Esther George

“When I think about risks to our economy, in terms of whether Europe goes into a recession, and some have said they may be there now, I worry more about things like financial contagion that could come across,” George said. “You see a lack of confidence. You see characteristics that we saw back in 2008.”

“The most critical issue in addressing TBTF concerns is having policy makers with the resolve to follow through,” George said a speech today in New York. The U.S. must “correct the misaligned incentives and the improper expansion of federal safety net protections that encouraged and enabled institutions to take excessive risks.”

To achieve those goals, George said that regulators must not “view stress tests, other forms of quantitative analysis and models used by macroprudential supervisors as being a substitute or replacement for examiners and onsite supervision.”

Federal Reserve Bank of Kansas City President Esther George said the U.S. banking industry and economy have benefited from having both federal and state supervisors.

“I’ve seen no evidence that other regulatory structures, including single regulator models, fared better in the most recent crisis,” George said today to the Conference of State Bank Supervisors in Savannah, Georgia.

Yes, bankers should serve {as directors of Federal Reserve Banks}. They provide valuable information about the economy, credit conditions and the payments system. There are high standards that apply to Reserve Bank directors, and when an individual no longer meets these standards, the director resigns voluntarily to allow someone who does meet the criteria to serve.

“I was not in favor of doing more. We have done a lot,” said Ms. George, in remarks in Oklahoma City Tuesday.

“When I look at the economy and think what it is that’s holding back demand” and causing unemployment to remain high, “it does not seem like these are factors conducive to more easing.” Cheaper money, she said, might help with getting credit flowing, but “in today’s setting, I can’t see that that’s the issue.

“So adding to it feels to me like compounding the risk.”

The slow nature of this recovery, the limited amount of new lending after more than four years and the continuation of banking issues in some countries may suggest that the [regulatory] actions we took left unresolved problems. In addition, we must consider whether what we are doing is sustainable in the long run or whether it only increases the chance of future crises.

A long period of unusually low interest rates is changing investors’ behavior and is reshaping the products and the asset mix of financial institutions. Investors of all profiles are driven to reach for yield, which can create financial distortions if risk is masked or imperfectly measured, and can encourage risks to concentrate in unexpected corners of the economy and financial system. Companies and financial institutions, such as insurance companies and pension funds, and individual savers who traditionally invest in long-term safe assets, are facing challenges earning reasonable returns, and so they may reach for yield by taking on more risk and reallocating resources to earn higher returns. The push toward increased risk-taking is the intention of such policy, but the longer-term consequences are not well understood.

Of course, identifying financial imbalances, asset bubbles or looming crises is inherently difficult, as policymakers were painfully reminded during the financial crisis in 2008. Public transcripts of the FOMC’s discussions from as early as 2006 show participants were clearly focused on issues in the housing market and yet did not fully appreciate the risk to the economy from the financial sector’s exposure to risky mortgages.

Accordingly, I approach policy decisions with a healthy dose of humility when considering the long-run effects of monetary policy. We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances. Prices of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels. A sharp correction in asset prices could be destabilizing and cause employment to swing away from its full-employment level and inflation to decline to uncomfortably low levels.

Simply stated, financial stability is an essential component in achieving our longer-run goals for employment and stable growth in the economy and warrants our most serious attention.

[A]s we learned from this most recent crisis, emerging risks can be hard to judge and it can be even harder to determine what action should be taken ahead of any obvious or near-term threat. In addition, riskier financial activity can grow outside the regulated sector. For these reasons, asking bank regulators and supervisors, or the newly-tasked monitors of financial stability, to single-handedly identify and contain the risks introduced by a highly accommodative monetary policy is not realistic.

The economy is making progress in recovering from a deep recession. I have acknowledged the important role that low rates must play in supporting this recovery even as I have raised significant concerns about the current stance of zero interest rates for an extended period. Can efforts to speed up the pace of growth with untested monetary policy tools be effective? The FOMC is carefully considering such issues and believes the risks are worth taking. However, our limited understanding of the possible effects of unconventional policy tools causes me to give more weight to their risks and eventual consequences.

In raising these issues, it is not my goal to prematurely withdraw support. It is critical, however, to ensure we transition from a crisis-type policy stance of aggressive easing to one of accommodation that allows markets, households and businesses to begin to normalize their expectations for interest rates. In my view, therefore, we should not underestimate the risk of an extended period of zero interest rates and the accompanying incentives that may lead to future financial imbalances. Such imbalances could unwind in a disruptive manner and cause the labor market recovery to stumble. I am concerned that monetary policy at its current settings is overly accommodative relative to the long and variable lags with which it operates.

