quantitative tools and models play an important role in good risk management, and they will continue to do so. But no model, regardless of sophistication, can capture all of the risks that an institution might face. Those institutions faring better during the recent turmoil generally placed relatively more emphasis on validation, independent review, and other controls for models and similar quantitative techniques.... The leaders of well-managed institutions of all sizes generally seek to have strong and independent risk functions. 

Regardless of its source, the presence of sluggish nominal adjustment brings to the fore three key elements driving wage and price dynamics: inflation expectations, supply shocks, and resource utilization...The tendency of some prices to adjust very quickly to changing circumstances in conjunction with sluggish adjustment in other prices and wages implies that large, sharp price movements, such as a change in the price of oil, lead to relative price distortions throughout the economy; these distortions imply that relative price shocks have important implications for the functioning of the economy.

The results of such exercises imply that, over recent history, a sharp jump in oil prices appears to have had only modest effects on the future rate of inflation. This result likely reflects two factors.  First, commodities like oil represent only a small share of the overall costs of production, implying that the magnitude of the direct pass-through from changes in such prices to other prices should be modest, all else equal. Second, inflation expectations have been well anchored in recent years, contributing to a muted response of inflation to oil price shocks.  But the anchoring of expectations cannot be taken as given; indeed, the type of empirical exercises I have outlined reveal a larger effect of the price of oil on inflation prior to the last two decades, a period in which inflation expectations were not as well anchored as they are today.

As a result, policymakers must look to lessons that are common across alternative specifications and base policy on our current understanding of the most likely important structural factors.  Fortunately, I think that many of the models of nominal price and wage adjustment imply similar conclusions regarding the influence of commodity prices on the inflation outlook and the appropriate response of monetary policy.

An efficient monetary policy {following an oil shock} should attempt to facilitate the needed economic adjustments so as to minimize distortions to economic efficiency on the path to achieving, over time, its dual objectives of price stability and maximum employment.⁹

In particular, an appropriate monetary policy following a jump in the price of oil will allow, on a temporary basis, both some increase in unemployment and some increase in price inflation.  By pursuing actions that balance the deleterious effects of oil prices on both employment and inflation over the near term, policymakers are, in essence, attempting to find their preferred point on the activity/inflation variance-tradeoff curve introduced by John Taylor 30 years ago.  Such policy actions promote the efficient adjustment of relative prices: Since real wages need to fall and both prices and wages adjust slowly, the efficient adjustment of relative prices will tend to include a bit of additional price inflation and a bit of additional unemployment for a time, leading to increases in real wages that are temporarily below the trend established by productivity gains.

Some have suggested that the price of oil is on a more significant upward trend than currently appreciated....An appropriate monetary policy response would share many of the characteristics I discussed earlier.  In particular, bringing overall inflation immediately back to the low rate consistent with price stability could be associated with a much higher rate of unemployment for a short time.  It may be efficient to allow some adjustment period in which both overall inflation exceeds its desired low level and the unemployment rate is higher than its long-run sustainable level; as before, setting policy in a manner that balances the undesirable effects of a shock to the system on both inflation and employment will tend to be more efficient than setting policy so as to deliver more extreme outcomes in either inflation or unemployment.

Finally, it is worth noting that the Federal Reserve's umbrella supervision role closely complements our other central bank responsibilities, including the objectives of fostering financial stability and deterring or managing financial crises. The information, expertise, and powers derived from our supervisory authority enhances the Federal Reserve's ability to help prevent financial crises, and to manage such crises should they occur, working with the Treasury Department and other U.S. and foreign authorities. In this manner, enhancements to our consolidated supervision program, which include close coordination with primary supervisors and functional regulators, should provide broad benefits for the financial system and the economy.

While liquidity pressures in banking and financial markets have eased of late, we do recognize that institutions must prepare themselves for the possibility that liquidity problems could return, either market-wide or at an individual institution.

Concerns in financial markets about the creditworthiness of some financial intermediaries have eased somewhat since the first half of March, but those concerns remain relatively high. More fundamentally, the proper management of counterparty credit risk--which is the risk of loss from a counterparty's failure to perform its financial obligations--is a prerequisite for protecting the entire system from contagion when any one institution fails.

Consistent with the recommendations of recent reports, we are looking at how firms are addressing weaknesses in counterparty credit risk management practices highlighted by recent events, including the measurement and aggregation of exposures stemming from a wide range of transactions with both unregulated and regulated entities...In this context, we have been closely monitoring counterparty exposures arising from transactions with monoline financial guarantors and have been discussing with banks the measurement and management of these positions.

We are ensuring that institutions take a more comprehensive and forward-looking approach to risk management across the entire firm, and are more intensely verifying assertions made by bank management about the robustness of their risk management capabilities.

Supervisors are also ensuring that banks understand the full spectrum and the scale of the risks inherent in increasingly complex banking activities and the potential for their risks to crystallize in times of stress. In particular, banks must focus on the inter-relationships among risk types, not just with respect to those areas that precipitated recent events, but more broadly.

We continue to encourage lenders and mortgage servicers to work constructively with borrowers at risk of default and to consider prudent workout arrangements to avoid unnecessary foreclosures. As you know, the Federal Reserve believes that prudent workout arrangements that are consistent with safe and sound lending practices are generally in the long-term best interest of both the financial institution and the borrower.

Furthermore, we are working to finalize the proposed amendments to the rules under the Home Ownership and Equity Protection Act that we proposed in December...Our proposal includes key protections for higher-priced mortgage loans secured by a consumer's principal dwelling and addresses concerns about a lender's assessment of a borrower's ability to make the scheduled payments, including verification of the consumer's income and assets. The proposal also addresses concerns about prepayment penalties and the adverse impact on consumers of lenders failing to escrow for taxes and insurance. Protecting consumers also has benefits for lenders because it should reduce delinquencies and defaults that can occur when consumers do not understand or cannot afford certain types of loans.

Broadly speaking, we believe that primary dealers are strengthening liquidity and capital positions to better protect themselves against extreme events. We also believe their management has learned some valuable lessons from the events of the recent financial turmoil that should translate into better risk management. We continue to monitor the effect of the PDCF and are studying a range of options going forward.

As our global economy becomes more intertwined and complex, the nature and transmission of business cycles and the associated policy responses will no doubt continue to evolve. Economies benefit from having independent monetary policies that provide room to respond flexibly to alternative configurations of economic and financial shocks. These benefits could be increased if exchange rate flexibility were to become more widespread and monetary policies given greater latitude to respond to shocks wherever they originate.

Recent analysis of the size and sources of spillovers between the United States, the euro area, Japan, and other industrial countries finds a central role for international trade. But spillovers also occur through commodity prices and through financial variables such as short- and long-term interest rates and equity prices.⁷ For example, when liquidity conditions tighten in one country, globally active banks may attempt to pull liquidity from overseas affiliates, reducing the liquidity consequences at home but simultaneously transmitting the shock abroad.⁸ What is particularly interesting is that in some cases, financial linkages might now be more important for transmission than the traditional trade linkages. 

