Eric Rosengren

The recent problems in financial and credit markets reflect a pulling back from what I would call surrogate securitization, whereby investors were willing to buy debt that had been assigned high credit ratings by the credit rating agencies, regardless of the underlying assets used in the securitization. In other words, investors basically delegated due diligence to the rating agencies. Utilizing ratings to help evaluate the riskiness of securities is a normal part of the securitization process. But when new securities arise, investors may need to exercise more caution as rating agencies themselves learn about the appropriate risk to attach to the new instruments.

Should we view the current developments and concerns in credit markets as a wholesale reassessment (or repricing) of risk by investors, and are the recent problems related to securitizing assets likely to have a longer lasting impact on the economy or financial markets?

I think the answer is no, investors are not reassessing risk in a wholesale way. Consider that a variety of assets that normally are impacted by investor desire for risk reduction have shown little reaction to current problems. For example, if one looks at emerging market debt, or stock prices in emerging economies, the current problems have left little trace in the data. Prices for stocks in many emerging markets are close to or at their highs for the year.

By contrast after September 11, 2001 and during the problems triggered by Long-Term Capital Management, stocks in many emerging markets fell sharply. Similarly, emerging market debt has shown only a modest widening of spreads. Following the September 11 attacks and during the Long-Term Capital Management problems, emerging market interest rates rose sharply.

Short-term debt markets, where relatively low risk financial assets are traded primarily between large financial institutions, are experiencing significantly reduced volumes and unusually large spreads. This is consistent with liquidity problems rather than a change in the willingness to hold risky assets in general.

As questions have been asked on ratings of securities, many investors have chosen not to roll over commercial paper that was not backed by solid assets and did not have liquidity provisions provided by banks. This freeze-up, of course, means problems for financing a variety of assets, including mortgages, student loans, and home-equity loans.

...

The alternative to securitizations and financing assets with commercial paper is financing by commercial banks. Fortunately, most banks are very well capitalized and have the ability to finance these assets. In fact, bank balance sheets did expand in both August and September, reflecting in part banks holding assets on their balance sheet that have been difficult to securitize. However, while banks have the capacity to finance many of these assets, it is likely that the cost of financing for these assets will increase if they are done by banks rather than through financial markets.

My expectation is that over time, investors will gain more confidence in their ability to evaluate the quality of ratings, and that conservatively underwritten securitizations and asset-backed commercial paper will find acceptance by investors. A reevaluation of ratings and the models used to determine ratings, and a greater onus on investors to understand the underlying assets and securities they are purchasing is likely to make these markets more resilient. However, this process of evaluation may take some time. While we have seen improvement in financial markets over the past month, we continue to observe wider spreads and reduced volumes on securitized products, which may remain until investor confidence has been restored.

Of course, we all want to consider whether the recent problems related to securitizing assets are going to have a longer lasting impact on the economy or financial markets. Securitizations have made it possible to efficiently finance pools of assets. In particular, investors with low risk tolerance were willing to buy what they thought were investment grade securities without a detailed understanding of the underlying assets as long as they had confidence in the ratings of the securities. To the extent that these investors have less confidence in ratings, they may choose to buy government or agency securities, where they do not need to make an independent analysis of potential credit risk. In part, this accounts for the reduction in rates on government securities relative to other financial instruments over the past two months.

The past two months have been quite unusual for financial markets. Short-term liquidity has been disrupted for almost two months, as investors have reevaluated the securitization process. I am hopeful that with appropriate underwriting, the securitization process and the ABCP [asset-backed commercial paper] will continue to be a source of financing for a wide range of assets.

Residential investment has been a major source of weakness in the economy for a year and a half. Forecasters who were predicting a recovery in the housing sector by the end of this year have been revising down their forecasts to incorporate the effect of rising mortgage defaults, financial turmoil, and softening housing prices. Particularly notable is the decline in housing prices in many regions of the country. Consumer spending is affected by households net worth and housing equity is an important component of wealth. While the effect of the problems in housing on consumption has been muted to date, further and more widespread deterioration in housing prices would increase the risk of a more adverse impact on consumption.

I am hopeful that financial institutions will play an important role in providing financing for many of the borrowers facing higher rates as their mortgages reset. In the past, rate-resets may not have been as problematic as they could be now, because borrowers had an easier time refinancing or selling. As we look at the situation now, we want to see borrowers continue to have the option to refinance, and want to see lenders continue lending so that resets do not become an increasing problem. As I said a moment ago, perhaps the most critical issue is that financing that supports responsible subprime lending continue.

In our research, we looked at what happened to homeowners who used subprime loans to buy their homes and found that five years later, 90 percent were either still in their house or had profitably sold it.  While our research also shows that number will likely be lower for the most recent vintages, which already exhibit elevated defaults, most subprime buyers have a positive experience with homeownership. So, perhaps the most critical issue is that financing that supports responsible subprime lending continues, despite recent problems. Since the broker channel has been disrupted, as described earlier, I believe there is an opportunity for commercial and savings banks to help provide liquidity in this market. Most commercial and savings banks were not involved in originating subprime mortgages and are well capitalized, and may have profitable opportunities to explore in this market.

To better understand the subprime issue, the Federal Reserve Bank of Boston has been studying publicly-available information from the Registries of Deeds in New England states, which allows us to study the patterns of mortgages issued on a given house over time. ... A first finding is that recent foreclosures have been disproportionately related to multi-family dwellings... This highlights a potentially serious problem for tenants, who may not have known that the owner might be in a precarious financial position. Second, the Banks research shows that the duration of a subprime mortgages is on average quite short for a sample of subprime mortgages used to purchase a home between 1999 and 2004, two-thirds have prepaid within two years and almost 90 percent have prepaid within three years. Prepayment will occur if the home is refinanced or if it is sold. While some of those sales may have been under difficult circumstances, it is plausible that many borrowers who purchased homes with subprime products did benefit from the appreciation of home prices in New England that occurred over the last decade.

Defaults in the subprime market have resulted in even the most secure tranches of subprime securitizations selling at a sizable discount. Investors are now questioning the appropriateness of surrogate securitization, contemplating more independent analysis of the securities and underlying assets and the need to distinguish between securitizations with different underlying assets. These are appropriate considerations, to be sure, but until they are more confident, investors have been shying away from even investment-grade securitization. The problems in securitization are highlighted by the impact on jumbo mortgage loans. Because of difficulties in securitization, the cost of these loans has risen significantly. This is particularly a problem in New England where the price of housing is quite high.

The elevated defaults we have already seen on recent vintages of subprime mortgages have resulted in losses for the highest risk tiers, and have caused investors to sell higher quality securities at a discount, reflecting uncertainty surrounding the accuracy of the investment-grade rating. If the ratings were accurate, highly rated securities containing subprime debt would have only a remote chance of default similar to investment-grade securities containing prime mortgages, home equity loans, or student loans. Unfortunately, underlying assumptions for the subprime market were inaccurate for several reasons I'll describe.

First and most importantly, most parties involved in the process assumed that house prices would continue rising nationally. This assumption seems to have had the biggest impact on the situation we see today. ... Second, the subprime market has grown very rapidly in recent years, so such widespread use of subprime mortgages is a relatively new phenomenon. This limited history made it difficult to assess the likelihood of defaults if underlying economic conditions changed. And third, the increased reliance on mortgage brokers who originated the loans but had little stake after they were securitized was a departure from the traditional buy-and-hold strategy of many financial institutions. These brokers typically are compensated based on volumes of loans made and sometimes on the rates and fees as well; as a result, the brokers have few incentives to worry about the longer-term viability of the mortgage.

Fundamentally, we want to encourage refinancing before a problematic reset. Banks may not have viewed this market as an engaging opportunity when mortgage brokers were going aggressively after the business, but banks may now find profitable lending opportunities in the current environment perhaps, in some cases, with guarantees provided by Federal Housing Administration (FHA) loan guarantees, or state programs.

The question is, should lenders be required to offer fixed rate loans, with the borrowers needing to actively opt out of the fixed rate loan in order to be offered an adjustable rate loan (or, should borrowers always be given, and have to make, a choice). Such proposals are beginning to surface in states (such as Massachusetts) and may be an experiment worth exploring.

There are also opportunities for FHA to look for ways to better meet subprime borrowers needs.[11] Greater outreach to borrowers and lenders seems needed. Potentially, FHA may want to raise loan amounts, if they are binding, in high cost markets. And of course there seems to still be a need to simplify and streamline the program for both borrowers and lenders. I should stress that our focus on the opportunities for the FHA program to play a role in alleviating this crisis does not represent advocating a government bailout of lenders, investors, or reckless borrowers. Rather, I am advocating using existing programs for what they were designed to do provide an option for low- and moderate-income borrowers to obtain financing at more affordable rates.

[T]he current problems in the subprime market are heavily dependent on economic conditions particularly housing prices.[3] As a result, the outlook for how much worse this problem could become depends critically on the outlook for the economy and the housing market. We are currently expecting the economy to grow well below potential for the next two quarters, before gradually improving over the course of next year. Our research suggests that the foreclosure crisis will get worse before it gets better, but our forecast is quite dependent on how far house prices fall.

My view is that the continued decline in residential investment has heightened the risk of a more significant downturn in the overall economy.  Falling housing prices further weaken the incentives for residential investment, but are also likely to dampen consumer and business confidence and spending.  Furthermore, falling house prices roil financial markets and financial institutions by exacerbating exposures to the housing market. 

Previous periods where residential investment declined for a year or more were either accompanied by, or closely followed by, an economic downturn. But history may or may not repeat itself, because this period of prolonged weakness in housing is distinctive in several other ways that add to uncertainty over its ultimate impact on the broader economy.

[I] n today’s situation we are fortunate that most financial institutions have entered the current problems with significant capital cushions and that many U.S. financial institutions are moving to proactively address the problems. However, the potential for a credit crunch remains. Commercial banks are still an important source of liquidity and there are troubling developments at work.

The TAF enables banks with illiquid collateral to borrow from the discount window at a price determined by an open auction. This innovative tool has the potential to provide greater flexibility for the Federal Reserve to respond to the sort of liquidity problems that we have seen in recent months. The benefit to banks is that they can borrow relatively low-cost funds using assets that are temporarily illiquid as collateral. This facility is particularly useful in providing term lending, and appears to have been helpful as financial institutions sought liquidity at the end of 2007.

The first two auctions have provided term funding at a rate above the overnight federal funds rate but below the primary credit rate that banks borrow from the Fed’s Discount Window. An added benefit of the TAF is that it allows the Fed to supply funds to the market without adding to stresses in Treasury markets by engaging in direct purchases of Treasury securities.

I think we need to use a multipronged approach to help reduce the downside risk to the real economy.

From remarks as delivered, as reported by Market News International

Since we started announcing the TAF program, we have seen many of the interest rate spreads narrow appreciably. Now, I'm not saying the TAF was the only reason that's occurred, but I think it was a contributing factor in that.

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So far, the TAF auctions have given banks access to "relatively low cost funding," at rates that are higher than the federal funds rate but lower than the Fed's discount rate.  "It was reasonable rates that these transactions occurred at," Rosengren said, adding that TAF participants could use "assets that are temporarily, or at least hopefully temporarily, illiquid and that they would prefer not to sell at this time."

From remarks as delivered, as reported by Market News International

Given falling housing prices, many financial institutions are likely less willing to be exposed to the mortgage market. One aspect of the current situation is the high LTV ratios facing many borrowers, as low down-payments and falling housing prices have made refinancing homes difficult. A possible solution would be shared appreciation loans with FHA guarantees. This approach, variants of which are currently being discussed, would provide the FHA and the lending institution with a portion of future appreciation in return for providing the FHA insurance on high LTV loans.

Given the recent difficulty in securitizing troubled or high LTV mortgage credits, and the possibility that many financial institutions will be reticent to lend to risky borrowers in a declining house price market, the housing malaise could be more protracted and the recovery more anemic than we have experienced in previous housing downturns.

To date, the resulting potential capital constraints are concentrated in the largest banks with the largest exposure to securities tied to subprime mortgages. While some of the capital losses have been mitigated by new capital, the losses in combination with involuntary growth in assets can potentially restrain the willingness of these institutions to engage in activities that would further swell their balance sheet.

Because these institutions are actively engaged in structured products and loans to finance leveraged deals, it is not surprising that participants in these markets are finding tighter financial constraints. For some markets where these banks are major market makers, the unwillingness to further increase balance sheets has impacted the liquidity in those markets.

Many small and medium-sized businesses are not complaining about credit conditions. This reflects the lack of exposure that many small and medium-sized banks had to securitized products or the subprime market. However, should housing prices continue to fall, losses in prime residential mortgages and construction loans are likely to cause these institutions to be more capital constrained. Banks under $100 billion still retain significant exposure to residential mortgages and construction loans which account for 26 percent of assets or $750 billion. Should housing prices continue to fall and the housing sector get worse, it is likely that these institutions will begin being impacted more significantly.

[L]ower rates are likely to result in higher house prices than would occur in the absence of monetary easing. This should reduce the foreclosure rate and reduce some of the concern that housing problems will become more widespread. Finally, lower rates should result in less unemployment – one of the main drivers in forced sales of houses. Thus, monetary policy actions may significantly reduce the depth of problems, but are of course not a panacea.  

A critical factor in the size of losses, and whether balance sheet constraints become more widespread, is the extent to which housing prices fall. Unfortunately, we have little historical precedent for sustained declines in national housing prices, which makes it difficult to forecast future home prices. However, one of the significant downside risks to the economy is that further declines in housing prices could depress residential investment, reduce consumer spending, generate elevated foreclosures, and contribute to financial instability. Taking appropriate monetary, regulatory, and fiscal actions to mitigate this risk seems prudent.

In the housing area, thought will likely be needed regarding programs for those with negative as well as positive equity in their houses. As long as housing prices continue to fall, the decline increases the risks to borrowers, lenders, markets and the economy.  

First, some financial products were not well designed to withstand liquidity problems. To avoid paying banks fees to provide a liquidity backstop, many financial products of recent vintage included provisions to force liquidation when necessary to insure payment to the holders of the higher-graded securities (or slices of securities). This structure was used, for example, by structured investment vehicles (SIVs)

13. However, due to the recent financial stress, assets of SIVs could not be liquidated at prices felt to be reasonable. Broadly speaking, products should be structured to better weather periods of illiquidity, and ratings models should take better account of liquidity risk.