Central banks must focus on achieving sustainable growth in the long run and be patient in pursuing its longer-run goals. Attempting to speed up the recovery process creates risks that, if realized, could lead the economy down a more difficult road back to full employment and price stability.

The so-called quantitative easing that has swollen the Fed balance sheet to $3.32 trillion may lead to “complications” as the central bank begins to exit the policy, George said. Risks include a jump in longer-term inflation expectations and a “painful adjustment” for investors when the benchmark interest rate is eventually raised, she said.

“Continuing this current policy outside of the crisis, outside of a recession, poses risks to us in the long term,” George said.

Given these dynamics, and in light of improving economic conditions, I support slowing the pace of asset purchases as an appropriate next step for monetary policy. Moreover, such actions would not constitute an outright tightening of monetary policy, but rather, it would slow policy easing. History suggests that waiting too long to acknowledge the economy’s progress and prepare markets for more-normal policy settings carries no less risk than tightening too soon.

In other words, a slowing in the pace of purchases could be viewed as applying less pressure to the gas pedal, rather than stepping on the brake. Adjustments today can take a measured pace as the economy’s progress unfolds. It would importantly begin to lay the groundwork for a period when markets can prepare to function in a way that is far less dependent on central bank actions and allow them to resume their most essential roles of price discovery and resource allocation.

My own view is that these thresholds should act similar to triggers. So once the [unemployment] rate nears 6.5 percent, markets and the public should expect lift-off of short-term interest rates.

I have been more skeptical than the majority of the Committee that the benefits of continued easing through unconventional policy actions justify the risks, particularly when the economy is growing and financial markets are not under acute stress. While continued accommodative settings for monetary policy are warranted as the recovery proceeds, I continue to support slowing the pace of purchases as the appropriate next step for monetary policy. For example, an appropriate next step toward normalizing monetary policy could be to reduce the pace of purchases from $85 billion to something around $70 billion per month, then have purchases going forward split evenly between Treasury and agency-MBS securities.

“Costly steps had been taken to begin to prepare markets for an adjustment in the pace of asset purchases,” George said today in a New York speech to the Shadow Open Market Committee, a group of economists that critiques Fed policy. “This week’s decision by the Fed to taper expectations and not bond buying surprised many, disappointed some like me.”

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“Signaling future policy and then failing to follow through could erode the policy intent,” George said. “Asking the markets to trust forward guidance is going to require a great deal of credibility,” she said, referring to the Fed’s strategy to guide expectations about future bond purchases and interest-rate increases.

Delaying action not only allows potential costs to grow, it also has the potential to threaten the credibility and the predictability of future monetary policy actions. Policy moves that surprise the market often result in additional volatility. And by deciding that it needs to await further data, the Committee is suggesting its desire to be “data dependent” involves putting more emphasis on the most recent data points, which can be volatile and subject to revision, rather than on its own medium-term view of the economy. Another risk is that markets might misconstrue the postponement of action as reflecting a Committee assessment that the broader economic outlook is substantially weaker, when that is not the case.

Beyond the communication challenges associated with asset purchases, explaining the Committee’s interest rate policy and how long rates will remain near zero will be a crucial next step. To further mitigate risks when the time comes to start raising interest rates, it may be important to signal that increases in the federal funds rate, after liftoff, are likely to be gradual in order to gauge the economy’s response.

It is too easily assumed that financial models, stress tests and macroprudential supervision will provide smarter supervision and identify what is presumed to have been missed by examiners in the run-up to the 2008 financial crisis. However, a more thorough analysis suggests that the largest banks were more vulnerable because regulators relied too heavily on erroneous assumptions about the quality of governance and controls over incentives, sophistication and measurement of risk management, and the strength of market discipline. As a result, regulators had already given up on the type of full-scope examinations that smaller institutions typically experience. Prior to 2008, most of the supervisory emphasis centered on a large institutions models and risk weights, and far less effort was given to a thorough examination and critical analysis of its loan portfolio, funding strategies and exposure to exotic risks such as synthetic derivatives. The Dodd-Frank Act requires enhanced prudential standards for firms in the United States that pose elevated risk to financial stability. These macroprudential efforts are worthy exercises, but no matter the tool, experience and informed judgments provided by trained and experienced staff are required to meet todays heightened supervisory expectations. Data and models provide information and choices that must be evaluated in the context of the more subjective or qualitative elements of the organization, such as the quality of internal controls and protocols, management and organizational culture.

The financial crisis is behind us, thankfully, but not far behind. The image in the rearview mirror is still largeand perhaps closerthan it appears. The Federal Reserves history is important, but it is only helpful to the extent that it positions us to consider how we might address the considerable challenges that await the central bank in the years to come. Those challenges include normalizing monetary policy, effectively supervising the largest financial institutions, and ensuring a safe, efficient and accessible payments system.