The evidence sometimes presented as indicative of a divergence in economic performance, referred to as decoupling, is not definitive. It is certainly the case that in recent quarters, the U.S. economy slowed to a greater extent than other industrial economies, and economic activity in the industrial economies, in aggregate, has slowed more than in the emerging market economies. This experience contrasts with that near the start of this decade, when the economic downturn of 2001 through 2002 was felt more uniformly throughout the global economy. In addition, financial conditions in most emerging market economies have remained relatively stable, considering the turmoil that overtook industrial country financial markets over the past year.

Even so, neither economic growth nor financial markets in the different regions of the world moved in lockstep in the past, nor are they expected to do so across all business cycles. It is far from clear that the divergences in performance we have seen of late, which are tentative in any event, represent distinct breaks from historical benchmarks. The recent divergences of economic performance reflect a particular set of shocks that have hit the global economy, as well as changes in the way that different economies have responded to those shocks.

In industrialized economies, such as the United States, rising inflation has chiefly reflected the surge in energy prices, whereas in developing countries, for which food takes up more of household budgets, rising food costs have been a more important culprit. The reasons for the trajectory and persistence of increases in prices of food and energy this year, as global growth has moderated, are not entirely clear. The upward trend in prices of food and energy over the past several years, however, importantly reflects the pressures posed by rapidly growing demand in developing economies against relatively inelastic global supplies of commodities.

For the moment, higher headline rates of inflation have shown only a few tentative signs of embedding themselves in core inflation or in longer-term inflation expectations. However, policymakers around the world must monitor the situation carefully for signs that the increases in relative prices globally do not generate persistently higher inflation. Additionally, in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability.

...[R]estraint on credit supplies is likely to persist because intermediaries have some way to go to rebuild their balance sheets.  The process of adjustment to a safer, more resilient financial system is going to take a while.    

I thought it might be useful to begin by giving you my perspective on where the economy stood prior to the recent intensification of financial turmoil. Overall economic activity--as measured by the growth of real gross domestic product (GDP)--held up surprisingly well over the first half of 2008 given the ongoing stresses in broader financial markets and the further rise in oil prices. At the same time, however, a number of disquieting signs lay underneath the surface of the aggregate growth figures.

I am optimistic that this multipronged approach {monetary easing with global central bank cooperation} is laying the groundwork for a return to more normal functioning in financial markets and a restoration of vigorous economic growth. The initial reaction has been positive, but it will take some time before we know to what extent the current stresses in the financial sector are being resolved. Over time, financial firms will need to bolster profits to offset losses and attract capital, to delever by reducing debt relative to equity, and in many cases to consolidate through mergers and acquisitions. All of this points to a prolonged period of cautious lending and a high cost of capital relative to benchmark interest rates like the federal funds rate, even as market functioning improves.

Given the likely drawn-out nature of the prospective adjustments in housing and financial markets, I see the most probable scenario as one in which the performance of the economy remains subpar well into next year and then gradually improves in late 2009 and 2010. As credit restraint abates, the low level of policy interest rates will begin to show through into more accommodative financial conditions. This improvement in financial conditions, together with the gradual stabilization of housing markets and the stimulative effects of lower oil and commodity prices, should lead to a pickup in jobs and income, contributing to a broad recovery in the U.S. economy.

At the same time, inflation seems likely to move onto a downward track. If sustained, the recent declines in commodity prices should soon lead to a sharp reduction in headline inflation. In addition, I expect core inflation to slow from current levels as lower commodity prices and greater economic slack moderate upward pressures on costs. Similar reductions in inflation abroad, as well as the recent appreciation of the dollar, should restrain increases in the prices of imported goods.

I would caution, however, that the uncertainty around my forecast is substantial. The path of the economy will depend critically on how quickly the current stresses in financial markets abate. But these events have few if any precedents, and thus we can have even less confidence than usual in our economic forecasts.

In addition, the commercial paper market became severely disrupted as money market mutual funds, the largest investors in that market, substantially reduced their demand in response to outflows and the difficulty of liquidating commercial paper in secondary markets. As a result, yields on commercial paper skyrocketed for most issuers, and funding became increasingly concentrated in paper with overnight maturities.

We will need to decide the appropriate timing of the winding-down of many of the special lending facilities. The actions taken by the Federal Reserve to intervene directly in some financial markets, such as the commercial paper market, are clearly emergency operations only. Except in the most extreme circumstances, when market functioning breaks down and systemic risk reaches unacceptable levels, central banks should distance themselves from decisions about the allocation of credit among private parties.

Robust, dynamic markets are the lifeblood of market economies. They are the source of rising productivity and, as such, of increasing standards of living. But the dynamic functioning of markets also means that productivity advances will not necessarily occur smoothly--and, indeed, are likely to involve some cyclical overshooting and undershooting, often exacerbated by waves of optimism and pessimism that seem to be inherent in human nature. Innovation by its nature is risky; some innovations work better than others, and, thus, some new ideas and the businesses that invest in or use them must be allowed to fail.

Central banks should be wary of placing too much faith in model-based analyses, which are necessarily predicated on past empirical correlations and relationships. As we have seen, financial innovation can induce structural changes that can importantly alter the way financial institutions, markets, and the broader economy respond to shocks. For this reason, policymakers should take a critical approach to evaluating analyses of this sort, and should always probe to find the sensitivity of results to unstated assumptions that may no longer be valid.

 "We have worked on the fuzzy border between monetary and fiscal  policy," Kohn said. " Now that the legislation has passed I would hope we could stay on the liquidity side."

As reported by Market News International.

He acknowledged that the Fed already has "engaged in forms of quantitative easing," and should look at it more "as a contingency plan, should that still remote possibility {of deflation} -- but I think less remote than it was -- occur.

...

The Fed official said monetary policymakers have not switched from using interest rates to quantitative easing, but are employing both.   "I don't think we've given up on one in favor of the other. I think we're doing both at the same time," he said. "So we are lowering our target rate. At the same time we are engaging in a great amount of liquidity provision to the system."

From the audience Q&A, as reported by Market News

Recent research, however, suggests reasons for why market participants who think they know that a bubble exists still may not trade to eliminate it.  For example, if some market participants recognize the presence of a bubble but do not know how common their knowledge is, they might reasonably expect to make the most profits by riding the bubble for as long as possible, with the goal of trying to sell the asset just before it collapses.⁴  Other research emphasizes that certain institutional structures--such as secured lending and delegated portfolio management--can create substantial costs in trading against an asset price bubble, so that even market participants who are conscious of the bubble will not find it profitable to trade against it.⁵  Together, these studies suggest that policymakers may be able to detect bubbles that will not be quickly arbitraged away, thus strengthening the argument for considering extra action.⁶    

The likelihood of deflation, "whatever I thought that risk was four or five months ago, I think it's bigger now, even if it's still small," he said.   But, "A lesson I take from the Japanese experience is not to let that get ahead of us, to be aggressive in moving against that risk if we see it coming," Kohn said, responding to questions following a speech to the Cato Institute's 26th Annual Monetary Policy Conference 

While "some people have argued that we should save our ammunition, that interest rate cuts aren't effective, etcetera, I think that were we to see this possibility that we should be very aggressive with our monetary policy, as aggressive as we can be," Kohn said.   