Securities that are consistent enough to trade on an exchange are more likely to have market prices that all participants can use.

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Finally, investors should give careful consideration to whether such complex financial products are necessary at all. With simpler and more understandable structures,

the difficulties in obtaining market prices are likely to be significantly reduced, as are the consequent uncertainties like those we are currently facing.

In contrast to corporate securities, corroborating information on mortgage securities is not as readily available. There is no equivalent to equity analysts and equity prices to give investors updated market information. The information needed to analyze the individual mortgages in the pool can be expensive to obtain. So investors are more reliant on rating agencies than they are with corporate securities.

 

The problems in the mortgage market highlight the need for caution where there has been limited ratings history, where the underlying characteristics that drive the asset’s price may not be fully understood or anticipated, and where evaluations cannot be easily corroborated by others such as equity analysts.9 Certainly one way to highlight these differences is to differentiate ratings on corporate securities from ratings on assets like mortgage-backed securities.

A couple of quarters of weak growth would indicate a slowly rising unemployment rate, but most forecasts currently say we will skirt a recession and I certainly hope those forecasts end up being accurate.

From Q&A as reported by Market News International and Reuters

It is too soon to call whether or not we are in a recession. But regardless of what you call it, it is a period of very slow growth. Slow growth does have the implication that you would expect a gradual increase in the unemployment rate.

From press Q&A, as reported by Reuters.

I would say that while to date the problem banks have been quite low, there clearly has been some deterioration since the beginning of this year, and should the economy continue to slow down, as many expect, it is likely that we will continue to see some growth in the problem institutions.

From Q&A as reported by Reuters

Let me emphasize that it is too early to determine the degree that consumers will be restrained by credit availability in the current situation. But such trends will be easier to detect sooner and more accurately if the central bank has supervisory engagement with financial institutions.   

Every other week, the Federal Reserve holds an auction where banks are able to use collateral at the Discount Window to get a loan. Currently the size of each auction is $50 billion. The auctions have been well received, and have generally resulted in financing terms (determined by the auction) that are somewhat above the Federal Funds rate.

To qualify, a bank first needs to be in sound financial condition, as the Federal Reserve must have confidence that the bank will be solvent over the time the loan is extended. While this determination is left to the individual Reserve Bank whose district the institution resides in, it generally requires that the bank not have low supervisory ratings. Second, the institution needs to have collateral at the Federal Reserve. Our Discount officers determine, as best they can, the market value of the collateral and apply an appropriate “haircut.”
There is little question in my mind that both the determination of the potential solvency risk and the evaluation of the institution’s collateral are greatly aided by having experienced bank supervisors at the central bank.

It is worth highlighting that the banks’ observations about being well capitalized were accurate. The attention that regulators have given to capital has caused banks in the United States to be much better capitalized going into these difficulties than they were in the 1990s (see Figure 1). The introduction of the Basel I and Basel II capital accord frameworks, and of modern risk management techniques that focus on value-at-risk modeling, have caused banks to increase their capital. Current problems would clearly be worse had this not occurred.

In sum, understanding banks is critical to understanding how financial shocks can be transmitted to the real economy. Unfortunately, understanding how banks are likely to respond to problems requires far more than published financial statements. While U.S. banks report detailed information on their balance sheets and their income statements, these reports do not provide sufficient information to allow central banks to really discern how banks are responding to problems.

The volume of term lending transactions has declined significantly, with few buyers or sellers of term funds. I can suggest several reasons.

First, many potential suppliers of funds have become increasingly concerned about their capital position, causing them to look for opportunities to shrink (or slow the growth of) assets on their balance sheets, in order to maintain a desirable capital-to-assets ratio. Since unsecured inter-bank lending provides relatively low returns and has little benefit in terms of relationships, banks may prefer to use their balance sheet to fund higher-returning assets that advance long-term customer relationships.

Second, as the uncertainty over asset valuations has increased, banks have become reluctant to take on significant counterparty risk to financial institutions – particularly with those that have significant exposure to complex financial instruments.

Third, many potential borrowers are reluctant to buy term funds at much higher rates than can be obtained overnight, for fear that they may signal to competitors that they have liquidity concerns. However, when the counterparty is a central bank, financial institutions have been quite willing to buy term funding, sometimes at rates higher than they would expect if they were to borrow funds overnight.

I believe this period of illiquid markets should also cause central banks to re-evaluate their roles. For a central bank to play an effective role during financial turmoil, it needs to understand the sources of liquidity problems, the interrelationships between market participants, likely losses, and market participants’ potential reactions to these losses

In my view, this can only be done if the central bank has some form of hands-on supervisory experience with institutions – particularly the "systemically important" institutions – regardless of who is the primary regulator. The Federal Reserve has been far more effective during this crisis because it has hands-on experience with bank holding companies that are among the most significant players in many financial markets.

In short, there are significant synergies between bank supervision and monetary policy during periods of financial turmoil – synergies that can be used to achieve better outcomes for the public as policy makers try to determine the impact of liquidity problems and how changes in credit will impact the broader economy

Having some form of similarly hands-on supervisory experience with any systemically important financial institution that may need to access the Discount Window is, in the long term, critically important. We need to understand the solvency and liquidity positions of firms that may access the Discount Window – with access, at the very least, to the information any counterparty would require in a lending relationship. For those financial institutions that do have access to the Discount Window, there is indeed a need for the Fed to have broader access to information than marketplace counterparty creditors, if we are to effectively manage our responsibilities as lender of last resort and custodian of financial stability. So, regardless of who is the primary regulator, it is important for the Fed to understand the consolidated capital and liquidity positions of such firms.

Smaller banks have generally not held these complicated financial instruments, so they have been more insulated from the financial turmoil.7 They also have not been liquidity providers for securities, so they have experienced less unexpected growth in their assets. As a result, there have been far fewer complaints from small and medium sized businesses – generally the clients of smaller banks – about credit availability.

However, it is important to note that the continued health of small and medium sized banks will be impacted should residential and commercial real estate prices decline in a severe manner. While that is not my forecast, it is only fair to note that for the liquidity problems to be confined it is important for collateral values to stabilize. Significant price declines will likely lead to more residential and perhaps commercial mortgage defaults not necessarily limited to the subprime market, and thus more likely linked to mortgages held in portfolio by smaller banks.8

If I were to select a light-hearted title for my remarks, it might be “Fear and Loathing on Wall Street.” The basic premise is that as firms have become increasingly concerned about the valuation (pricing) of certain assets, their ability to accurately assess counterparty risk and the liquidity position of counterparties has become clouded. The lack of transparency in the prices of underlying assets, and the significant losses of some financial firms whose deteriorating situation had not been evident in earlier financial statements, have together made investors skittish. As a result, financial firms are increasingly willing to pass up the use of other attractive financing opportunities if they believe that action might lead to speculation about the liquidity or financial strength of their firm.

While such skittishness is not unusual during periods of illiquidity, it is unusual for a period of illiquidity to last this long.

Unlike the credit crunch in the early 1990s in the United States, many financial firms have raised significant capital. Unfortunately, while in many cases these equity issues have offset recent losses, they may leave little additional buffer should further credit losses occur. A number of large financial institutions have reduced their dividends, and given the potential for additional capital shortages it goes without saying that financial institutions should continue to assess whether further reductions or cessation of dividends would be advisable.

2 Discount Window loans are generally described as overnight loans, and had traditionally been. Due to actions taken by the Federal Reserve in response to market events, however, depository institutions can take Discount Window loans out for any term between overnight and up to 90 days. In August 2007 the Federal Reserve Board announced a change to allow the provision of term financing for as long as 30 days, renewable by the borrower. Then in March 2008 the Board approved an increase in the maximum maturity of primary credit loans to 90 days.

So, in essence a 28-day term Discount Window loan could be secured by a depository institution – a loan that would be similar to using the TAF’s structure, but at lower rate.

Also, it is worth highlighting that another structural difference between the TAF and the Discount Window is that a Discount Window loan can be prepaid at the option of the depository institution while the TAF cannot. This suggests that an institution with all other factors being equal, and absent consideration of any "stigma" or signaling issues, might use the Discount Window over the TAF.

3 By some accounts the reporting of Discount Window borrowing by Federal Reserve District is particularly concerning to a firm in a District which has few large participants – because any large borrowings from within such a District are likely to be done by only a limited pool of institutions, making market speculation more finely focused.

4 Recently, the financial press has reported on market speculation that Libor fixings are being under-reported.

From the footnotes

 

The fact that banks are still choosing more costly financing options to avoid any potential signal of liquidity or balance-sheet constraints is very noteworthy – in that the financial turmoil that began in July of 2007 continues, even nine months after the onset of problems.

Similarly, firms’ concerns about signaling have hampered the ability of the Federal Reserve to encourage borrowing from the Discount Window during times of stress. A particularly interesting example of this occurred last week with the latest auction conducted under the auspices of the Federal Reserve’s new Term Auction Facility (TAF).

The results of the latest TAF auction are shown on Figure 1. Allow me to provide a bit of background.

The TAF is an alternative to a Discount Window loan. Both result in a loan from the Federal Reserve to a financial institution, collateralized by assets that the borrowing institution has pledged to the Federal Reserve. However, with the addition of the TAF, financial institutions have two ways to borrow from the Discount Window. They can borrow using a traditional Discount Window loan, which is a loan at the primary credit rate – traditionally overnight but now up to 90 days term.2 Currently the primary credit rate is 25 basis points over the Federal Funds rate, or a rate of 2.5 percent. Alternatively, they can borrow for 28 days by participating in the Term Auction Facility, where the bidder is free to bid for funds at any rate above the minimum required for the auction (2.11 percent in the latest auction), and all those bids that are above the stop-out rate get the stop-out rate for the loan.

As can be seen in the graph, last week the stop-out rate was 2.82 percent, significantly higher than the primary credit rate of 2.5 percent. Such a bid could be explained if market participants believed it was likely that market rates would rise over the 28 day term, but evidence from trading in Federal Funds futures and in overnight index swaps indicate the opposite – that market participants believe it is far more likely that the Federal Funds rate will fall from its current target. Similarly, the TAF stop-out rate exceeds the one-month London Interbank Offered Rate (Libor), the rate at which banks can borrow one month unsecured money in London.
So how can this seeming anomaly be explained?

First, the Federal Reserve does not trade for profits in the markets, so the firms can bid in the auctions without fearing that their bids imply any immediate signaling of potential balance-sheet constraints or liquidity problems to the counterparty, the Federal Reserve. As a result, firms may be willing to pay a premium for transacting with the Federal Reserve in order to avoid any immediate public signaling, and to avoid taking actions that could potentially be construed as signaling the existence of problems.

Second, firms may want to be sure that they have some term funding, and by placing bids well above the primary credit rate they are in effect offering the equivalent of a non-competitive bid in a Treasury auction. They are willing to purchase the use of the term funds at whatever the current market clearing price is in the auction, even if there are less-costly options at the Discount Window or with private parties.

Third, the winners of TAF auctions are not disclosed by the Federal Reserve. Of course, neither are institutions that take out Discount Window loans disclosed by name. However, market participants may believe that the auction process, where a variety of 5 banks are jointly acquiring funds, may be interpreted differently than an individual institution borrowing from the Discount Window.

While much of the turmoil in financial markets occurred during relatively benign macroeconomic conditions, the economic situation has changed.  We have seen job losses, persistent increases in food and energy prices, and falling asset prices – all increasing the risk that less benign economic circumstances will add to the already intense challenges faced by financial institutions this year. 

[D]espite a number of lessons from the recent financial turmoil, we should not despair, nor should we see investments in risk management as wasted. Indeed, had the discipline not advanced as far as it has, I believe the recent financial turmoil would be much more damaging.

Extreme losses have occurred much more frequently than we would have assumed four or five years ago ... When we were
first seeing billion dollar losses, people would say those are thousand year events ... but we need to think more about them now.

From Q&A as reported by Market News International

Asked if there is any way to pump liquidity into the markets without reinforcing commodities speculation, Rosengren said that, "Unfortunately, we don't have much control over where the money goes after we push it into the market."

The purpose of the liquidity provisioning "has not been to cause commodity speculation," he said. "I think there have been some very beneficial things to come out of liquidity moves."

From Q&A as reported by Market News International

As noted earlier, the rapid rise in delinquencies for home equity lines and junior liens held at banks is occurring despite an unemployment rate of about 5 percent – so, should the unemployment rate rise and housing prices continue to fall, financial stresses caused by the housing correction could well spread beyond the large banks involved in complex securitizations, and the smaller banks with sizeable portfolios of construction loans, to a larger set of financial institutions. 

The extent of eventual housing problems is highly dependent on the outlook for the economy and the future path of housing prices.  Fortunately, aggressive monetary and fiscal policy actions have been taken to help mitigate some of the downside risk.  These policies will likely result in some pick up in economic activity in the second half of this year, which should help to stabilize the housing market.

To reiterate, falling housing prices continue to be a significant source of down-side risk to the economy.  Previous periods of real estate problems have taken significant time to be worked out, with foreclosures remaining elevated well after their peak.  The current foreclosure problem has been exacerbated by the difficulties related to many of the problem loans being held in securities.

Despite some promising proposals, these factors – the presence of piggyback loans, the desire of lenders to continue to get paid unless the borrower does not have the capacity to make payments, and the legal restrictions and tax-liability concerns surrounding securitization agreements – make any across-the-board modification of loan terms challenging. 

As long as loan modifications are taking place on a loan-by-loan basis (a time-consuming and labor-intensive process), to significantly increase the number of loan modifications and avoid significant numbers of foreclosures, many servicers will need to quickly expand the pool of staff capable of making these evaluations. 

What about today? Using the same rough method to approximate home equity for the same subset of homeowners, the data imply that about 10 percent of post-1987 purchasers were in a position of negative equity as of the fourth quarter of 2007. Assuming that the unemployment rate and benchmark interest rate (the 6-month London Interbank Offered Rate or LIBOR) stay at their fourth-quarter 2007 levels, the statistical default model of Gerardi, Shapiro and Willen predicts that less than 10 percent of these homeowners with negative equity will default.

Continued declines in house prices, higher unemployment, and possibly a greater willingness to default on home mortgages might raise this estimate of future defaults. Even so, many lenders will not be inclined to make concessions unless borrowers clearly lack the ability to pay.

Over the past year, the economy has been buffeted by a series of shocks including financial turmoil; an emergency acquisition of a major investment bank to avoid a sudden, disorderly failure [Footnote 2]; falling national housing prices; and oil prices that have exceeded $130 a barrel. Despite all these challenges, the U.S. unemployment rate is at 5 percent; the rise in prices of “core” consumer goods and services (Personal Consumption Expenditures) to a little above 2 percent, while unwelcome, has not been large compared with past episodes; and the economy has been growing, albeit at a much slower pace then we would prefer. These relatively benign outcomes to date are at least partly the result of recent monetary and fiscal policy actions taken to mitigate some of the problems facing the economy.

In the long run, in my view, it is total inflation – rather than core inflation, which excludes the volatile food and energy components – that should be the focus of monetary policy.

It is important to note, however, that futures prices do not generally reflect an expectation that oil prices will continue rising at their recent rapid rate. In the past, higher oil prices have spurred conservation efforts and contributed to slower economic growth – both reducing energy demand. Higher oil prices also encouraged new technological improvements, and exploration and production from higher-cost sources – increasing supply. In other words, economists expect that the laws of supply and demand will ultimately limit price increases – even in the face of relatively rapid economic growth in emerging markets. That said, it seems to be taking quite a long time to date for long-run supply and demand influences to rein in oil price increases. You might say the short run is getting longer every day. 

More comprehensive statistical work by researchers at the Boston Reserve Bank concludes that the impact of relative price shocks from oil – and other related supply shocks – has had a very minor impact on the underlying rate of inflation.

Recent increases in U.S. wages and salaries have been quite modest and do not show evidence of “ratcheting up” related to recent supply shocks (see Figure 7).

Let me say that looking only at the Federal Funds rate during periods of significant economic headwinds will, in my view, provide a misleading gauge of the degree of monetary stimulus that the Federal Reserve has put in place.  At such times, a low Federal Funds rate does not signal a particularly accommodative monetary policy, but rather offsets some of the contraction that would otherwise occur as financial institutions tighten credit standards and offer borrowing rates with a spread over the Federal Funds rate that is larger than usual (in other words, larger than would be the case outside of credit crunch conditions).

That said, make no mistake: in my view, credit conditions would likely be much worse if the Federal Reserve had not lowered the Federal Funds rate and taken several innovative steps to enhance liquidity in the marketplace – steps like opening our new Term Auction Facility and other facilities that complement our traditional “Discount Window” for banks.

The problems relating to the securitization market and the GSEs have reduced the responsiveness of mortgage and other consumer lending rates to reductions in the Federal Funds rate.  It is also a sign of the times that for many borrowers, access to credit may be limited because of an unwillingness to lend to borrowers with troubled credit histories, or because falling housing prices have reduced their ability to utilize home equity lines of credit.  Where credit is available, the yields have remained high despite the reductions in the Federal Funds rate.

That is not to say that monetary policy has been ineffective – quite the opposite, in my view.  The rate easing and liquidity measures undertaken by the Federal Reserve were appropriate and effective, in that credit problems would likely be a great deal more severe, and widespread, had we not taken the steps.

...

While the Federal Funds rate is low by historical standards, I would argue that one cannot capture the stance of monetary policy by only looking at this one rate, particularly during a period when the transmission of monetary policy has been impeded by problems with securitization, financial institutions, and GSEs. 

With the economy expected to expand at a rate below its potential in the second half of this year, further increases in the unemployment rate are possible.  It now appears that the national unemployment rate may rise above 6 percent, an increase of more than one and a quarter percentage points – or about 2 million workers – from last August, when the financial problems emerged. 

[A] new and unwelcome wrinkle to the financial turmoil is occurring in many short-term credit markets − something you might call a "liquidity lock." By liquidity lock, I am referring to extreme risk aversion by many investors and institutions, which makes short-term financing difficult to come by for even the most creditworthy firms – including financing for very short maturities, measured in days.

The facility needed to be quickly organized to help stem the immediate flow out of prime funds. The Federal Reserve Bank of Boston was charged with setting it up. It was announced on Friday, September 19. We set it up over the weekend and began making loans the following Monday (September 22). The AMLF lending program involves a non-recourse loan to banks, provided they have purchased ABCP directly from a money market fund. [Footnote 10]

...

With the announcement of the AMLF and the Treasury's insurance, redemptions from prime funds slowed appreciably (Figure 5). However, the percent of ABCP held by prime funds did decline, as the AMLF was used to meet redemptions (Figure 6). It should be noted that on Tuesday the Federal Reserve Board announced the creation of an additional facility, the Commercial Paper Funding Facility (CPFF), in light of market conditions and to complement the efforts to date. [Footnote 14]

...

Our hope is that the new liquidity facilities will make it easier for commercial paper to serve its important purposes and for financing to flow to assets that rely on issuing high-grade ABCP. With the ability to access Federal Reserve facilities, in addition to the new Treasury insurance for money market funds, investors should be less concerned that institutional money market funds will experience liquidity problems.

The Boston Fed’s position has long been — despite some determined mischaracterizations — that some flexibility in underwriting criteria may be appropriate if the borrower’s willingness and ability to handle the debt can be affirmed, and such flexibility is considered in a consistent and fair manner across applicants.

We have not, and do not, advocate for irresponsible or poorly underwritten lending. That perspective, however, is not at odds with advocating that the various participants in housing markets continue to strive for fair access to credit, appropriately extended. Nor is it at odds with our belief that responsibly underwritten loans to borrowers in low- and moderate-income areas — including those whose credit situation is considered “subprime” but can document their ability to afford the loan — are welcome and indeed crucial.

{E)conomic and financial conditions have deteriorated recently, and while the housing and financial markets are most impacted, there is little doubt that the effects are spilling over to the rest of the economy. However, now with appropriate and determined policy actions underway, I believe much of the spillover can be mitigated and the economy can return to growth that is closer to potential next year.  To that end, I believe that policymakers should maintain a focus on three key areas, which I’ll mention briefly.

First, it is essential that liquidity for companies is maintained, or more accurately, is re-established.  It is really in every citizen’s interest that firms — particularly our most creditworthy ones — not face uncertainty over whether they will be able to continue to finance themselves with short-term debt.

...

My second observation is that financial firms need to have the financial strength to continue to lend to creditworthy borrowers. Making sure that banks have sufficient capital to continue to lend is vital, because access to credit is critical for households and businesses.

...
My third broad observation for policy focus involves the housing market — it needs to reach bottom and potential homebuyers need to gain the confidence to return to the market. By this I mean that individuals shopping for homes need to be confident that appropriate financing is available for home-ownership.

The likelihood of further weakening of labor markets, and a reluctance of consumers or businesses to increase spending until economic conditions are more certain, together imply a continued difficult environment for banks.  There are several conditions necessary for financial markets to resume a more normal state, and I would like to briefly discuss each.

First, we need short-term credit markets to return to normalcy. 

...

Second, we need to see some improvement in the housing market before financial markets will resume a more normal state. 

...

Third, officials must take into account – and develop policies and actions that reflect –  the degree to which monetary policy tools are currently deployed.   The stance of U.S. monetary policy reflects our rate reductions, with the Federal Funds rate target currently at 100 basis points.  Given that interest rates cannot be negative, further monetary-policy actions are limited by the zero lower bound for interest rates.  While other monetary policy tools can be employed, increasingly many observers and commentators are suggesting that fiscal stimulus will be an important element of economic recovery.

There can sometimes be a tendency to move to proposals for regulatory design before building a consensus on the underlying principles that should guide the debate.  To that end, I would like to use my remaining time to discuss a few key principles that I hope will inform the many proposals that are likely to emerge.

• Principle 1:
  Financial regulation must be more clearly focused on the key goal of macroeconomic stability as well as the safety and soundness of individual institutions.
• Principle 2:
  Because it is a key determinant of macroeconomic stability, systemic financial stability must receive greater focus, with roles and responsibilities during a financial crisis more clearly articulated.
• Principle 3:
  Liquidity risk must receive greater policy focus in determining regulatory structures.
• Principle 4:
  Careful thought must be given to coordinating the work of the various domestic and international regulators in the design of the regulatory structure.
• Principle 5:
  Responsibility for strengthening market infrastructure should receive more attention in regulatory design.

 

While regulatory reform proposals are already beginning to surface, I see value in first evaluating the principles that should frame the discussion.  Before we begin to work on regulatory details we need to evaluate whether the problem was poor execution of a well-considered regulatory framework, or that important principles were absent from the framework.  While in my view the recent experience shows elements of both, I want to focus today on regulatory principles rather than their implementation.

...

Our regulatory framework clearly needs to be reconsidered, in light of recent events.  Both in the U.S. and globally, we had in place a complex set of regulations and supervisory structures intended, in part, to increase the likelihood that financial intermediaries would remain well capitalized without government assistance.  Like the risk models, bank regulators did not foresee the dramatic illiquidity that could emerge during a period of acute financial turmoil – nor the changes in the value of assets on balance sheets, or the degree of correlation of those asset values.

...

The current crisis provides the opportunity and impetus to reexamine a regulatory framework that originated in the Great Depression.  While I believe there is a clear need to redesign the current regulatory structure, it is important that we not lose important features of the current market.  It is critical that any regulatory design not stifle the industry’s innovation and creativity.  However, the regulatory structure needs to be more adaptable to innovations – in order to ensure that new safety and soundness, and systemic, concerns are not ignored.  And it needs to be aware of the details of the evolving financial-market structure.

Additional regulations do run the risk of moral hazard where the presence of a safety net creates an incentive to take additional risk.  While any countercyclical monetary, fiscal, or regulatory policy runs this risk, it should be minimized.  Ideally, situations requiring public support should occur only after losses have been borne by equity holders, and existing management and directors have been held responsible for the losses.

To the extent a new regulatory structure reduces counterparty risk, or requires offsets in capital for transactions involving significant counterparty risk, the likelihood of spillover effects from one firm’s failure should be significantly reduced.  Ideally a new structure will reduce the likelihood of future financial turmoil of the length and severity of current financial problems.

(T)his recession looks to be longer and more severe than was originally forecast. Still, there are indications that the second half of the year will show improvement.

By supporting short-term credit markets, the Federal Reserve is signaling its determination to take appropriate actions to prevent “seize-ups” in financial markets, reducing the risk premium. In short, we have seen improvements of late in the functioning of many short-term credit markets, and I expect this improvement will continue.

On the fiscal side, it is possible that Fannie Mae and Freddie Mac could play a more significant role in restoring liquidity and providing a secondary market for mortgages that reflect the lower cost of funds in many credit markets. Further exploration of the GSEs’ options for pricing and programs may result in additional support to the mortgage market.

On the monetary policy side, the Federal Reserve announced on November 25 that it would be buying up to $100 billion in GSE direct obligations, and up to $500 billion in mortgage-backed securities.[Footnote 9] A subsequent announcement on December 30 provided more details.[Footnote 10] Since the announcement of the program, designed to reduce the recently widening rate spreads on GSE debt and on GSE-guaranteed mortgages, mortgage rates have declined (see Figure 8). Some mortgages in Boston are now available for under 5 percent.

...

Since stabilizing the housing market is critical, expanded use of policies that address the cost of housing finance may give further impetus for new home buyers and existing mortgage holders to take advantage of what are very low rates by historical standards.

(A) proposal developed by several Federal Reserve economists, and available on our website,[Footnote 13] suggests that the U.S. government could pay a significant portion of monthly payments for borrowers who are facing severe but temporary financial setbacks. There are two variants to the proposal. One way in which such a plan might work is for the government to offer these borrowers temporary loans that must be paid back once the borrower returns to financial health. Another version of this plan calls for the government to offer grants, not loans, to borrowers who have adverse life events, such as job loss.

With the economy likely to shrink significantly in the first half of this year, the unemployment rate rising higher than 8.5 percent is, unfortunately, very likely.
...
I believe that below-potential growth is likely to persist until financial markets and financial institutions can resume more normal functioning.  So in addition to the other steps being taken to stimulate the economy, we need to be sure that actions to support the stability of the financial system are taken without delay – and, in the slightly longer term, that regulatory frameworks are thoughtfully reformed.

Currently, significant excess capacity in the economy risks lowering inflation and inflation expectations.  Since short-term interest rates are effectively zero, reductions in inflation expectations imply a higher real interest rate – and, effectively, tighter monetary policy.  So the additional clarity on the long-run intentions of monetary policy (as reflected in the longer-range forecasts) might keep inflation expectations well anchored[Footnote 4] and real interest rates low enough to help get the economy moving again. 

An important consideration involves what the long-run goal for inflation should be, given recent experience.  Twice this decade, short-term interest rates have approached zero, and the probability of possible deflation has risen significantly.  In light of this experience, some might conclude that the implicit inflation target has been too low.  A fruitful area for future research would be to re-consider the likelihood and the cost of hitting the zero lower bound, and what that cost implies for setting inflation targets.[Footnote 5]

In general, the various programs that have expanded the Federal Reserve’s balance sheet should be less attractive to market participants as financial conditions improve. Figure 4 shows that of late, the rate on asset-backed commercial paper has fallen dramatically, and many issuers can receive better terms by issuing commercial paper directly to the market. Figure 5 shows that the prime money market funds have tended of late to have a net inflow of funds, which has helped stabilize short-term credit markets because money market funds are a key investor in these markets.

It is very important to note that the largest components of the expansion of the Federal Reserve balance sheet are likely to become unappealing to market participants as financial conditions improve and interest rate spreads decline.  Thus, much of the Fed’s balance-sheet expansion should be reversed as we see the return of more normal trading.

...

(T)he Federal Reserve programs I have described today are intended to reduce the unusually large spreads created by financial disruptions, so that the cost of credit for a variety of borrowers returns to the level we would expect with more normalized functioning of credit markets.  The Federal Reserve’s recent monetary policy actions, combined with the fiscal stimulus package that the government recently enacted, should in my view help pull the economy out of the severe recession we have been experiencing.

I think there is a compelling argument for some form of action to address procyclicality through policy change.  Whether that policy change should be addressed through accounting or regulatory rules is open to debate.

(A)s bad as the initial problems were, the failure to quickly restore banks’ financial health had serious consequences for the Japanese economy, which as you know experienced growth below potential for over a decade.  There are several lessons – admittedly intertwined – that I take from my studies of this experience:

• First, undercapitalized banks behave differently than well-capitalized banks.
• Second, certain bank-regulatory and accounting policies may amplify the business cycle.
• Third, troubled assets need to be moved off bank balance sheets as quickly as possible.