From the audience Q&A, as reported by Market News

Nonetheless, even if policymakers are confident that a bubble has emerged, the question of the timeliness of the call remains.  The essential problem is the timing of the detection of the bubble relative to the timing of its collapse.  The risk is that the detection and subsequent policy response occurs not long before the bubble collapses on its own.  Given the lags associated with monetary policy, the resulting contractionary effects on the economy of the monetary tightening would occur just when the adverse effects of the bubble's collapse are being realized, worsening rather than mitigating the effects of the bubble's collapse.  And the inevitable lags in detecting bubbles increases the likelihood that, by the time action is taken, speculative activity will have progressed to the point that its collapse is not far off. 

More time and study will be needed before we can be confident about the lessons of the current crisis.  But... based on what we know today, I still have serious questions about whether trying to use monetary policy to check speculative activity on a regular, systematic basis would yield benefits that outweigh its costs.

...

...in the 2006 speech I concluded that a strategy of extra action might be justified if three tough conditions were met.  First, policymakers must be able to identify bubbles in a timely fashion with reasonable confidence.  Second, a somewhat tighter monetary policy must have a high probability that it will help to check at least some of the speculative activity.  And third, the expected improvement in future economic performance that would result from the curtailment of the bubble must be sufficiently great.  Of course, we live in an uncertain world, and accordingly policymakers should always be open to the possibility that these conditions might be satisfied and that extra action would be appropriate.  But my thought at the time was that, in practice, the likelihood of ever meeting the three conditions seemed remote. 

For example, in light of the demonstrated importance to the real economy of speculative booms and busts (which can take years to play out), central banks probably should always try to look out over a long horizon when evaluating the economic outlook and deliberating about the appropriate accompanying path of the policy rate.  The Federal Reserve staff has for sometime regularly provided the FOMC with this sort of extended-horizon analysis.  In particular, the staff regularly generates likely paths for the economy over the next five years or so under different economic and policy assumptions; these scenarios often highlight different possibilities for the evolution of prices for homes and other assets.  Note that the focus here is not a single baseline outlook; rather, the emphasis is on exploring the various ways events could play out and the implications for monetary policy.

Addressing the mystery of why the federal funds rate has remained below the target, despite the Fed's policy of paying interest on reserves in order to set a floor, Kohn said, "So far that hasn't worked as well as I had hoped it would."

He speculated that the phenomenon "to some extent that reflects people getting used to a new system, banks getting used to and adapting to new systems.  "In order to bring that federal funds rate to the floor, somebody has got to be willing to buy funds from people who are selling it or would like to sell it below the floor and then put it to the Federal Reserve and that means expanding your balance sheet.  So I think the fact the federal funds rate has been somewhat below our target and somewhat below the rate we're actually paying on reserves reflects some of the stresses in the financial system," Kohn said. "Over time I would think that would provide a floor, and that wouldn't constrain our use of quantitative easing." 

He noted in response to another question on paying interest on reserves that the "excess reserves are a consequence of the problems private parties perceive in lending to each other. They're not a cause."

Another lesson of the current crisis is that central banks need to improve their understanding of the workings of the financial system, its vulnerabilities, and its links to the real economy.  We must try to find ways to discern more quickly if financial innovation and other factors are leading to a buildup of destabilizing forces, such as rapidly rising asset prices or excessive leverage.  Moreover, the unexpectedly rapid resonance of financial turmoil through global markets signals a need for further study of the complex cross-country linkages among lenders and borrowers, and the ways in which those linkages are influenced by such factors as leverage, interdependent counterparty relationships, and backup liquidity agreements.  Finally, more effort needs to be spent on further investigation of the financial accelerator and other credit-channel effects, given the accumulating evidence that such effects can give rise to an adverse feedback loop between financial markets and the real economy.

The challenge for regulators and other authorities is to create an environment that supports greater bank intermediation, which should help to restore the health of the financial system and the economy. We want banks to be willing to deploy capital and liquidity, but they must do so in a responsible way that avoids past mistakes and does not create new ones.

...

The events of the past year and a half have highlighted the need for changes in our financial system. Presumably, such changes may include a different balance between bank-based and market-based financial intermediation. As regulators of banks and thrifts, our job is not to determine what this balance should be. Rather, our job is, and has been, to create an environment in which, in the short run, banks can step up to fill as much of the gap as possible that has been left by still-dysfunctional markets, consistent with a strong, stable banking system. Over time, of course, we will need to work with the Congress and the new Administration to construct a system of oversight over both markets and institutions that better protects the stability of the financial system and the U.S. economy.

A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions' balance sheets  The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit private investment and new lending. 

Chairman Bernanke used the same wording earlier in the day.

Finally, I would expect the bulk of the remaining TARP funding to be devoted to strengthening financial institutions, thereby supporting the normalization of credit markets and the flow of new credit. Some of this support might take the form of additional capital injections, both to offset additional credit losses and to further expand lending capacity.  Consideration should be given to whether it is feasible for some capital injections to be made on a matching basis with private capital raises, thereby providing a market test for those injections.  In addition, prudence requires that funds be held in reserve as needed to address urgent contingencies, such as averting the disorderly failure of a systemically important financial institution.

History clearly shows, and recent experience confirms, that--because of the dependence of modern economies on the flow of credit--serious financial instability imposes disproportionately large costs on the broader economy.  The rationale for public investment in the financial industry is not, therefore, any special regard for managers, workers, or investors in that industry over others, but rather the need to prevent a further deterioration in financial conditions that would destroy jobs and incomes in all industries and regions. That said, the public is entitled to demand that policymakers take near-term, concrete actions to ensure that we do not face a similar crisis in the future.  An important part of those actions should be to create a stronger supervisory and regulatory system in which gaps and unnecessary duplication in coverage are eliminated, lines of supervisory authority and responsibility are clear, and oversight powers are sufficient to curb excessive leverage and risk-taking, particularly in systemically critical institutions.  The Federal Reserve stands ready to work closely with the Congress to achieve meaningful and effective regulatory reform.

Our judgment has been and continues to be that, in this time of severe market and economic stress, the failure of AIG would impose unnecessary and burdensome losses on many individuals, households and businesses, disrupt financial markets, and greatly increase fear and uncertainty about the viability of our financial institutions.  Thus, such a failure would deepen and extend market disruptions and asset price declines, further constrict the flow of credit to households and businesses in the United States and in many of our trading partners, and materially worsen the recession our economy is enduring.

We are also conscious of a potential adverse feedback loop between persistent economic weakness and a continuing decline in inflation and inflation expectations...  Indeed, if such a process continued for some time, we could fall into deflation, much as Japan did for a time in the 1990s and earlier this decade. Then again, the substantial increase in the size of the Federal Reserve's balance sheet as a result of the credit programs that have been implemented have led some to worry that inflation could rise sharply when the economy recovers unless the Federal Reserve moves quickly when the time comes to unwind the programs and limit the growth in credit.

U.S. Federal Reserve Vice Chairman Donald Kohn on Friday said it was right for the Financial Accounting Standards Board to ease its rules on how companies determine the "fair value" of their assets.

"I think what the accountants are doing is the right thing to do," Kohn said during a question-and-answer session following a speech he gave at the College of Wooster in Wooster, Ohio. "Investors aren't well-served where assets are being carried at prices above or below what they're really worth."  "We're trying to loosen that up with some of these things, and it's going to be a process," he continued.

From the Q&A session, as reported by Dow Jones

[T]he conditions for government assistance need to be carefully calibrated to protect the taxpayer while still allowing the policy objectives to be accomplished. Firms might hold back on accepting government help if they saw the cost of meeting the conditions as greater than the benefit of the assistance or if they were concerned that the conditions might change in an undesirable way after the assistance had been accepted. Such hesitance could impede the effectiveness of government programs and slow the recovery of jobs and income.

The steps we have taken need to be seen as part of an effort by the government to smooth the transition of our financial sector and economy to a more sustainable situation. Both markets and regulators are going to press financial firms to employ less leverage. Similarly, households will need to save more of their income over time, and in that process domestic spending will be brought more into line with our nation's potential to produce, thus reducing our dependence on foreign savings. However, the speed and force of the private-sector adjustments risk overshooting...

However, while near-term stability seems to require slowing these adjustment processes, we must put in place frameworks for exiting these programs if we are to end up with a market-based economy that is more balanced and more resilient. Over time, the Federal Reserve must reduce its lending; the government must put its deficits on a distinct downward track; financial institutions must retire government assistance and operate on their own.    

Lenders have been concerned about counterparty risk and about conserving their own capital against unforeseeable events. We can't deal with those concerns through our lending because we do not take appreciable credit risk. But confidence about access to funding has been a part of the problem, as reflected in the evaporation of trading in term maturities in a wide range of wholesale funding markets and the elevated spreads paid by even very safe borrowers. The limited availability of credit to sound borrowers, even when secured by what had been seen as good collateral, has been a source of instability and constraint on credit flows. Central banks can address such a shortage because they can remain unaffected by panicky flights to liquidity and safety. Their willingness to extend collateralized lending in size against a broad range of assets can replace flows of private credit that are normally uncollateralized.

However, our newly purchased Treasury securities and MBS will not mature or be repaid for many years; the loans we are making to back the securitization market are for three years, and their nonrecourse feature could leave us with assets thereafter. But we have a number of tools we can use to absorb the resulting reserves and raise interest rates when the time comes. We can sell the Treasury and agency debt either on an outright basis or temporarily through reverse repurchase agreements, and we are developing the capability to do the same with MBS.

In gauging the effects of market interventions in the current crisis, one approach is to look to the size of increases in the quantity of reserves and money to judge whether sufficient liquidity is being provided to forestall deflation and support a turnaround in growth--an approach often known as quantitative easing. The linkages between reserves and money and between either reserves or money and nominal spending are highly variable and not especially reliable under normal circumstances. And the relationships among these variables become even more tenuous when so many short-term interest rates are pinned near zero and monetary and some nonmonetary assets are near-perfect substitutes. In our approach to policy, the amount of reserves has been a result of our market interventions rather than a goal in itself. And, depending on the circumstances, declines in reserves may indicate that markets are improving, not that policy is effectively tightening or failing to lean against weaker demand. Still, we on the Federal Open Market Committee (FOMC) recognize that high levels of Federal Reserve assets and resulting reserves are likely to be essential to fostering recovery, and we have discussed whether some explicit objectives for growth in the size of our balance sheet or for the quantity of the monetary base or reserves would provide some assurance that policy is pointed in the right direction.

The recovery that followed the recession in the early 1990s was fairly sluggish. And with a lackluster recovery after the 2001 recession, the evidence supporting rapid bouncebacks after downturns was weakened further. Some analysts have suggested that those slow recoveries reflected the shallowness of the downturns--indeed, the research on the pre-1990 episodes indicated that the strength of recoveries was correlated with the depth of the preceding recessions, and the slowness of the recoveries from the 1990 and 2001 recessions would be consistent with that correlation. However, many commentators instead attributed the slowness of those recoveries to the drag from structural factors--namely, the financial headwinds in the early 1990s and the need to work off capital overhangs after 2001. All in all, the historical record leaves us with at least two possibilities for the coming recovery: a strong recovery from the deep recession or a sluggish recovery because drag from the underlying structural factors partly offsets the usual forces that generate a rapid bounceback.

[M]y best guess is that we are in for a relatively gradual recovery, though a very wide range of uncertainty surrounds that outlook.
...
Although the recovery in the U.S. economy is likely to be gradual in its early stages, it should gain momentum over time. As credit markets improve, the accommodative stance of monetary policy will show through more clearly. And a rebound in confidence about the future should help spur demand. As demand strengthens and financial markets improve, some of the adverse feedbacks should reverse and begin working to bolster activity. In time, as these forces come into play, economic growth will pick up, ultimately returning the economy to its full productive capacity and bringing the unemployment rate down to a more normal level.

The extent of a decline in inflation...should be limited by the relative stability of longer-term inflation expectations.  That said, there are sizable risks on both sides of the inflation forecast.
On the one hand, we cannot rule out the possibility that adverse economic conditions will cause deeper cuts in prices, a greater softening in wages, and a steep decline in inflation expectations.
...
On the other hand, the Federal Reserve's actions to ease credit conditions have resulted in a tremendous increase in its assets and in bank reserves.  Some observers have expressed concern that these actions, if not reversed in a timely manner, are sowing the seeds of a sharp pickup in inflation down the road. ..[W]e are working with the Treasury to introduce legislation that would enlarge our tool kit for moving away from the extraordinary degree of financial stimulus we have put in place when the time arrives.

In our open market operations, we have embarked on large-scale purchases of intermediate- and long-term Treasury securities, agency debt, and agency-guaranteed mortgage-backed securities (MBS) in order to put further downward pressure on borrowing costs, greatly increasing the degree of maturity transformation on our balance sheet. In addition, our traditional liquidity operations have been extended to include new borrowers and new markets, with the potential for greater credit risk than usual.