Banks with the lowest supervisory ratings have reduced their lending significantly more than have banks in better health.  Empirical research suggests that during previous banking crises this behavior was, to an important degree, explained by differences in the ability to supply credit not just differences in the demand for credit. [Footnote 5] Thus the evidence from Japan and previous problems in the U.S. indicates that allowing poorly capitalized banks to continue operations with insufficient capital is likely to exacerbate problems with credit availability.

[M]oney market funds have reduced their reliance on the Fed liquidity facility that was designed to help them – the asset-backed commercial paper money-market mutual fund liquidity facility, or AMLF. This experience provides a clear example of how improved market conditions provide incentives for financial firms to reduce reliance on our facilities. We expect this to be the case for many of our facilities as the economy and financial markets gradually improve.

These two programs (TAF and central bank liquidity swaps) were designed to stabilize and improve the functioning of the interbank dollar-lending market – indeed, to ease conditions in global dollar markets that were spilling over into our own funding markets.  The Libor rate is now much more aligned with the federal funds rate.  The reduction in the Libor rate helps a variety of borrowers.  Most subprime mortgages have reset rates tied to Libor, many credit card rates are tied to Libor, and the rates on many business loans are tied to Libor.  The actions we have taken are reducing the cost of financing for borrowers and businesses whose rates are tied to Libor and thus influenced by the functioning of interbank dollar lending markets.

A key point is that the systemic regulator cannot just look institution by institution, but needs to think about the potentially difficult trends emerging across a swath of interconnected institutions and their counterparties. And while it may go without saying, for a systemic regulator to be effective, the regulator needs to be able to identify whether actual systemic problems are emerging. This involves, in part, assessing the “feedback effects” that might result from initial problems.

A starting point for an effective systemic regulator would be to carefully monitor any rapid appreciation of a particular asset class, and any rapid expansion of particular financial institutions or financial markets. While rapid growth in asset prices would not in and of itself necessitate any direct actions, it should cause a systemic regulator to ask several questions.
First, can one develop a plausible fundamentals-based explanation of the rapid rise in prices?
...
Second, is the rapid growth in an asset class financed by leveraged institutions?
...
Third, has the rapid expansion of the financing caused any financial institutions to increase their leverage?
...
Fourth, has there been a significant change in the mismatch involved in funding long-term assets with short-term liabilities?

I think it is important to note that three of the largest exposures were held by a commercial bank, an investment bank, and a foreign bank, which likely made the potential problem less obvious to any single regulator.

[Y]ou might say that a systemic regulator must connect potential dots – not just actual dots. Assuming the systemic regulator has the ability to monitor solvency risk, liquidity risk, and risk management practices, and react to practices viewed as unsafe or unsound, some of the most serious financial problems might have been identified, and their severity lessened.

[F]inancial institutions are likely to have a larger global presence over time, and to be more active in financial derivatives. Both trends represent the normal outgrowth of globally integrated economies and financial markets, and are not necessarily unwelcome or unhealthy. But the critical point is that the roles and powers of supervisors and regulators have not kept up with these developments.

[B]ankruptcy procedures are designed to provide a clear priority among creditors, but do not provide any special provisions for an insolvency that has broad systemic implications. In such situations, it is very possible that a preferable public policy would be to minimize systemic implications rather than follow the normal creditor priority set out in the bankruptcy code.

Had there existed the authority and procedures to resolve Lehman outside of bankruptcy proceedings, there may have been a much more orderly “wind down” of Lehman’s operations. Of course, the Lehman failure suggests that even with resolution powers in place this would have been a very challenging situation – Lehman would have been difficult to wind down, in part because of the scope of its global operations.

After two quarters where real GDP shrank by more than 6 percent, I expect that the economy will contract by much less than that this quarter, and that we will begin to see positive growth – perhaps by the end of the year.
...
With significant growth in payroll employment unlikely until next year it will obviously and unfortunately be some time before we see labor markets return to what we think of as “full employment.”  And it is too soon to know when the trough of the recession will occur, although there are hopeful signs that we are nearing it.

Normally forecasters are slow to recognize a recovery.  Just as economic models usually do not foresee the depth of economic problems at the onset of a recession, most models miss the speed of the recovery.  Thus, while I do indeed expect the recovery to be slow, I am well aware of the perils in making such a forecast – given the forecast errors often made at this time of the cycle.  Still, while every recession has its unique features, this recession has involved larger impacts on our economic and financial infrastructure than others – a fact that makes my outlook on the speed of this recovery rather subdued.

Examination and understanding of the role of off-balance sheet activities deserves significantly more supervisory attention, going forward. It will be important to ensure that capital held for offbalance sheet exposures is commensurate with the risk that they pose.

I suspect that the shift in money-market funds’ liquidity preferences is likely to have longer-term repercussions for the medium-term financing needs of firms.

The stress tests provide a top-down assessment of capital, based on economic assumptions – and thus provide a very good complement to the bottom-up risk assessment that is the cornerstone of most risk-management frameworks at major banks and is the cornerstone of the Basel II Capital Accord. In addition, making the results public allowed outside investors to “bound” the likely losses at financial institutions, even considering the more dire outlook (compared to the base forecast of many) that was part of the stress tests. This ultimately helped financial institutions raise additional capital at a critical juncture for the economy.9

Periods when earnings are strong and nonperforming loans are low are likely the times that a macroprudential supervisor would need to be particularly vigilant...[U]nlike the focus on incurred losses and accounting reserves of traditional safety and soundness supervision – a systemic regulator would need to be focused on forward-looking estimates of potential losses that could cause contagious failures of financial institutions.

I should acknowledge that even in traditional supervision, examiners can also focus on future or unexpected losses – and in theory, capital is expected to provide protection for losses occurring outside the accounting reserve model. But in practice, this is not always the case.

Periods of market booms and other expansionary periods are precisely the times that macroprudential supervision would diverge from more traditional prudential supervision. Historically, prudential supervision has been largely reactive, becoming more activist as losses mount (or conditions otherwise deteriorate) at an institution. In contrast, a macroprudential supervisor should be particularly attuned to changes – especially dramatic ones – in such areas as leverage, asset-liability mix, or underwriting standards. This requires the macroprudential supervisor to be willing and able to “lean against the wind” during booming markets or other periods.

[A] systemic regulator should have the ability to supervise capital structure, supervise liquidity risk and asset-liability management, and supervise risk management – all to minimize the likelihood of systemically important institutions negatively impacting market functioning and economic stability, proving “contagious” to counterparties, and possibly needing government support to avoid further spreading damage or instability.

A systemic regulator or macroprudential supervisor would need not only the ability to monitor systemically important institutions, but also the ability to change behavior if firms are financing a boom by increasing leverage and liquidity risk. It follows that legislation that aims to design an effective systemic regulator needs to provide the regulator with the authority to make such changes.

Based on the historical experience with inflation in the United States and Japan, I personally expect our primary short-run concern to be disinflation rather than inflation. The growth rate of the core PCE inflation index over the past year is 1.3 percent. This rate is well below the 2 percent rate that most members of the FOMC expect to see in the long run, as revealed in their published forecasts.

There remains substantial excess capacity in the economy, and while I expect that we will see positive growth in the third and fourth quarter of this year, it will not be sufficient to make significant headway in improving labor-market conditions right away. This significant excess capacity in labor markets has the potential to be disinflationary at a time when the inflation rate is already below where we expect it to settle in the long run.

[S]ignificant expansion of the central bank’s balance sheet is not likely to be inflationary during a period when financial institutions are capital-constrained and substantial excess capacity exists in the economy.

A second question I think we ought to be discussing is whether or not we can simplify the structure of many of our institutions... There have been questions about whether institutions should have what amount to “living wills” – meaning they’ve come up with a plan so that if they get into financial problems, the plan for resolution is relatively clear. That would probably require simplifying institutions’ structures.  So, we should explore the extent to which regulatory and supervisory procedures should make sure institutions are easy to resolve – in other words, that they have simple enough structures so that if they do get into trouble you can sell parts of them without necessarily having to take them over.

Again, as the discussion of too-big-to-fail institutions has increased so (somewhat ironically) has the size of many of our largest global financial firms. Figure 1 shows the size of the three largest U.S. banks, relative to the size of U.S. GDP. As is clear from the figure, the largest institutions have over time become larger relative to the size of the economy. And not only have many of the largest U.S. banking institutions grown larger, but in some cases they have become more complex – as they acquired firms that offer investment banking services and, also, expanded the global reach of the acquiring firm.

A more draconian solution that has been floated by some observers is to move to narrow the activities of banks. Narrowed banks would be constrained to only engage in very limited activities, and in particular would be banned from activities viewed as especially risky, such as proprietary trading.

Personally I am skeptical that such dramatic action would significantly limit systemic risk, for several reasons.

First, even narrowly defined financial institutions can run into difficulties...

Second, firms that do not engage in traditional banking activities can run into difficulty and transmit their problems to the broader financial system...

Moving to a narrow-bank approach is likely to merely shift the systemic risk out of banks but not significantly reduce it. Large interconnected firms with extensive lending do not necessarily need to be financed by bank deposits, as was shown by problems at many investment banks. Instead, I would advocate an alternative approach. For systemically important institutions, the risk of insolvency should be reduced by requiring more capital, and requiring the institutions to build up larger reserves during good times. Also, measures should be put in place that would facilitate systemically important institutions obtaining and retaining capital during economic downturns. By having mandatory conversion of debt and mandatory reduction of dividends, banks could retain sufficient capital – so they hopefully would not need to shrink during downturns. In addition, as I have argued in other talks, supervisors of such systemic institutions should have the mandated responsibility and authority to address emerging systemic concerns.

Federal Reserve Bank of Boston President Eric Rosengren signaled Tuesday that the Fed isn't close to exiting from its easy monetary policy, with both inflation and unemployment still moving in an undesirable direction.

...

"I would say at this point that we're not there. Both elements of our mandate are moving in the opposite direction," with core inflation falling and unemployment continuing to rise, said Rosengren.

He said that the unemployment rate, at 10.2%, was roughly double the trend rate, and core inflation was well below 2%.

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

[M]y conclusions... are that the employment response in the last two recoveries was much slower than it was in the two earlier recoveries in the 1970s and 1980s.  And unfortunately the financial headwinds, lingering labor market problems, and a cautious attitude of consumers and businesses in the wake of the financial crisis make it likely that recovery in employment terms will also be slow this time. 

Unfortunately, I expect a rather slow recovery in output, and a rather slow recovery in employment given the level of output growth

So, did accommodative interest rates fuel the housing bubble? Actually, the relationship between interest rates and bubbles is not as obvious as one might think... I am not saying that low rates could have had no role in moving housing prices higher. But I suspect the booming demand for real estate derived in large measure from incorrect expectations that housing prices would not fall, rather than from the short-run effect on housing demand of low short-term rates and slightly lowered mortgage rates.

We have seen some stability over the last couple of quarters in real estate... Nonetheless, it’s something we have to worry about.

As reported by Dow Jones.  The associated Powerpoint presentation can be found here.

To reduce the likelihood of problems in the future, Rosengren said, "holding more capital will reduce the probability of insolvency," which he said is "particularly important if failure has broad ramifications."

So he recommended raising minimum capital standards. He said banks should "reserve for more than just accrued loss," which he said is "too influenced by accounting standards."

He said banks should "retain capital as problems emerge" and should "limit dividends and stock buybacks earlier" than they did in the recent crisis.

Given the amount of substantial excess capacity that we have in the economy, there is some risk of further disinflation. And I would say the risk of deflation has gone up and is more of a risk than I would like to see at this point.

[S]een through the lens of community, however, foreclosure may be viewed as a symptom of broader problems affecting neighborhoods – such as high concentrations of unemployment, elevated crime rates, and poor code enforcement. Let me be clear; I am not saying that “the community is the problem,” but rather that, in this view, different communities will experience problems differently because of their different characteristics, requiring different solutions in many cases. The public policy solution for this problem may be to have more general revenues available for non-profits and local governments to address the problem in a more holistic fashion.

[T]he most recent recession is far less a reflection of dislocation in a few industries but rather reflects a general decline in almost all industries... According to survey data, businesses are having no problem finding skilled workers for what were considered hard-to-fill vacancies. This is consistent with my ongoing discussions with representatives of businesses, who generally report no difficulty finding qualified workers even for quite specialized positions... However, most small businesses are not expecting to increase employment. When I talk with representatives of businesses, the primary reason they give for this is they are not seeing sufficient demand for their products. If they were confident that demand would pick up, they would – and easily could – hire additional workers.

Editor's note:  to understand why President Rosengren felt the need to state the obvious, please see:  http://www.wrightson.com/federal_reserve/fedspeak/item/5585

Rosengren, a voting member of the Fed’s policymaking Federal Open Market Committee, said in an interview with Market News International that he will go into the Nov. 2-3 meeting with an “open mind” about whether or not the Fed should inject more monetary stimulus into the economy.

However, he made clear that he would favor a resumption of quantitative easing if the economy does not show improvement on both unemployment and inflation. Further deterioration is not necessary to justify Q.E. in his mind.

Rosengren was more dubious about the merits of changing the Fed’s communication strategy to raise inflation expectations and lower rates, saying he doesn’t perceive there to be a communication problem with the market. He was also skeptical as to whether cutting the already  bare-bones interest rate on excess reserves would accomplish much.

Rosengren, a voting member of the Fed’s policymaking Federal Open Market Committee, said in an interview with Market News International that he will go into the Nov. 2-3 meeting with an “open mind” about whether or not the Fed should inject more monetary stimulus into the economy.

However, he made clear that he would favor a resumption of quantitative easing if the economy does not show improvement on both unemployment and inflation. Further deterioration is not necessary to justify Q.E. in his mind.

Rosengren was more dubious about the merits of changing the Fed’s communication strategy to raise inflation expectations and lower rates, saying he doesn’t perceive there to be a communication problem with the market. He was also skeptical as to whether cutting the already bare-bones interest rate on excess reserves would accomplish much.

Note:  Rosengren's views about lowering the IOER had changed a year later.  [Link]

While such estimates are by nature quite uncertain, we estimate that the impact could be a reduction in the unemployment rate by the end of 2012 of a little less than half a percent. This would translate into more than 700,000 additional jobs that we would not have had in the absence of this monetary policy action.

In additional comments to Bloomberg News, Rosenberg said:

"Given my forecast, I fully anticipate we will purchase the entire amount. Certainly if the economy were to weaken substantially and further disinflation were to occur, we should take more action," and officials could also make "adjustments" if the economy turned out to be much stronger than expected.