...

In open market operations, we have announced our intention to purchase up to $1.75 trillion in longer-term Treasury notes and bonds, agency debt, and agency MBS during this year. This program is intended to stimulate real economic activity by holding down intermediate- and long-term interest rates by bringing down the term premium on these securities--a mechanism that is distinct from the traditional channel whereby a shift in the stance of monetary policy affects longer-term yields by changing the expected path of short-term interest rates.⁵ The preliminary evidence suggests that our program so far has worked; for example, our announcements regarding the large-scale asset purchase program coincided with cumulative restraint on the average level of longer-term interest rates, perhaps by as much as 100 basis points by some estimates.

For example, suppose the level of federal government purchases is increased permanently by 1 percent of gross domestic product (GDP). Under normal circumstances, the fiscal spending multiplier--that is, the percentage response of real GDP to the boost in government spending--starts out at about 1 but then quickly falls to zero as long-term interest rates rise so that private spending and exports decline. However, if financial market participants anticipate that the federal funds rate will remain at zero for an appreciable period of time following the hike in government spending, the simulated short-run fiscal multiplier rises to 1.3 for some time. Model simulations also indicate that the fiscal spending multiplier may rise even further--to around 2--if the fiscal stimulus is expected to be temporary and to last no longer than the period when monetary policy holds short-term interest rates at the zero lower bound.⁴

...

Although any calculation of the effect of our asset purchases on the economy is highly uncertain, estimates from our models suggest that nominal GDP could be as much as $1 trillion higher over the next several years than it would be without the large-scale asset purchase program. Such stimulus would not only significantly improve the economic welfare of our nation's citizens, but also could provide the federal government with as much as about $175 billion in greater tax revenues than it would otherwise receive.

[S]ome of the Treasury and GSE debt that we are acquiring will run off over the next few years without any need for outright sales, as will some of the MBS as individuals sell or refinance their homes.

My personal view is that the Federal Reserve is well placed to do a good job in the public interest on consumer regulation. I think the fact that we have various disciplines within the (Fed) system: we have a view of the macroeconomy, the markets, our supervision system -- these are congruent with good consumer regulation. (They) give us a way of balancing issues having to do with consumer regulation…I would hope that the Congress might think about whether there are ways of strengthening the Federal Reserve's commitment to consumer regulation as an alternative to creating a new regulator.

As reported by Reuters.

Is monetary policy independence threatened by giving a central bank other responsibilities, such as supervisory and regulatory authority for some parts of the financial system? Are there potential conflicts between a high degree of independence for monetary policy and accountability in supervisory and regulatory policy? I believe that U.S. and foreign experience shows that monetary policy independence and supervisory and regulatory authority are mutually compatible and even have beneficial synergies.

 Any substantial erosion of the Federal Reserve’s monetary independence likely would lead to higher long-term interest rates as investors begin to fear future inflation. Moreover, the bond rating agencies view operational independence of a country’s central bank as an important factor in determining sovereign credit ratings, suggesting that a threat to the Federal Reserve’s independence could lower the Treasury’s debt rating and thus raise its cost of borrowing.¹ Higher long-term interest rates would further increase the burden of the national debt on current and future generations.²

The latitude for the Federal Reserve to pursue its statutory objectives is expressed in several important ways. For example, the Congress determined that Federal Reserve policymakers cannot be removed from their positions merely because others in the government disagree with their views on policy issues. In addition, to guard against indirect pressures, the Federal Reserve determines its budget and staff, subject to congressional oversight. Thus, the system has three essential components: broad objectives set by the Congress, independence to pursue those legislated objectives as efficiently and effectively as possible, and accountability to the Congress through a range of vehicles.

...

The Congress, however, has purposefully--and for good reason--excluded from the scope of potential GAO audits monetary policy deliberations and operations, including open market and discount window operations, and transactions with or for foreign central banks, foreign governments, and public international financing organizations. By excluding these areas, the Congress has carefully balanced the need for public accountability with the strong public policy benefits that flow from maintaining the independence of the central bank’s monetary policy functions and avoiding disruption to the nation’s foreign and international relationships.

In my opinion, the root cause of the problems was the underpricing of risk as the financial sector interacted with nonfinancial sectors. On the lending side of the financial sector balance sheet, underpricing of loans relative to true risk resulted in a buildup of leverage in the household sector that left lenders vulnerable to declines in collateral values and debt servicing capacity. On the borrowing side, households ended up with some assets--like shares in money market mutual funds--that weren't as liquid as they were thought to be; when money funds began to worry about the liquidity of their assets, like asset-backed commercial paper, and when households and businesses tried to use their perceived liquidity, the resulting fire sales accentuated asset price declines and transmitted problems from one sector to another.

Our framework for {the large-scale asset purchase} aspect of our credit policies relied on preferred habitats of investors and imperfect arbitrage. There was ample evidence that private agents had especially strong preferences for safe and liquid short-term assets in the crisis; in those circumstances, sizable purchases of longer-term assets by the central bank can have an appreciable effect on the cost of capital to households and businesses. The marked adjustments in interest rates in the wake of the announcements of such actions, both in the United States and elsewhere, suggest that market participants also saw them in this light.

[T]he presence of a large volume of reserves on bank balance sheets--even when remunerated--could have undesired effects on the portfolio decisions of banks. So we continue to develop tools that enable the Federal Open Market Committee (FOMC) to drain or neutralize large volumes of reserves were the Committee to decide that doing so would support its objectives.⁵

The Administration has agreed to seek to remove the so-called Maiden Lane facilities from the Federal Reserve's balance sheet.

Still, draining reserves at some point also will be an aspect of exiting. The large volume of reserves is contributing to the loose relationship of our deposit rate and market rates. In addition, although to date the high volume of reserves evidently has not increased bank lending or reduced spreads of rates on bank loans or other assets relative to, say, Treasury rates, it could begin to do so if banks start to perceive the risk-adjusted returns on loans as superior to our deposit rate. An increase in lending and narrowing of spreads on bank loans is a necessary and desirable aspect of the return to better-functioning markets and intermediation to promote economic growth. But spreads eventually could become narrower than what would be consistent with underlying risk, and lending could grow more quickly than appropriate for price stability if very high levels of reserves remain in place. We are developing new techniques for draining reserves, including reverse repurchase agreements against mortgage-backed securities and time deposits for banks at the Federal Reserve. And, of course, we retain the option to sell securities from our portfolio on an outright basis. The range of tools will permit us to drain large volumes of reserves if necessary to achieve the policy stance that fosters our macroeconomic objectives.

The opportunity for banks to earn interest on a highly liquid risk-free deposit at the Federal Reserve should put a reasonably firm floor under short-term rates, including the federal funds rate. To date, that floor has been somewhat soft, perhaps because not all participants in the federal funds market can hold deposits at the Federal Reserve, and because banks have been reluctant to allocate the needed capital to arbitrage a few basis points. But I am confident that when we begin to raise our deposit rate, it will put upward pressure on the rates on competing assets, increasing actual and expected short-term interest rates with the usual types of effects on other interest rates and asset prices.

In standard theoretical model environments, long-run inflation expectations are perfectly anchored. In reality, however, the anchoring of inflation expectations has been a hard-won achievement of monetary policy over the past few decades, and we should not take this stability for granted. Models are by their nature only a stylized representation of reality, and a policy of achieving "temporarily" higher inflation over the medium term would run the risk of altering inflation expectations beyond the horizon that is desirable. Were that to happen, the costs of bringing expectations back to their current anchored state might be quite high.

Uncertainty about the course of the economy is a lot lower than it was just a few short months ago. But we cannot lose sight that this uncertainty remains quite high; we are still in largely uncharted waters when it comes to fully understanding how our economy will recover from the severe recession and financial disruptions of the past several years and how that recovery and inflation will be affected by the extraordinary actions we took. We need to base policy on our best estimate of the evolution of inflation and output relative to our objectives, but we also need to be ready to adjust our plans if events don't turn out as predicted in either direction. We have the tools to exit our unusual policies when the time comes. And we must act well before demand pressures or inflation expectations threaten price stability.

Even as the economy begins to recover, substantial slack in resource utilization is likely to continue to damp cost pressures and maintain a competitive pricing environment. I expect that the persistence of economic slack, accompanied by stable longer-term inflation expectations, will keep inflation subdued for some time. Indeed, if inflation expectations were to begin to ratchet down toward the actual inflation rates that we have experienced recently, inflation could move appreciably lower.

We can never directly observe the level of economic potential--it is largely inferred from the behavior of related variables, like output, productivity, costs and prices. In that regard, a widely discussed upside inflation risk is the possibility that as a result of the financial turmoil and deep recession, the extent of economic slack in the economy is not as great as is commonly estimated. One possibility is that the steep drop in investment has caused a decline in capital services that could damp the rise in productivity. Another possibility is that the needed reallocation of resources away from a number of sectors--including finance, construction, and motor vehicles--will have a restraining influence on potential output for a time. In addition, prolonged periods of unemployment could have adverse effects on the skills of workers and their attachment to the labor force.

The financial crisis may also have affected potential output by reducing the ability of financial markets to effectively lubricate the flow of credit throughout the economy--and to allocate capital resources to their most productive uses. The deterioration in the health of the financial system conceivably may have disrupted the credit allocation system enough to seriously impair the efficiency of business operations, and this impaired efficiency could show up at some point in more meager gains in productivity. And, some have argued, as governments seek to build more stable financial and economic systems, they may impede innovation and efficiency.

Each of these arguments contains a grain of truth, and they are worthy of further research. But in my view, the cumulative reduction in aggregate demand has been much greater than any possible cutback in potential supply. The unemployment rate has risen by 5 percentage points in a very short period, and capacity utilization in industry hovers just above its lowest level in the history of the series, dating back to 1948. The downward pressures on both prices and labor compensation reinforce my impression that our economy is operating well below its productive potential. And, if anything, productivity has been surprisingly strong, not weak, in recent quarters.

When the monetary authorities judge that important asset prices or rates of credit expansion are deviating from sustainable long-run trends, should they adjust their policy setting to damp those price and credit movements--beyond whatever actions might be called for to preserve macroeconomic stability over the usual two- to three-year planning horizon for monetary policy?

To preview, I don't think we know enough to answer those questions with any confidence--to judge whether the benefits of such extra action would outweigh the costs...

The difficulties I've just outlined lead me to a strong preference for using prudential regulation to deal with potential problems in credit and asset markets. Historically, bank supervision has been focused on individual institutions rather than on the system as a whole. Unfortunately, such microprudential regulation in practice was not as effective as it should have been, and an important challenge for policymakers will be to strengthen the supervision of individual institutions. However, the experience of this crisis also strongly suggests that policymakers need to pay close attention to developments across the financial system--that is, to engage in macroprudential supervision and regulation. Both microprudential and macroprudential oversight are essential to making the financial system more resilient to the inevitable cycles in asset prices, and less prone to large cycles.

In sum, it seems to me that under most circumstances monetary policy is not the appropriate tool to use to address asset-price developments or growing vulnerabilities in financial markets. As I argued earlier, microprudential and macroprudential policies seem likely to me to be more effective and targeted at the problem than monetary policy adjustments, and in my view these tools should be the first that policymakers deploy.

The TAF combines aspects of open market operations and the discount window. The legal form of the TAF is the same as that of regular discount window loans. But by providing funds through an auction mechanism rather than through a standing facility, the TAF resembles open market operations rather than the standard discount window and, partly as a result, it appears to have largely avoided the stigma problem that limited the effectiveness of the discount window. Important questions for the Federal Reserve going forward are whether the benefits of the TAF warrant its maintenance on an ongoing basis or whether, now that the TAF has been developed, it can be brought off the shelf sufficiently quickly if warranted by circumstances.

The Federal Reserve Act was designed when most credit flowed through banks, but over time securities markets have assumed a much more prominent role in the distribution of credit. Our ability to preserve financial stability may be enhanced by making sure the Federal Reserve has authority to lend against good collateral to other classes of sound, regulated financial institutions that are central to our financial markets--not on a routine basis, but in some circumstances when the Board of Governors finds that the absence of such lending would threaten market functioning and economic stability. The collateral would have to be of good quality and the institutions sound to minimize any credit risk the Federal Reserve might take. And the institutions would need to be tightly regulated and closely supervised to limit the moral hazard of permitting access to the discount window, even when such access is not routinely granted. I want to be quite clear that I am not referring to lending under section 13(3) to individual troubled institutions, like American International Group. That sort of lending is more appropriately done by the fiscal authorities and conducted only in association with the exercise of new authority to resolve systemically important financial institutions.

First, we have no shortage of tools for firming the stance of policy, and we will be able to unwind our actions when and as appropriate. Because we can now pay interest on excess reserves, we can raise short-term interest rates even with an extraordinarily large volume of reserves in the banking system. Increasing the rate we offer to banks on deposits at the Federal Reserve will put upward pressure on all short-term interest rates. In addition, we are developing and testing techniques for draining large volumes of reserves through reverse repurchase agreements and through term deposits at the Federal Reserve. And we can sell portions of our holdings of MBS, agency debt, and Treasury securities if we determine that doing so is an appropriate approach to tightening financial conditions when the time comes.

For all these reasons, my strong preference would be to use regulation and supervision to strengthen the financial system and lean against developing problems. Given our current state of knowledge, monetary policy would be used only if imbalances were building and regulatory policies were either unavailable or had been shown to be ineffective. But, of course, we should all be working to improve our state of knowledge, so as to better understand economic and financial behavior and to further expand the range of policy tools that can be employed to enhance macroeconomic performance.