Large expansions of the balance sheet can complicate exit strategy, when that becomes appropriate. While the Federal Reserve has a variety of tools designed to tighten policy, either by raising interest on excess reserves, removing reserves, or selling securities, some of these tools have not been used in the past. Naturally this makes the exact impact of various tools somewhat more uncertain than normal. Still, I am very confident of the Fed’s ability and will to exit, when necessary.

Of course, those who worry about the inflationary consequences of our balance sheet may be looking to the future. As the economy improves, banks may use their reserves to rapidly expand business lending – increasing economic activity and putting upward pressure on inflation.  But as Chairman Bernanke has emphasized, the Federal Reserve has at its disposal a variety of tools that will allow it to remove reserves from the banking system once economic conditions get closer to normal. Thus the fear that our large balance sheet and the large stock of reserves in the banking system will cause inflation – either now or down the road – seems misplaced to me.

I expect core inflation to remain below 2 percent over the next several years.

While, the goal in the long run is to achieve fiscal sustainability, "the first thing we should be doing is trying to get the slack out of the economy ... we need to be careful not to go the austerity route too quickly," Rosengren said.

I think the evidence shows that over the past 25 years most supply shocks have been transitory – and have had no long-lasting imprint on longer term inflation, or on inflation expectations.

Until we make more progress on both elements of the Federal Reserve’s mandate – employment and inflation – the current, accommodative stance of monetary policy is appropriate.

While many observers see food and energy prices rising and assume the Fed should tighten policy – raise the cost of money and credit – to head off inflation, I would suggest taking a step back and recognizing that tighter U.S. monetary policy will do nothing to stabilize Libyan oil production, reduce uncertainty about political stability in the rest of the Middle East, or increase the wheat harvest in Russia.

In fact, tightening monetary policy solely in response to contractionary supply shocks would likely make the impact of the shocks worse for households and businesses.

Asked whether a third round of so-called quantitative easing was still under consideration, Rosengren said that “nothing’s off the table, it depends on economic conditions, so we have to do whatever makes sense given our outlook for the economy.”

The emphasis in Basel III on improving the quality and quantity of capital is an important regulatory response to the financial crisis. Clearly we need to focus on the narrow definitions of capital – that which can readily absorb losses.

Under the Dodd-Frank legislation a group of regulators, the Financial Stability Oversight Council, is now tasked with providing financial stability oversight. However, as I noted at the outset, financial stability was never defined in the legislation. This leaves some ambiguity on how broadly or narrowly financial stability should be defined.

As we consider the national outlook, I would note that some have referred to the first half of this year as a “slow patch” in the recovery. I am not sure that phrase is quite right, however – the notion of a slow patch suggests strong growth that has been temporarily interrupted by some sort of headwind or shock, like natural disasters or extreme weather that crimps economic activity. I would instead describe the past two years as a consistently weak recovery, interrupted by a period of stronger growth.

With fiscal austerity slowing down economies both here and abroad, it will in my view be important to maintain sufficiently accommodative U.S. monetary policy so that national labor market conditions can improve.

Rosengren said reducing the interest rate on excess reserves–which is the rate banks get for keeping money in cash–to zero would “make sense.”

The Boston Fed president, who is among the more dovish of Fed officials, said the Fed might need to go beyond the unconventional measures now being considered to spur economic growth.

One idea that might deserve consideration if there is a new shock to the economy or if it fails to pick up, he said, would be setting a ceiling on U.S. Treasury borrowing rates for securities with durations of as long as two years.

“You could peg medium-term Treasurys out for a fixed period of time,” he said. “You could say any security maturing between now and the end of 2013, we won’t allow [the yield] to get above a certain amount of basis points.”

 Note:  Rosengren's view had been different one year earlier.  [Link]

There should be strong encouragement for the GSEs to focus on the housing recovery so home buyers and those that already have loans can fully benefit from the lower interest rates generated by our monetary policy action. Given that Fannie Mae and Freddie Mac are currently under conservatorship by the U.S. government, I believe they should play a larger role in achieving the public policy goals inherent in addressing these housing-market problems.

I would suggest that the financial stability issues raised in 2008, and which have become increasingly prevalent of late, require a reexamination of issues that influence the stability of short-term credit markets.

However, three years after the failure of Lehmann Brothers, there remain significant impediments to avoiding the need for government intervention to protect large financial intermediaries.  Everyone knows that some large European financial institutions have of late encountered problems. So it is critical that we focus on strengthening the financial architecture, so that the struggles of one institution or a group of them no longer poses risks to the broader global economy. 

Given the very weak labor market conditions and the low expected inflation rate, the Federal Reserve should in my view continue to take action to aggressively try to reduce the stubbornly high U.S. unemployment rate.

Let me admit that in the midst of the financial crisis in the fall of 2008 one could fairly say that we did not spend sufficient time explaining to the public the unique and extraordinary actions being taken. All I can say is that in the midst of the crisis there was a focus on solutions, and given the severity of the situation, this resulted in our spending less time communicating well about what we were doing and why. Though no excuse, reacting to a crisis in real time effectively requires something else “give” – and we were frankly so preoccupied with extinguishing the fire we did not explain as well as we should have what we were doing and why. At the Fed we have tried since to explain precisely what we did and why, but we are still some distance from being understood, or fully trusted for that matter.

I think the Fed has learned from this.

“The sooner the economy returns to full employment, the sooner we’re going to be able to normalize interest rates,” Rosengren said. “Our goal is to have a normalized economy, and the reason we’re keeping rates so low at this time is to try to get that normalized economy.”

Further purchases of mortgage-backed securities would in my view help provide a more rapid recovery in housing, by reducing the costs of refinancing or purchasing new homes. Of course, these Fed actions would be even more effective if accompanied by fiscal policies designed to speed the recovery in housing.

If real GDP does not grow more rapidly and unemployment remains at its current unacceptably high level, monetary policy may need to be more accommodative. The U.S. unemployment rate remains well above a level that could be considered full employment, while we are likely to undershoot our inflation targets.

The bottom line, in my view, is that the status quo is not acceptable. As I have shown today, a number of money market funds took significant credit risk that ultimately led to them needing sponsor support in the period from 2007 to 2010...

Funds need to be structured so that neither sponsor support nor government support is likely or necessary, even during times of stress.

I believe monetary policy should remain accommodative at this time and indeed that we should be looking for ways that monetary policy can foster more rapid growth, to bring down the unemployment rate more quickly. I believe further monetary policy accommodation is both appropriate and necessary.

"[Low inflation and the weak U.S. job market] gives us some flexibility to think about additional monetary-policy accommodation,” Rosengren said today at an Institute of International Finance conference in Copenhagen.

Rosengren said he expects U.S. gross domestic product to grow 2.3 percent this year. Inflation will probably be lower than the roughly 2 percent target the Fed aims to preserve, he said, citing forecasts for personal consumption expenditure measures.

Despite the lessons provided by the crisis, there remain a variety of financial structures that are “capital efficient” from the perspective of market participants, but in my view continue to be susceptible to strains on short-term funding during times of financial market stress or crisis.

By using stress tests to identify the possible capital and liquidity demands from these structures during a crisis, the institution’s management, board of directors, and regulators can better determine the appropriateness of the structures and the associated capital and liquidity – and whether these structures are likely to be beneficial to the organization at all times, or only during good times.

There has been a pattern of support for money market mutual funds without an explicit recognition that such funds can be a capital drain during times of stress.

 

[A] quick resolution for European sovereign debt concerns and banking problems may remain elusive, and the same for the large deficit problems in many countries. This suggests that slow growth is likely to continue for quite some time.

European stocks were badly impacted by the financial shock from the U.S. during the last financial crisis. Were there to be a serious financial shock from Europe, these correlations suggest it is quite likely that it would have a large impact on financial stocks and the broader stock market in the United States. Such stock price declines could impact households and businesses on both sides of the Atlantic, and problems in Europe could potentially cause a more significant retrenchment by European financial institutions operating in the United States.

[W]hile Asian banks did not have a high correlation with U.S. and European bank stock returns during 2007 and early 2008, Asian banks are likely to be more impacted now should a significant shock occur in Europe. European bank presence in Asia has been rising, and Japan and Taiwan have relatively large claims in Europe. In short, I would say that as interconnectedness increases globally, it will be difficult for any one region to insulate itself from financial strains or crises elsewhere in the world.

Mr. Rosengren said the Fed should buy more mortgage-backed securities and possibly U.S. Treasury securities in an open-ended program, and state that it will continue to buy bonds "until we start seeing some pretty significant improvements in growth and income."

A new program, Mr. Rosengren said, should be "at least of the magnitude that we've had before." The difference, he said, should be that a new program shouldn't set a fixed amount or end-date.

Mr. Rosengren said he wanted to do more than launch a bond-buying program. As an additional step, he said the Fed should gradually reduce the 0.25% interest rate that it pays banks for cash they leave with it on reserve. Other short-term lending rates are lower, such as Treasury bill rates, he noted. "It seems like we're paying too much for people to hold reserves," he said.

He said he didn't expect a reduction in the reserve interest rate to significantly damage short-term lending markets. But because of worries he said he favored only gradual cuts and that he didn't support setting the rate at zero, as the European Central Bank recently did.

At the Fed’s next meeting in six weeks, Rosengren said he wants decision-makers to authorize the central bank to “accumulate a fairly substantial amount of assets” that are “largely focused on mortgage-backed securities.”

“It’s going to need to be fairly large to have an impact,” he said in an interview with the Herald. “I’d want to tie it to economic outcomes rather than a calendar date.”

“The bottom line is we’ve been treading water long enough,” he said. “It’s time to take tangible action.”

On the market response to the Fed's September 13, 2012 asset-purchase announcement:  [S]tock prices are up substantially, mortgage rates are lower, and exchange rates are lower. On the latter I would point out that our efforts to lower long rates are focused on stimulating domestic demand, but at the same time lower long-term rates affect demand for U.S. assets, resulting in a modest change in the exchange rate – and this is likely to provide some support for export-oriented industries.

I am very pleased that monetary policymakers in the U.S. are proving willing to take difficult actions like these rather than accept the possibility of a long, slow recovery turning into a stagnation that someday earns the dubious title of “Great.”

Given that the current inflation rate is quite low and is expected to stay low for several years, we have the flexibility to push for more improvement in labor markets than if inflation were not so subdued. My own personal assessment is that as long as inflation and inflation expectations are expected to remain well-behaved in the medium term, we should continue to forcefully pursue asset purchases at least until the national unemployment rate falls below 7.25 percent and then assess the situation.

I think of this number as a threshold, not as a trigger – and the distinction is important. I think of a trigger as a set of conditions that necessarily imply a change in policy. A threshold, unlike a trigger, does not necessarily precipitate a change in policy. Instead, I think of my proposed threshold as follows. Once the unemployment rate declines to this level, we would undertake a full assessment of labor market conditions and inflationary pressures to determine whether further asset purchases are consistent with the desired trajectory for reaching our inflation and unemployment mandates in the medium term. Thus, a threshold precipitates a discussion and a more thorough assessment of appropriate policy, versus a trigger which starts a change in policy.  As an example, suppose we reach one’s threshold unemployment rate but at that time the economy is slowing, and no further improvement in the unemployment rate is expected in the short to medium term. This hypothetical situation would not necessarily imply a change in policy stance, especially if inflation was projected to remain below target.

Let me say also that an unemployment rate of 7.25 sounds high, but achieving an unemployment rate of 7.25 percent would require real GDP growth of roughly 3 percent for a year. That would be growth that is a full percentage point faster than the economy’s so-called “potential” rate of growth, making this a challenge to achieve.

...

Despite the challenge to communicating in simple terms the likely exit strategy, I will say that my own preference would be to continue asset purchases until we had at least reached an unemployment rate of 7.25 percent, given the low rates of inflation we have been experiencing and are likely to be experiencing over the medium term – however, I will say again that this is a threshold, not a trigger. Assuming that inflation and inflation expectations remain well-behaved, at that point the discussion should center on whether overall labor market conditions are consistent with “substantial improvement” – for example, whether the lower unemployment rate reflects job creation rather than reductions in the labor force as discouraged workers stop seeking jobs; whether we are seeing sustained, robust payroll employment growth; and whether we envision continued substantial improvement in labor markets for some quarters to come. Under those conditions, I would stop asset purchases.

in my view, a strong case can be made for the Federal Reserve continuing to purchase the current $85 billion in longer-term securities a month – even after our so-called “Operation Twist” maturity-extension program (a portion of those purchases) is completed at the end of 2012.

"We need some substantial improvement" in the jobless rate to consider a major shift in the Fed's purchases of Treasury and mortgage debt, Federal Reserve Bank of Boston President Eric Rosengren said in an interview with Dow Jones Newswires.

Compared to the current 7.8% unemployment rate, the official said once a 7 1/4% rate is achieved, central bankers would need to have a "full discussion" about the utility of pressing forward with bond buying.

…

Mr. Rosengren also said in the interview he doesn't believe the Fed's very aggressive policy is creating new financial market imbalances.

"I am not seeing strong evidence there is collateral damage" from Fed actions, and "I'm not seeing anything more generally that would pose a macroeconomic concern at this time." For those who believe historic low yields in the bond market represent a bubble, Mr. Rosengren said "the lower interest rates are exactly what we intended on doing," adding "these rates won't stay in place" forever.

Federal Reserve Bank of Boston President Eric Rosengren said the central bank could still enlarge its $85 billion monthly purchases of bonds if policy makers are not making progress toward their twin goals of stable prices and full employment. “I think there is the capacity to enlarge it if that were to become necessary,” Rosengren, 55, said in a telephone interview with Bloomberg News... “We’re partly calibrating this on trying to get the appropriate amount of stimulus without creating market functioning problems,” he said. “Given the risks of market functioning problems I think we’ve appropriately calibrated it at this time, but if it became necessary to do more I think we have some capacity to do that.”

[T]o capture the benefits of the LSAP you need a fuller model. One of the models currently used by the Federal Reserve Bank of Boston provides a relatively conservative estimate of the economic benefits of a hypothetical additional $750 billion LSAP. Based on historical experience, the model implies that such a purchase would lower long-term rates by 20 to 25 basis points, relative to not making the additional purchases. The impact of this large a reduction in long-term rates is a cumulative gain in real GDP, relative to the base, of 1.6 percent or $260 billion. In our model such a purchase also results in a decline in the unemployment rate of 0.25 percent or 400,000 jobs. Some of the models we run provide a larger impact to such purchases.