Given the heavy costs that have resulted from the financial crisis, the question naturally arises as to whether the circumstances that caused the crisis could have been avoided. Among other crucial policy issues, we now need to reexamine, with open minds, whether conventional monetary policy should be used in the future to address developing financial imbalances as well as the traditional medium-term macroeconomic goals of full employment and price stability. .. Obviously preventing situations like the current one would be very beneficial. But against this important objective we need to balance the potential costs and uncertainties associated with using monetary policy for that purpose, especially in light of the difficulty in judging the appropriateness of asset valuations.

One type of cost arises because monetary policy is a blunt instrument. Increases in interest rates damp activity across a wide variety of sectors, many of which may not be experiencing speculative activity... In the current situation, with output expected to be well below its potential for some time and inflation likely to be under the 2 percent level that many FOMC participants see as desirable over the long run, tightening policy to head off a perceived threat of asset price misalignment could be expensive in terms of medium-term economic stability.

Furthermore, small policy adjustments may not be very effective in reining in speculative excesses. Our experience in 1999 and 2005 was that even substantial increases in interest rates did not seem to have an effect on dot.com stock speculation in the first instance, and housing price increases in the second. And larger adjustments would incur greater incremental costs...

 

 

[W]e can sell portions of our holdings of MBS, agency debt, and Treasury securities if we determine that doing so is an appropriate approach to tightening financial conditions when the time comes.

[B]ecause monetary policy typically acts with long lags on the economy and price level, the choice of when and how to exit will depend on forecasts. We will need to begin withdrawing extraordinary monetary stimulus well before the economy returns to high levels of resource utilization.

As the interest rate risk advisory issued by each of the financial regulators earlier this month recognized, interest rate risk is inherent in the business of banking. But it is especially important now for institutions to have in place sound practices to measure, monitor, and control this risk. They must not become distracted from this critical task by their efforts to deal with credit problems, nor can they think that assuming greater interest rate risk is a sound strategy for compensating for the losses they are taking on their loan portfolios. The recent crisis has been a stark reminder that borrowing short and lending long is an inherently risky business strategy.

Another uncertainty deserving of additional examination involves the effect of large-scale purchases of longer-term assets on expectations about monetary policy. The more we buy, the more reserves we will ultimately need to absorb and the more assets we will ultimately need to dispose of before the conduct of monetary policy, the behavior of interbank markets, and the Federal Reserve's balance sheet can return completely to normal. As a consequence, these types of purchases can increase inflation expectations among some observers who may see a risk that we will not reduce reserves and raise interest rates in a timely fashion.

In our explanations of our actions, we have concentrated, as I have just done, on the effects on the prices of the assets we have been purchasing and the spillover to the prices of related assets. The huge quantity of bank reserves that were created has been seen largely as a byproduct of the purchases that would be unlikely to have a significant independent effect on financial markets and the economy. This view is not consistent with the simple models in many textbooks or the monetarist tradition in monetary policy, which emphasizes a line of causation from reserves to the money supply to economic activity and inflation. Other central banks and some of my colleagues on the Federal Open Market Committee (FOMC) have emphasized this channel in their discussions of the effect of policy at the zero lower bound. According to these types of theories, extra reserves should induce banks to diversify into additional lending and purchases of securities, reducing the cost of borrowing for households and businesses, and so should spark an increase in the money supply and spending. To date, that channel does not seem to have been effective; interest rates on bank loans relative to the usual benchmarks have continued to rise, the quantity of bank loans is still falling rapidly, and money supply growth has been subdued.

We are also uncertain about how, exactly, the purchases put downward pressure on interest rates. My presumption has been that the effect comes mainly from the total amount we purchase relative to the total stock of debt outstanding. However, others have argued that the market effect derives importantly from the flow of our purchases relative to the amount of new issuance in the market. Some evidence for the primacy of the stock channel has accumulated recently, as the prices of mortgage-backed securities appear to have changed little as the flow of our purchases has trended down.

One type of cost arises because monetary policy is a blunt instrument...

We simply do not have good theories or empirical evidence to guide policymakers in using short-term interest rates to limit financial speculation. Given our current state of knowledge, my preference at this time would be to use regulation and supervision to strengthen the financial system and lean against developing problems. Monetary policy would be used only if imbalances were building and regulatory policies either were unavailable or had proven ineffective. The homework assignment is to improve our ability to identify incipient financial imbalances and understand their interactions with changes in policy interest rates.

Some observers have attributed the bubbles observed in some asset prices in recent years to a decades-long downward trend in real interest rates. In this view, the decline in interest rates has caused investors to reach for yield by purchasing riskier assets with higher returns, driving the prices on riskier assets above fundamental values... From my perspective, the decisions the central banks were making about their policy rates were shaped by the underlying determinants of the balance of saving and investment, including, in the past decade or so, the high saving propensities of the newly emerging Asian economies and the sluggish rebound in investment globally after the recession early last decade. Nonetheless, it is important that we understand the reasons for the decline in average real rates and whether low rates are likely to persist--and that very tough problem is the extra credit assignment. For one thing, as the economic expansion gains traction and central banks back off the current highly accommodative stance of policy, policymakers will need to understand how the longer-term trend in real rates has influenced the point at which the policy rate becomes restrictive...

 

Recently, some prominent economists have called for central banks to raise their inflation targets to about 4 percent...

Although I agree that hitting the zero bound presents challenges to monetary policy, I do not believe central banks should raise their inflation targets. Central banks around the world have been working for 30 years to get inflation down to levels where it can largely be ignored by businesses and households when making decisions about the future. Moreover, inflation expectations are well anchored at those low levels.

Increasing our inflation targets could result in more-variable inflation and worse economic outcomes over time. First of all, inflation expectations would necessarily have to become unanchored as inflation moved up. I doubt households and businesses would immediately adjust their expectations up to the new targets and that expectations would then be well anchored at the new higher levels. Instead, I fear there could be a long learning process, just as there was as inflation trended down over recent decades. Second, 4 percent inflation may be higher than can be ignored, and businesses and households may take inflation more into account when writing contracts and making investments, increasing the odds that otherwise transitory inflation would become more persistent.

For both these reasons, raising the longer-term objective for inflation could make expectations more sensitive to recent realized inflation, to central bank actions, and to other economic conditions.

See also:  Greenspan 2002 and Mishkin 2008 for comments about effective price stability

Gross investment in equipment and software has fallen so low that it is not even covering estimated depreciation, meaning that further spending increases are needed just to prevent the capital stock from continuing to shrink, let alone to foster a modest expansion of the capital stock as the recovery proceeds. So this sector has the potential to be a source of strength for the economy.

I can be reasonably certain of only one point: My economic forecast is highly likely to be wrong--but I don't know how. One implication of this pervasive uncertainty is that any statement about the future path of monetary policy must be conditional--dependent on the economy following the expected path. Although the FOMC has stated that the federal funds rate is likely to remain exceptionally low for an extended period, this statement explicitly depends on an economic outlook similar to the one I have given today. We cannot provide a precise timetable for when short-term interest rates will begin to return to normal because that depends on the evolution of actual and projected activity and inflation.

One implication of this pervasive uncertainty is that any statement about the future path of monetary policy must be conditional--dependent on the economy following the expected path. Although the FOMC has stated that the federal funds rate is likely to remain exceptionally low for an extended period, this statement explicitly depends on an economic outlook similar to the one I have given today. We cannot provide a precise timetable for when short-term interest rates will begin to return to normal because that depends on the evolution of actual and projected activity and inflation.

In my experience, these and other considerations put a premium on flexibility. The need to learn from and respond to news means that policy should have a substantial discretionary component. We have certainly needed to innovate over the past several years to contain the damage from unprecedented events in financial markets. But discretion has its limits as well. We must be able to explain and justify our actions within a coherent framework--even if the elements of that framework are adjusted from time to time as experience dictates. And to the extent that we can act predictably, households and businesses will be able to anticipate our actions, reinforcing their effects. Finally, we must not be flexible about our objectives. The goals of monetary policy--price stability and maximum employment--are stable and well known. The flexibility relates to the actions we take to get there.

Critically, the financial regulatory structure needs to be modernized to bring oversight and market discipline to bear much more effectively on our rapidly evolving financial system and to give regulators more tools to deal with problems as they arise. At the Federal Reserve, we are improving our supervision and regulation to incorporate a broader view of emerging risks in the financial system and to become more effective at translating identified risks to supervisory oversight and, if required, remedial actions by the banks.

[W]e also emphasize that collecting more data is only part of the process of developing early warning systems. More fundamental, in our view, is the need to use data in a different way -- in a way that integrates the ongoing analysis of macro data to identify areas of interest with the development of highly specialized information to illuminate those areas, including the relevant instruments and transactional forms.

...

We can easily imagine specifying ex ante a program of data collection that would look for vulnerabilities in the wrong place, particularly if the actual act of looking by macro- or microprudential supervisors causes the locus of activity to shift into a new shadow somewhere else.

 

We argue that the focus on a fixed set of metrics changes behavior in a way that diminishes the usefulness of the indicators. Given the dynamic nature of the financial system, the process of specifying these metrics inevitably leads to active management of these metrics, at which time they cease to fully reflect the risks that they were intended to capture.

{Editors Note:  A classic expression of Goodhart's Law}

Instead, the main causes of the crisis originated in the financial sector and stemmed from a widespread underappreciation and underpricing of risk. Failures of risk-management systems, incentive problems in securitization and compensation structures, and regulatory shortcomings and gaps led to a vulnerable, overleveraged financial system with inadequate capital and liquidity buffers. These problems were amplified by the eagerness of U.S. households to take on huge amounts of mortgage debt and of lenders to advance them the credit, justified by overly optimistic expectations for house price appreciation as the real estate boom progressed.

But these financial sector problems were enabled, if not encouraged, by developments in the global economy. The capital outflows associated with the persistent current account surpluses were large even in net terms and, combined with relatively restrained business capital spending in many advanced economies (including the United States), put downward pressure on real interest rates globally.⁴ 

From a purely theoretical perspective, there is no compelling reason to believe that low real interest rates, by themselves, pose a particular risk to global economic and financial stability, as real interest rates should be driven by underlying forces to balance the global demand for saving and investment. Capital inflows from abroad can be beneficial if they are invested prudently. But in an environment in which the financial sector is prone to excess and the supervisory structure does not respond sufficiently, the interaction of low interest rates and financial vulnerabilities can clearly be dangerous. Notably, the generally stable macroeconomic environment that prevailed before the crisis may have exacerbated this problem, as it contributed to overly sanguine perceptions of risk.

Rather than financing productive business investment, capital inflows too often facilitated spending on housing and consumer goods. This circumstance was particularly true in the United States, where an innovative and entrepreneurial financial system aggressively competed for the opportunity to channel this capital to customers, in part by devising new and complex mortgage products. The resulting availability of funds and reduced interest rates boosted asset prices, particularly in the housing sector, and market participants assumed housing prices would continue to rise.

For some economies, a rebalancing of demand toward domestic sectors will require significant changes in relative prices, and hence more flexible exchange rates will need to be part of the equation. These measures will not be undertaken solely to satisfy the ethereal principle of global rebalancing enunciated at countless meetings in international policy circles; instead, these measures will be undertaken because they are in the best interests of the countries themselves. In particular, more flexible exchange rates will help domestic demand fill in the gap left once foreign demand falls back to a more sustainable level. More flexible exchange rates also provide domestic policymakers greater scope to focus on domestic goals of full employment and price stability.

Most policymakers do not tend to put too much stock in the very simple theories relating excess reserves to money and inflation that I mentioned earlier. But we are aware that the size of our balance sheet is a potential source of policy stimulus, and we need to be alert to the risk that households, businesses, and investors could begin to expect higher inflation based partly on an expanded central bank balance sheet. As always, the Federal Reserve monitors inflation developments and inflation expectations very closely and any signs of a significant deterioration in the inflation outlook would be a matter of concern to the FOMC.

Having inflation expectation anchored in this situation (zero interest rates) is really critical... Risking unanchoring of expectation would be far too risky and far too costly. No one has done it and it is understandable why.

They’ve tightened some with the stock market down, the dollar up, and LIBOR up, which will feed through to some bank loans; below-investment-grade borrowing rates also are higher. That, along with the slowdown in Europe, is going to take something off of growth. I don’t think it’s going to be a major setback. But it will take something off of what already was a gradual expansion.

I think they'll judge him well, especially on his leadership on monetary policy. I think they'll judge him to have missed some regulatory, supervisory issues, especially toward the end—of having been too optimistic about financial innovations and not seeing how they were misunderstood and misused.

"But, taking the 19 years as a whole, I think on monetary policy, they'll judge him pretty well. I have a stake in that judgment myself, having been a close advisor to the Greenspan FOMC for so long."

In response to a question about how history would judge Alan Greenspan

To not trigger [additional measures from the Fed like resuming purchases of government securities], I would want to see that there was the prospect of progress in the forecast toward achieving both much higher levels of employment and, eventually, higher inflation, closer to my 2 percent target...

“To have a substantial effect, people would have to anticipate substantial purchases,” Mr. Kohn said. “Does the Federal Reserve need to announce it’s buying $1 trillion? Not necessarily. If the Fed said, ‘We’re buying a smaller amount now, but we’ll continue to watch the situation and if it warrants, we’ll buy more,’ that sort of thing would give the public and the markets a sense that someone was out there, ready to buy if the economic situation weakened further or didn’t improve.”