Federal Reserve Bank of Boston staff use two different models to estimate the impact of asset purchases on the economy. One explicitly articulates household and business behaviors and the other is a purely statistical model. Reassuringly, both models give similar results. Our best estimate implies roughly a one-quarter-point decrease in the unemployment rate for a $500 billion asset-purchase program.

By this estimate, the benefits of the large-scale asset purchase (LSAP) program include almost 400,000 additional workers employed for every $500 billion in purchased assets (which earn a return while on the Fed’s books), returning to our inflation target somewhat more quickly, and a somewhat better debt-to-GDP ratio as a result of the lower interest rates and improved GDP and revenue growth. While these estimates are model dependent, and are clearly subject to estimation error, they are broadly consistent with other studies – and with the growth in asset prices and the expansion of the interest-sensitive components of GDP seen since last September.

While the Federal Reserve’s accommodative monetary policy has been an important driver of the current economic recovery, and the financial stability costs appear relatively modest at this time, we cannot be Pollyannas. There are areas that we should closely monitor. Some areas that bear watching, in my view, are specific markets where underwriting standards are slipping – or where rapid growth in financial products could become a more significant concern.

In terms of underwriting standards, the covenant quality on new high-yield bond issuance should be closely monitored…

Also, financial structures that involve the use of short-term borrowing to finance longer-term assets should be monitored carefully. For example, agency real estate investment trusts (agency REITS) have grown rapidly, involve leverage, and are susceptible to sharp interest rate movements…

Finally, many non-depository financial institutions that were susceptible to runs during the financial crisis still have not resolved that run risk. For example, money market mutual funds experienced a severe run requiring substantial government intervention during the crisis, yet the regulatory reform effort is moving only slowly. Similarly, Federal Reserve Governor Daniel Tarullo and New York Fed President William Dudley have raised concerns about broker-dealers and wholesale funding markets...

Federal Reserve Bank of Boston President Eric Rosengren said today the central bank should be “drawing down” its bond buying of $85 billion a month as the economy improves and at some point it should stop the purchases.

“On the other hand, if the economy does much worse, we have the option to be buying more of them,” he said in an audience question-and-answer session in Manchester, New Hampshire.

As reported by Bloomberg News

One could argue that consistently missing our inflation target alone would justify a highly accommodative policy. However, coupled with persistently high unemployment, the justification for continuing highly accommodative policy by large-scale asset purchases is clear. This is a time when the dual mandate is important and, I would add, particularly useful for communicating policy to the general public.

I think ideally it would actually come from the fiscal side. My own forecast is we’ll get to roughly 7.25 percent unemployment by the end of the year. I would continue our program and if we get to 7.25 and we’re starting to see payroll growth that is north of 200,000, and it looks like we’re getting a real self-sustaining recovery then I think you can make an argument [that it’s time to curtail asset purchases].

I think we need to be careful about what kind of side effects we’re having.

Broker-dealers experienced dramatic difficulties during the 2008 crisis, and the Federal Reserve needed to temporarily backstop broker-dealers with substantial lending. Given that recent history, the assumption that collateralized lenders like broker-dealers are not susceptible to runs has been proven wrong.

At the same time, broker-dealer capital regulation by the SEC remains largely unchanged, despite the lessons of the financial crisis. Consequently, broker-dealers remain vulnerable to losing the confidence of funders and counterparties should the world economy again experience a significant financial crisis.

Let me close by reiterating that a long-term sustainable solution for fiscal balance is absolutely in the country’s interest. But timing is an issue. We have suffered a severe financial crisis, a deep recession, and a painfully slow recovery. Fiscal policy is obviously the jurisdiction of the legislative and executive branches of government, but given the economic realities I would urge policymakers to consider scenarios where some elements of fiscal rebalancing take effect only after the economy has more fully improved, and the possibility of a less restrictive fiscal stance until that time.

Since the 3-month Treasury rate has remained very close to zero for more than four years, the movements in the real rate must primarily reflect changes in the other part of the equation – the inflation rate. Importantly, as the inflation rate falls, the real interest rate rises. Higher real interest rates make it more expensive to borrow, after controlling for changes in inflation. Japan has been an extreme example of this dynamic, given that deflation has caused the real interest rate to remain positive despite a weak economy and falling prices.

In sum, the longer we in the U.S. remain so far below our 2 percent target, the greater the risk that inflation expectations could fall and real interest rates rise. In part to offset this risk, the Fed has conducted large-scale asset purchases that increase its balance sheet.

In terms of monetary policy, it would in my view be premature to stop the Fed’s large-scale asset purchase program at this time. I believe the Fed should continue the purchase program until we see more sustained improvement in labor markets and have greater confidence that the economic recovery is sufficiently self-sustaining to yield continued progress in reducing the still very high unemployment rate.

However, I would also say that it may be undesirable to abruptly stop purchases, so it may make sense to consider a modest reduction in the pace of asset purchases if we see a few months more of gradual improvement in labor markets and improvement in the overall growth rate in the economy – consistent, by the way, with my forecast, which is somewhat more optimistic than that of many private forecasters.

I would reiterate that with an open-ended asset purchase program, changing the flow of purchases does not necessarily yield, in the end, a smaller central bank balance sheet. That would depend on having a fixed point for cessation of purchases, combined with a lower flow of purchases. So, even if we were to adjust the rate of monthly purchases, the ultimate size of the Fed’s balance sheet would depend on the point of cessation. If economic growth proves sufficient and the purchase program was not extended over a longer time period, the size of the balance sheet could be smaller than otherwise.

In summary and conclusion, I would stress that MMMF reform is overdue. However, it is important that the reforms actually reduce the financial stability issues that remain under the current structure. Promising a fixed NAV with no capital while taking credit risk is not sustainable – especially in potential future crises where the response of the public sector will be substantially limited, compared to 2008. MMMF runs should not be allowed to once again impede the flow of stable funding within our financial system.

The SEC proposal to allow funds to impose liquidity fees and redemption gates should be dropped. This particular proposal is, in my view, worse than the status quo. It would only increase the risk of financial instability.

However, I strongly support requiring a floating NAV for all prime funds, both institutional and retail, which would treat these funds like other mutual funds. Investors who want a fixed NAV can keep their funds in government-only funds – and those should have the vast majority of their portfolios invested in cash and government securities.

The bright spot in real GDP through much of the recovery has been the interest-sensitive sectors. Figure 4 shows that residential investment has been strong – in fact it has averaged just over 15 percent growth over the last four quarters. This strength comes, in part, in response to the Federal Reserve’s asset-purchase program, which was designed to lower market rates and boost interest-sensitive economic activity. Similarly, auto sales have been quite strong – helped by unusually low auto-loan rates, which reflect competitive forces among auto lenders (including community banks) as well as the Fed’s asset-purchase program. In short, the most interest-sensitive sectors have been growing strongly, in part because of highly accommodative monetary policy.

I do not mean to imply that the communications and signaling issues of the last few months have not been difficult, for many. Without question, there are difficulties inherent in communicating a data-contingent policy – but a data-contingent policy is far preferable to the alternatives. The Federal Reserve will continue to refine its policy-related communications, but I would just point out that predictive certainty will never be the case when policy is rooted in actual incoming data, which may or may not follow forecasts.

My hope and my forecast is that we will continue to accumulate evidence indicating a strengthening economy in coming months. Thus, my decision to cast a dissenting vote was focused on counseling patience in removing monetary accommodation... Over the recovery period, my forecasts, as well as forecasts of many others, have proven to be more optimistic than the actual outcomes. Furthermore, we remain far from both parts of the Federal Reserve's "dual mandate" on employment and inflation. As a result, I would prefer to wait until the economic improvement that I am forecasting is clearly evident in the data before reducing the size of the asset-purchase program. Given the remaining shortfalls from our targets, I think patience remains appropriate at this time.

And in the area of monetary policy, the dynamics of inflation both during and following the recession have presented puzzles. For instance, why is inflation both here and abroad remaining stubbornly low today, even as the economic recoveries in the U.S. and the Euro area strengthen, in part boosted by highly accommodative monetary policy? In Boston, we have examined the extent to which a number of factors might explain recent behavior time-variation in the slope of the Phillips curve, a reduced impact of relative prices (especially oil) on inflation, survey measures as proxies for short-run and long-run inflation expectations, and downward nominal wage rigidities. While these factors appear to provide partial explanations, no effects singly or severally provide a complete accounting of recent inflation behavior. Given these uncertainties about inflation dynamics, we have reason to have less confidence than usual in the inflation forecasts from our suite of models, many of which would suggest a gradual rise toward the Fed's inflation target in coming quarters. This makes the current low level of inflation more troubling from the perspective of risk management. So, in short, we need to better understand inflation dynamics.

I have discussed three examples of ways the Boston Fed has tried to make unique policy contributions within the Federal Reserve System. Moreover, my footnotes contain citations illustrating that we also make academic contributions by publishing our research on these topics, as well as many other topics that I do not have time to highlight today, in the top economics and finance journals. However, as I hope my remarks have illustrated, we have tried to advance not only diversity of thought in the Federal Reserve System, but also diversity of actions. The work that I have highlighted today illustrates our belief that data-driven research of the type that can appear in major professional journals can also inform and guide policy actions in monetary policy, supervisory policy, financial stability policy, and the economy more broadly. Ultimately, our hope is to make a positive difference in these important areas. Finally, I would add that our work at the Boston Fed has benefitted significantly from our interactions with the rich academic community in New England. Most of the articles I have cited in my footnotes have multiple authors. We value collaboration with the academic community, and there are certainly important topics that would benefit from further academic work and collaboration.

While the Fed has tied further withdrawal of stimulus to continued economic progress, Rosengren detailed what he would need to see to either halt the tapering or ramp it up.

"To halt it, certainly if we stop seeing progress in the labor markets ... and we were to start seeing the unemployment rate go up—that would be certainly a source of concern and a reason to stop it," he said.

On the other hand, "it would take some fairly strong, unexpected growth, and inflation much more quickly than I'm expecting back towards 2 percent, to make me want to remove accommodation more quickly," Rosengren said. "I don't expect that to happen," he added.

Recent incoming data continue to be consistent with a slowly improving economy. This improvement is allowing the Federal Reserve to slowly pare back asset purchases and to gradually become less precise in our forward guidance. However, I believe there are several reasons to be cautious and patient before returning monetary policy to a more normal, less accommodative stance.
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Admittedly, this rather qualitative forward guidance is somewhat less specific than the previous forward guidance involving the 6.5 percent threshold. My personal view is that, ideally, forward guidance should, for the time being, remain qualitative but increasingly be linked to progress in achieving our dual mandate based on incoming economic data. In particular, I believe the FOMC’s forward guidance should be consistent with keeping interest rates at their very low level until we are within one year of reaching full employment and our 2 percent inflation target – and the guidance could explicitly state that intention.

At non-financial corporate businesses, the level of checkable deposits and currency has been growing rapidly, as Figure 7 shows. This could represent a form of “scarring” from the recession if it means that firms are less confident in raising funds from the market or financial intermediaries, and are now essentially more risk-averse and banking cash. While some risk aversion is clearly vital, a growing degree of risk aversion among non-financial corporate businesses may signal subdued investment behavior by firms – behavior that would, on net, lead to slower economic growth.

WSJ: What role should overnight reverse repos play in the monetary framework?
Mr. Rosengren: It is a little early to know what the end point is going to be and the committee hasn't announced any decision, which I think is appropriate given that no one has exited from this kind of balance sheet. We're in some respects in unchartered grounds.
Interest on reserves is likely to be reasonably effective at raising short-term rates, but the reverse repo facility has the capability of tightening that relationship a little bit more than would occur with just interest on excess reserves…
It is not appropriate to be tightening now, but when it does become appropriate to tighten, we're going to have to look at the full set of tools that we have and there's going to be a little bit of experimentation to see exactly how interest rates move as we use some of our different tools.
At this point we're basically kicking the tires and making sure that operationally we're in good shape when it becomes appropriate to raise rates. We'll need to do things fairly gradually because we're going to be in some sense learning by doing.
WSJ: Do you have any concerns about reverse repos?
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WSJ: The Fed in June 2011 laid out a framework for how it planned to go about exiting from these low-interest-rate policies. Is it the case that you don't need to have a rigid, laid-out framework, that you have to be open to adapting as you go?
Mr. Rosengren: Personally, that would be my preferred path, to be reasonably flexible about what we're doing in the short term and what we're doing in the long-term. I'm fully confident that we have the set of tools to raise rates, but I think that until we actually operationalize it we may learn something about various tools that make us shift our emphasis among the potential ways that we could move markets to tighten.
WSJ: Are you concerned that that kind of approach could cause uncertainty in markets and the financial system about how people should adapt to the Fed's framework?
Mr. Rosengren: We can't give more certainty than we know ourselves. It would be premature to lay out a fixed path until we have more information.
…
WSJ: Do you have a preference for what the spread should be between the interest on reserve rate and the repo rate?
Mr. Rosengren: It's too soon to have a strong preference. There are a number of considerations. For example, reverse repo set at a lower rate might be less expensive to administer.
…
WSJ: This sounds like a much different vision of exit than the Fed laid out in 2011. We're talking about something that, like it or not, is going to be more uncertain for people in the market.
Mr. Rosengren: Speaking for myself, and not for the committee, I think it is inevitable when you are in a place you haven't been before and you don't have good underlying data that tells you what will happen when you do certain things, that you be a little bit experimental.
The goal is to have an exit strategy that isn't going to be disruptive to the market and that achieves our goals of raising rates when that is appropriate. We may find out things when we start the process that make us favor one strategy over another. But until we start moving some of these things to scale it would be premature to lock ourselves down. This is my view. I'm not speaking for anyone but myself.
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WSJ: There is a view that with a reverse repo program you could have investors flooding out of bank deposits and into reverse repo-oriented money market funds in a crisis. Is that a legitimate concern?
Mr. Rosengren: That is a concern that we have to think about. Financial stability broadly is something we have to think about in terms of the exit strategy. If we're coming up with tools that we haven't used in the past, there are likely to be institutional arrangements that are going to differ.
Some of that is going to be what people tie their contracts to. Some of that is going to be where people move their assets during times of crisis. You could easily imagine a very significant government-only money-market fund developing that is primarily focused on reverse repos if that is a tool we are going to be using for a longer period of time, and it gives people access to something they currently don't have for a very low-risk opportunity to put their short-term funds in.

Once the U.S. economy began to improve and the Federal Reserve began to discuss a gradual reduction in purchases, many market participants who had been invested “alongside” the Federal Reserve became active sellers.

This was particularly true for highly leveraged investors who had borrowed “short” and invested “long” by engaging in the so-called “carry trade” – an issue of particular relevance in emerging markets where interest rates were considerably higher than in the United States. The result was a fairly significant increase in long-term rates and a repatriation of funds that had been previously borrowed short and invested long in emerging-market securities.

The unwinding of the carry trade was a particularly thorny issue for countries with high dollar-denominated yields and fixed exchange rates, and for countries that had high yields and a policy of gradual currency appreciation relative to the dollar. The speed and magnitude of the readjustment highlighted just how low long-term rates had been pushed. It also suggested that many models of the impact of Federal Reserve asset purchase programs had not fully accounted for potential investor reaction to the policy, or the impact of a sudden reassessment of investor desire to engage in the carry trade.
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In sum, this episode made clear the importance of Federal Reserve communication and market understanding about programs and policies. The episode also underlined the importance of calibrating investor reactions into models of policy impact.
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Importantly, I suspect that the benign reaction to the gradual tapering of stimulus over the last 6 months may be instructive as we consider how best to wind down the Federal Reserve’s balance sheet once the tapering of asset purchases is complete. While the optimal program for reducing the Fed’s balance sheet will need to be dependent on the state of the economy, the recent tapering experience suggests to me that a predictable, transparent reduction in the balance sheet could be done in ways that may minimize the risk of financial disruption.

Let me offer one scenario that I have been considering, in light of the sorts of financial stability concerns that I and my colleagues keep in mind. In one scenario, a reduction in the balance sheet, when that becomes appropriate, could be implemented as a basically seamless continuation of the tapering program used for reductions in the purchase program. For example, the Committee could decide to reinvest all but a given percentage of securities on the balance sheet as they reach maturity, and increase that percentage at each subsequent meeting, assuming conditions allow.

Such a tapering of the reinvestment program could allow for a gradual and transparent reduction in the Fed’s balance sheet. As the economy moved closer to the Federal Reserve’s 2 percent inflation target and full employment, there could be a gradual reduction in the reinvestment policy – which would allow for a predictable reduction in the size of the balance sheet. However, the pace of reinvestment should always be considered in the context of the economic outcomes we are seeking to achieve. If the economy was substantially stronger or substantially weaker than was expected, the reinvestment program would need adjustment. Again, I mention this as simply one scenario for consideration.
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[A] positive collateral impact of using reverse repos and interest on excess reserves in these ways is that the ability to control short-term rates would not be tied to actions that impact the size of the Federal Reserve’s balance sheet. This means the Federal Reserve could have additional financial stability tools at its disposal, if it chose to maintain a larger-than-traditional balance sheet with a greater mix of assets. Naturally, maintaining a large balance sheet comprising both U.S. Treasury securities and mortgage-backed securities would provide the Federal Reserve with continuing options for impacting long-term interest rates and the spread between mortgage-backed securities and U.S. Treasury securities. For example, if a bubble seemed to be developing in housing markets generally, the Federal Reserve would have the option of addressing it by selling MBS or long-duration U.S. Treasury securities. This again is a notion that I consider worthy of further exploration and debate.

Let me be quick to add that one negative, collateral impact of engaging in reverse repos is that during a period of heightened financial risk, investors might flee to the reverse repo market. This would provide a safe asset for investors, but might also encourage runs from higher-risk, short-term private debt instruments. This would have the potential to create significant private sector financing disruptions during times of stress. Presumably, capping the size of the reverse repo facility could help limit the impact.

Perhaps the most direct way to reduce runs related to unstable funding is to require financial organizations dependent on unstable funding to hold significantly more capital than they would if they used stable sources of funding…  To reduce run risk, a larger share of long-term subordinated debt could also be utilized to finance securities positions. Long-term financing reduces the need for short-term and more “runnable” funding. While some broker-dealers have utilized long-term financing to reduce run risks, paradoxically, other broker-dealers have been reducing their use of more stable sources of financing.

Another way to minimize run risks would be to limit the amount of maturity transformation that can be done with repurchase agreements specifically. This would call for limiting the extent to which short-term repurchase agreements held by regulated financial intermediaries could be used to finance long-term assets or high-credit-risk assets. Alternatively, institutional investors such as money market mutual funds could, with new regulation, be prohibited from holding repurchase agreements secured by collateral that they, by rule, could not purchase.

Other remedies are possible and should be explored … One would be regulation that specifies eligible collateral for a repurchase agreement and that mandates the “haircut.” Another approach could be focused on accounting treatment – for example, perhaps repurchase agreements collateralized with less-liquid collateral should not count as a “cash and cash equivalent” to the investor.

…

Allow me to mention one other possibility – a complex and likely controversial one, to be sure. In my view, the Federal Reserve’s Discount Window could theoretically provide a way of reducing liquidity risk, by providing a standing liquidity facility for broker-dealers like the primary dealer facility that was established during the financial crisis. The rationale for such a step would be rooted in the notion that market-making is as important as lending in today’s economy.

However, I realize that such an outcome seems unlikely. And at any rate a number of other steps I have mentioned – such as a significant re-evaluation of broker-dealer regulatory requirements and, particularly, much-higher solvency standards that would reduce the risk of runs – would seem to be prerequisites for such a path.

...

In sum, given the widespread support provided to broker-dealers and the difficulties they encountered during the crisis, a comprehensive re-evaluation of broker-dealer regulation is
overdue.

In addition, given the uncertainties surrounding our forecasts of the pace of labor market improvement and the degree of remaining slack, monetary policy has to be determined largely by incoming data and the signals that data provide about the health of labor markets. If the economy disappoints we should be in no rush to raise short-term rates, but if the economy improves more quickly than anticipated we should raise short term rates earlier. Thus, we should be moving away from providing date-based forward guidance, and instead focus on what incoming data tell us about reaching full employment and 2 percent inflation within a reasonable time period.

...

In fact, I actually hold the view that as we approach levels of unemployment that many consider “full employment,” the Fed should no longer issue guidance on the approximate timing of any monetary policy changes.

I do not intend this to reduce transparency in monetary policymaking. Rather, I simply want to acknowledge that any reference to calendar dates has the potential to be inaccurate. The date of “liftoff” from near-zero short-term rates is highly dependent on how the economy actually evolves – in other words, is going to be tied to the current and expected path of inflation and employment. We are getting close enough to targets that, given the uncertainty around forecasts of these variables, incoming data that cause Federal Reserve policymakers to significantly change our outlook for the economy will shift any expected lift-off date forward or backward in time. So, again, reference to calendar dates as we approach targets has the potential to be inaccurate.

If one assumes that the unemployment rate will continue to fall at the same pace in 2016 as it is expected to fall in 2015, both forecasts would reach the Boston Fed’s 5.25 percent estimate of full employment around the middle of 2016. As I’ve said on many occasions, I personally do not expect that it will be appropriate to raise short-term rates until the U.S. economy is within one year of both achieving full employment and returning to within a narrow band around 2 percent inflation. Again, that is my personal view. And, if one were to also assume that tightening would begin roughly one year before reaching full employment and the 2 percent inflation target, then one could say that the primary dealers’ estimates of a rate rise bunched around mid-2015 seem roughly consistent with the forecasts for unemployment in Figure 2.

Figure 6 shows how states look when plotted in terms of the U-3 rate (the horizontal position) and workers part-time for economic reasons (the vertical position), both compared to a pre-recession average (calculated from 2005 to 2007). A large number of states are clustered in the upper right hand quadrant of the figure, indicating that both U-3 unemployment and those who are part-time for economic reasons remain well above levels from before the recession. There is also a clear trend in the data, where states with U-3 unemployment well above that pre-recession average tend to have higher part-time workers relative to pre-recession levels. I would also point out that many of the states that have very high U-3 unemployment and workers part-time for economic reasons are states that were disproportionately impacted by the financial crisis (states such as Arizona, Nevada, and Florida).

Mr Rosengren said Fed asset purchases have achieved their stated goal, the jobs report for September is already in and his economic forecasts have not changed. There has been substantial improvement in labour markets, he said. As a result I would be pretty comfortable [ending purchases] at the end of the month.

However, he suggested recent turmoil in financial markets which led to the US stock market plunging last week before recovering on Friday means there is no rush to change how the Fed phrases its forward guidance on future interest rates.

It has to be contextual. Financial markets are volatile, he said. The October statement will have to balance the desire to highlight data dependence with the concern this might not be a time that you want to further destabilize financial markets.

That suggests the Feds considerable time language could survive past its October meeting, although Mr Rosengren now wants to do away with forward guidance altogether. He says that, with the economy nearing full employment, there is too much uncertainty to lay out firm plans.

If youre pretty close to where you want to go, you cant have nearly as much certainty how long its going to take, said Mr Rosengren, pointing out that unemployment at 5.9 per cent is a full percentage point lower than the Fed forecast it would be just 18 months ago.

I would like to tighten when were one year away from full employment, said Mr Rosengren, which on his current forecast would mean a first rate rise in 2015. But he points out how a forecast error could make guidance based on that estimate completely wrong.

Mr Rosengren said recent volatility in financial markets was not such as to make him change his outlook. The fact that its just volatile doesnt bother me, he said. If we were to start seeing long-term rates trending well below our inflation target, that is a warning signal . . . financial markets dont have confidence were going to hit 2 per cent.

While it is difficult for individuals to overcome limited opportunities, the ability of entire communities to reinvent themselves has become increasingly important as evidence mounts suggesting how important social surroundings can be for individual success.

[D]eflation is particularly problematic for debtors. The real value of their loan payments rises over time, making it more difficult to make repayment.

Figures 2 and 3 showed that expectations for 2014 inflation have declined, and with inflation having consistently undershot the Federal Reserves 2 percent target, it is possible that longer-term inflation expectations are starting to decline as well. Figure 6 provides one way to capture longer-run inflation expectations. By subtracting the 10-year inflation-indexed Treasury yield (TIPS) from the 10-year Treasury yield, you get a measure of so-called break-even inflation. That is, this difference represents the prevailing inflation rate that should make you indifferent between holding a fixed-rate bond and holding a Treasury bond of the same maturity that floats with the inflation rate. The latest readings have been at the low end of recent experience. However, one must be cautious to infer too much from Treasury interest rates, particularly given the recent volatility and the flight to quality by many global investors that may have temporarily reduced Treasury yields.

Figure 16 highlights how low 10-year Treasury rates have fallen recently. Japans experience and now Europes current situation both indicate that indifference to very low inflation rates can generate a significant loss of confidence in the ability of a central bank to hit its inflation goal. It is hard to reconcile the market evidence a 10-year German bond trading around 85 basis points and a 10-year Japanese bond trading below 50 basis points with the publicly announced inflation targets. Bond market evidence suggests that investors have little expectation that 10-year average inflation rates will be anywhere close to their publicly announced targets.

I am happy to be participating on todays panel, especially since the topic is monetary policy normalization. At the AEAs annual meetings since 2008, my sense is that monetary policy discussions have not had the word normal in the title. It is a pleasure to be seeing the types of economic conditions where such a discussion is not just theoretical where the economy has improved enough for the discussion to move from whether normalization will occur to when normalization will occur.

As I consider these questions for this cycle, I believe the continued very low core inflation and wage growth numbers provide ample justification for patience. A patient approach to policy is prudent until we can more confidently expect that inflation will return to the Feds 2 percent target over the next several years. Such patience also provides support to labor markets, boosting the prospects of the many Americans who were adversely impacted by the financial crisis, severe recession, and slow recovery

Clearly, an unusual set of conditions prevails as the Federal Reserve considers beginning a move toward more normal rates. Both short-term and long-term rates are unusually low, and remain below their historical average in most countries. Large central bank balance sheets here and in many developed countries and very low inflation rates in developed countries are important contributors to current low rates. Also, unlike in some previous periods, some countries will be easing while others will likely be tightening, causing more complicated exchange-rate dynamics. These are all factors that complicate the period of normalization.

The low inflation rates experienced globally may also allow for a more gradual normalization process than typically occurs. With so little wage and price pressure, and relatively slow productivity growth, it is possible that rates may not normalize at the same level they were prior to the financial crisis.

In sum, the complexity of monetary policy normalization is more pronounced than in 1994 and 2004. However, as I noted at the outset of my remarks, the fact that discussion of policy normalization is now appropriate is a welcome change from discussions of monetary policy over the past six years.

Given how low total and core inflation have fallen in most developed countries, a policy of patience in the United States continues to be appropriate. This is particularly true given the inherent asymmetry that we face at the zero lower boundmeaning, while we have all kinds of room to respond to an unexpectedly favorable shock, we remain quite limited in our ability to respond to negative shocks.

Were the U.S. economy to unfold as I and other policymakers expected in our June SEP forecasts, beginning the policy normalization process later this year might be appropriate. However, the assumption that our current forecasts for labor markets and for inflation will unfold as expected is still subject to considerable uncertainty... …[A]s we near our dual mandate goals, monetary policymaking needs to be particularly data dependent. As I have emphasized today, data dependence at this point means, in my view, that we wait for data that gives us greater confidence in our forecast, especially our forecast for inflation. And it also means we wait to get a better handle on how the crisis in Greece gets resolved, so that we can better gauge its potential to impact financial markets and the domestic economy.

An interesting implication of this demographic shift is that the unemployment rate should perhaps be lower at so-called “full employment.” Younger workers tend to have higher unemployment rates, since they are only beginning to acquire the skills needed by employers. Older workers tend to have very low unemployment rates if they remain in the workforce. As a result, the estimates of the unemployment rate at full employment need to consider whether changes in the demographic composition of the workforce have an impact. This is one reason why I personally have lowered my estimate of the natural rate of unemployment to 5 percent, and I believe it may need to be adjusted even lower if inflation continues to undershoot our forecasts.

First, the statement indicated the committee needed to see “some further improvement in the labor market.” In my own view, this condition has largely been met by the continued growth in payroll employment – averaging in excess of 200,000 jobs per month, year-to-date through July, and a U-3 unemployment rate – the typical, widely reported measure of unemployment – that is currently at 5.3 percent.

The second condition noted in the statement was that policymakers must be “reasonably confident that [PCE] inflation will move back to its 2 percent objective over the medium term.” For this condition, the data have not been as clear-cut. Core PCE inflation for the past year has only been 1.2 percent, and recently there have been substantial declines in oil prices and other commodity prices. These will likely feed into core (and headline) measures of inflation for some months to come, temporarily lowering inflation readings. Adding to this, recent reports on wages and salaries still show few signs that the tightening labor markets are translating to increases in wages and salaries consistent with reaching 2 percent inflation.

As a result, current data have yet to indicate that this second condition will be met in the coming months; instead, policymakers will need to rely on forecasts of inflation...

Such a forecast needs to be mindful of recent developments, including data that suggest the slowing of foreign economies, coupled with volatile stock prices and falling commodity prices – both of which are consistent with a weaker global economy. In my view, these developments might suggest a downward revision in the forecast that is large enough to raise concerns about whether further tightening of labor markets is likely. And without an expectation of growth above potential and further tightening of labor markets, I would lose my primary rationale for a forecast of rising inflation, diminishing my confidence that inflation will reach the 2 percent target within a reasonable time frame.

All future committee meetings -- including December’s -- could be an appropriate time for raising rates, as long as the economy continues to improve as expected.

Given the uncertainties surrounding the degree of accommodation that is necessary to achieve 2 percent inflation and full employment, I prefer a path that involves only gradual increases in interest rates and that essentially probes how tight labor markets can be, consistent with our 2 percent inflation target

FT: What kind of number represents a satisfactory reading for you on non-farm payrolls to feel that slack is continuing to diminish at a reasonable pace?

Rosengren: That is really tied to what you think the participation rate is going to be doing. It is probably under 100,000 jobs if you are assuming participation, if you are not pulling people into the labour force and just looking at the demographics, it is probably under 100,000 a month. If you are including pulling people into the labour force that is probably 125,000. Anything above that should be enough to have a gradual diminishing of the labour market slack. That being said, if we were getting reports of 126,000 that would not be giving me a lot of satisfaction. There is not a lot of precision in these numbers. I do think that the numbers if you average through what we have been seeing are substantially better than that. It shows that both the U6 and U3 measures have come down relatively rapidly.

FT: The Fed all year has been trying to shift the debate from timing of the first move to the pace. We may be on the cusp of that debate being concluded if things do go ahead in December, which your speech seemed to suggest you thought was a reasonable case. That then takes us to what we mean by gradual. What is your notion of gradualism?

Rosengren: This is where Summary of Economic Projections actually is useful. It hasn’t been completely clear that the Summary of Economic Projections [SEP] always provided information that provided additional clarity to the market. But I do think you are going to get both the range and the median view of what gradual means. December is an SEP meeting. That is going to define what gradual means among all the participants. Already, and I had this chart in the talk, relative to the 25 bps in each meeting that we had at the previous recovery, both the SEP in September — and the markets seem to think it is going to be much flatter than that; I mentioned in the talk that I thought the markets were probably a little bit closer than the September SEP. The September SEP was closer to 100 bps a year. The market is a little bit flatter than that. My own view now, and obviously it could change depending on how data comes in... is that the market path is probably about right.

FT: We talked earlier this year about raising the inflation target. That doesn’t seem to have gained traction. Are there any other changes to central bank mandates, strategy, that you would want to see?

Rosengren: In the short run getting off the zero lower bound here and abroad should probably be the primary focus of central banks in most of the developed world. We have yet to have a real success story with lifting off the zero lower bound and staying off the zero lower bound. My guess is in the next year that is where we should focus our attentions.
...
If there was going to be one lesson I would additionally take it is if you look at the SEP for where the long run nominal fed funds rate will be, it is pretty low rate by historical standards. It is also a low rate relative to how we have reacted when there were negative shocks in a recession. If we are at 3.5 per cent on the federal funds rate that doesn’t give us a lot of ammunition if we have a shock that is the size of a traditional recession in the US. That is something we will have to think more about in time.

“Policy makers should take seriously the potential downside risks to their economic forecasts and manage those risks as we think about the appropriate path for monetary policy,” said Rosengren, a voting member of the FOMC this year.

“These downside risks reflect continued headwinds from weakness within countries that represent many of our major trading partners, and only limited data to support the projected path of inflation,” he said.

Significant progress has been made in eliminating too big to fail and the possibility that taxpayers in the United States would need to bail out the domestic [Global Systemically Important Bank Holding Companies] to preserve the financial system’s functioning. But it is important to remember that significant work still remains. Some of the proposals need to be finalized, some of the regulations are only in the process of being phased in, and more work needs to be done on resolution plans to insure that GSIBs can be resolved in an orderly fashion.

Nonetheless, capital ratios at the GSIBs have been steadily increasing, with the goal of reducing the chances that a GSIB will fail. In the event that one does fail, the new total loss-absorbing capacity proposal and resolution plans intend to reduce the potential costs to taxpayers of such a failure and make it less likely that there would be a need for any financial support from taxpayers to preserve financial system functioning.

While most observers expect that the appreciation of the dollar and the fall in oil prices will eventually stabilize, recent global events may make it less likely that the 2 percent inflation target will be achieved as quickly as had been projected in recent forecasts by private economists or by Federal Reserve policymakers. In my own view, if inflation is slower to return to target, monetary policy normalization should be unhurried. A more gradual approach is an appropriate response to headwinds from abroad that slow exports, and financial volatility that raises the cost of funds to many firms.

There is one way that these temporary downward pressures on reported inflation could pose more permanent impediments to reaching the 2 percent inflation goal – if inflation expectations were to change as households and firms viewed the prospects for future inflation differently. [The Federal Reserve Bank of New York’s survey of consumers’ expected inflation rate one and three years ahead] does show a gradual but clear downward trend in inflation expectations over the past several years. This suggests we cannot take for granted that regular, persistent, but seemingly temporary shocks to inflation will not have a larger and more lasting impact.

If a shock or event occurs, and banks prove to be not sufficiently resilient, it is critically important to proactively recapitalize the banking sector as quickly as possible while at the same time avoiding collateral damage from tighter credit standards. Put another way, with respect to the capital-to-assets ratio, it is vital to increase the capital (the numerator of the ratio) rather than allowing the adjustment to occur primarily through a reduction in assets, i.e. loans (the denominator).

Indeed, as of the end of last week... the federal funds futures market implied the belief that there would be roughly one more quarter-point increase by the end of 2016, and an additional quarter-point increase by the end of 2017. This extremely gradual path for reducing monetary policy accommodation would imply either a weak outlook for the economy or significant concerns that even if the expected outlook was benign, there were significant “tail” risks. My own view is that the outlook is not as weak, and the tail risks not as elevated, as would be implied by this very gradual path.
...
With financial market volatility subsiding since earlier this year, it is to me surprising that
the expected path of monetary policy embedded in futures markets is so low. A weak forecast
doesn’t seem to explain the path expected for the funds rate. As I see it, the risks seem to be abating that problems from abroad would be severe enough to disrupt the U.S. recovery. Financial-market volatility has fallen, and most economic forecasts do not reflect expected large spillovers from continued headwinds from abroad.

So, while problems could still arise, I would expect that the very slow removal of accommodation reflected in futures market pricing could prove too pessimistic. While it has been appropriate to pause while waiting for information that clarified the response of the U.S. economy to foreign turmoil, it increasingly appears that the U.S. has weathered foreign shocks quite well. As a consequence, if the incoming data continue to show a moderate recovery – as I expect they will – I believe it will likely be appropriate to resume the path of gradual tightening sooner than is implied by financial-market futures.

While I believe that gradual federal funds rate increases are absolutely appropriate, I do not see that the risks are so elevated, nor the outlook so pessimistic, as to justify the exceptionally shallow interest rate path currently reflected in financial futures markets. The forecast for economic variables contained in the most recent Fed policymakers’ Summary of Economic Projections is consistent with my own estimate – GDP growth slightly above potential and a continued slow decline in the unemployment rate.

Furthermore, I would point out that the extremely shallow rate path reflected in the market for federal funds futures seems at odds with forecasts by private sector economists and by financial firms that serve as counterparties to the Federal Reserve (the so-called primary dealers), as well as my own forecast for the U.S. Economy. Most of these forecasts envision a much healthier U.S. economy than is implied by that unusually shallow path of the funds rate, and many of the major private forecasters expect short-term rates to rise more rapidly than implied by financial futures.

My concern is that given these conditions, an interest rate path at the pace embedded in the futures markets could risk an unemployment rate that falls well below the natural rate of unemployment. We are currently at an unemployment rate where such a large, rapid decline in unemployment could be risky, as an overheating economy would eventually produce inflation rising above our 2 percent goal, eventually necessitating a rapid removal of monetary policy accommodation. I would prefer that the Federal Reserve not risk making the mistake of significantly overshooting the full employment level, resulting in the need to rapidly raise interest rates – with potentially disruptive effects and an increased risk of a recession.

If the incoming economic data continue to be consistent with gradual improvement in labor markets and inflation getting closer to target, the Fed should be ready to gradually normalize interest rates, perhaps at a pace not currently anticipated by the federal funds futures market.

In my view, the market remains too pessimistic about the fundamental strength of the U.S. economy, and the likelihood of removing monetary accommodation is higher than is currently priced into financial markets based on current data.

I would say that most of the [tightening] conditions that were laid out in the minutes as of right now seem to be . . . on the verge of broadly being met.I think the Federal Reserve minutes were pretty clear that a number of conditions would be necessary but if those conditions were met it would be appropriate to raise rates. One of the conditions was economic growth picking up in the second quarter. Given that real GDP was only a half a per cent in the first quarter that is a relatively low threshold. If you look at how the data has actually been coming in I was a little surprised that there was not more of a market reaction to the very strong retail sales for April. If you look at the economic forecasters in the private sector most of them have raised their consumption forecasts for the second quarter to be in the range of 3 per cent to 3.5 per cent. When consumption is roughly two-thirds of GDP, a number that high for that major a component means that it is likely we will see growth around 2 per cent.
...
The second condition was labour markets continuing to strengthen. While the payrolls number was a little lower than market expectations it is still consistent with a gradually tightening labour market. 160,000 jobs is well above what we are going to need in order to take into account new workers coming into the labour force. If we were to continue to get 160,000 jobs [a month] it is less than what we were getting in the first quarter of a little bit above 200,000, but it is well above what we need to have a gradual tightening of labour markets.
...
We are still a month away from the actual meeting. We are going to get another employment rate in early June. We are going to get a second retail sales report. So I want to be sensitive to how the data comes in, but I would say that most of the conditions that were laid out in the minutes as of right now seem to be . . . on the verge of broadly being met. We have more data to observe before we actually go into the meeting. If we were to get a lot of weak data between now and when the meeting occurs that would obviously influence how I was seeing the economy. Just focused so far on what we have seen to date since the last FOMC meeting, and broadly all that data has been pretty supportive of the criteria that were laid out in the minutes.

Votes by themselves shouldn’t be a reason for altering monetary policy. If we were experiencing significant changes in financial conditions that made us significantly alter the outlook going
forward that would be something that we should take into account.

But the fact that there happens to be an election or not be an election on a particular date by itself should not be determinative . . . What we care about is we will have data on the second quarter but ideally we want to see the third and fourth quarter making the same kind of progress that we are hopefully going to be seeing in the second quarter and if there were events to alter our expectation for how the economy was going to evolve in the future that we obviously should take into account before we tighten rates.

If there is nothing that is altering our overall forecast for the economy that shouldn’t influence the timing of a decision.

It is quite reasonable that we will get close to the 2 per cent target on the current path that we are on. The economy is improving but at a relatively slow rate. The inflation rate has been improving but at a very slow rate as well. So I think we are on the right path. It is not obvious to me right now that we are necessarily going to overshoot.

But one of the things that I highlighted in that New Hampshire talk is that [there are] both benefits and costs for waiting. The benefits tend to be accruing to the labour market and hopefully getting labour force participation to improve...

But there are also some potential costs. We talked about one, which is financial stability. A second one is that in the past we have tended to overshoot the natural rate of employment and when we overshoot significantly on the natural rate of unemployment it takes a while for the inflationary pressures to pick up but we are not so good at slowing down the economy and getting right at the NAIRU.

So if you look at the unemployment rate curve you tend to blow through the natural rate and when you start tightening you tend to get a recession shading. So it tends to be much more abrupt than we were hoping. Which means we are not like a thermostat where you can easily calibrate the difference between 70 degrees and 68 degrees . . . When we start tightening we tend to get more of a reaction in the economy than we are hoping for.

So it makes me a little tentative to hope we would overshoot significantly, because I am not so sure we are good at fine-tuning the economy. History would say we haven’t. Ideally what you would see is long periods where we are around the estimates of full employment. That is not actually what you see.

That is not my outlook that we will have a big negative shock, but if a big negative shock were to occur we should think about all the possible tools. I think the global experience so far is probably more positive on quantitative easing than on negative interest rates . . . if I were to pick a tool for the United States the first tool would be to lower the short term interest rates, depending on when this shock were to occur. Hopefully we have some latitude to lower short-term rates.

I would think the next tool would probably be to revisit quantitative easing which has proved fairly successful in the US and other parts of the world. And then if that doesn’t work we have to explore a wide variety of other alternatives — there is forward guidance, and obviously negative interest rates have been tried in some countries. The results on negative interest rates to date look to be mixed.

With regard to the use of negative interest rates, I would say the experience in Japan and parts of Europe seems mixed. It will take some time before one can fully assess the overall impact on the Japanese and European economies. But my assessment so far of the effectiveness of the transmission mechanism of negative-rate policy, and of behavioral responses to negative interest rates, make this a tool to use only after other nontraditional monetary policy tools – the “more-conventional unconventional” tools – have been exhausted.

The most comprehensive and complete evaluation of monetary policy tools can take place only after a return to more normal economic conditions and monetary policy. Still, with that caveat, my overall assessment of quantitative easing is that it was quite successfully utilized in the United States. One reason the U.S. is now relatively close to achieving both aspects of the Federal Reserve’s dual mandate from Congress – full employment and price stability (which the Federal Reserve targets at 2 percent inflation) – is the early and forceful use of quantitative easing in the aftermath of the financial crisis.

Given that the labor market contrasts with the pattern in the first quarter, and the pick-up in spending observed so far from other data, it will be important to see whether the weakness in [the May employment] report is an anomaly or reflects a broader slowing in labor markets.