An End the Fed demonstration took place outside my office last Saturday on Main Street in Kansas City, Missouri. It was a reminder that democracy demands accountability from its most powerful institutions to its citizens. The Federal Reserve is no exception.

I am skeptical of a clean separation principle that places financial stability squarely in the purview of the supervisors. Instead, I think monetary policymakers also need to maintain a careful eye on the financial system and how interest rate policy affects incentives for financial markets and institutions.

As a result of near-zero interest rates for five years, the profitability of traditional banking activities is strained and incentives to reach for yield are tempting. Net interest margins continue to trend lower and are at their lowest level in 30 years. Banks are responding as we should expect, which is to say they are engaging in riskier activities. For example, an all-time high of $600 billion of leveraged loans were issued in 2013. This lending is often characterized by weaker underwriting standards, including higher debt ratios and fewer covenant provisions.

The incentives to reach for yield extend to smaller financial institutions as well. Commercial banks with assets of less than $50 billion have increased exposure to interest rate risk, due in part to the guidance the FOMC has provided regarding future interest rates. Today, 53 percent of the securities and loans held by these banks have maturities of more than three years, compared to about 37 percent back in 2005. If longer-term interest rates were to suddenly move higher, these institutions could face heavy losses.

I would like to see short-term interest rates move higher in response to improving economic conditions shortly after completion of the taper. Many of the rules offering policy guidance on the federal funds rate such as the Taylor rule and its variants are already or close to prescribing a policy rate higher than the current funds rate. Second, the path toward the longer-term neutral funds should be gradual. Given the lengthy period of unconventional policy and low rates, the necessary adjustment by financial markets to less central bank intervention and influence could be volatile. In this environment, the pressure to quickly back away from a rising rate policy will be significant; such pressures will need to be resisted. If not, we risk moving into a confusing stop-and-go policy environment.

In terms of the path after liftoff, the FOMC has signaled that it will take a gradual approach toward the longer-run funds rate... So, the funds rate could reach its longer-run level well after the economic recovery is complete and inflation has returned to the 2 percent goal. These signals suggest to banks that they will continue to contend with a low interest rate environment for a few years, even as economic conditions are likely to improve. I see this as a set of conditions ripe for greater risk-taking as firms reach for yield and the imbalances related to such incentives grow.

Gradualism can promote financial stability, as it reduces the incidence of unexpected shifts in interest rates. Even so, the degree of inertia suggested in the median path of the federal funds rate in the FOMCs Summary of Economic Projections goes beyond what is required to achieve a smooth exit. In my view, it will likely be appropriate to raise the federal funds rate at a somewhat faster pace than the median of committee members projections. Low rates into late 2016 will likely continue to provide incentives for financial markets and investors to reach for yield in an economy operating at full capacity and risks achieving our objectives over the longer run.

I would also note that a number of central banks did engage in a form of macroprudential supervision before the crisis through their Financial Stability Reports. Overall, these reports show that potential risks were identified before the crisis, but it was far more difficult for central banks to judge whether these risks would be fully realized and to then pursue corrective supervisory action in an effective and timely manner. Until we better understand how to utilize such tools, macroprudential supervision and the identification of systemic risk can be most effective when it serves as a complement to a rigorous microprudential regime. Assessing risk-management policies and governance offers a window into the incentives that drive decision-making and risk appetite at the level of an individual firm, providing important context for macro views of the system.

My concern is that keeping rates very low into late 2016 will continue to incentivize financial markets and investors to reach for yield in an economy operating at full capacity, posing risks to achieving sustainable growth over the longer run.

Like skiers, our ability to anticipate what is likely to be around the next turn will make the difference between a smooth run down the mountain or an unpleasant spill.

Despite these issues, I think a return to more-normal economic conditions is on the horizon. At the same time, we must remember normal is a range, and the economy will look different this time around compared to other recoveries.

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Cutting rates is easy when economic activity is slowing and inflation falling, but raising rates can be more difficult as the economy strengthens. This is especially true if the signals of sustainable growth are not entirely clear cut. While some have argued the aggressive easing actions taken during the crisis required courage, both from a policy and political standpoint, I expect the normalization phase will require a great deal more.

For that reason, I believe community banks have a vested interest in seeing that regulatory reforms move ahead to ensure that the largest banks are well capitalized, well supervised, well managed and subject to failure. Achieving that end will serve the public well. While that work is underway, regulators must also allow examiner judgment and common sense to play a greater role in their supervisory regimes for community banks.

I'm often told that the world has become more complicated, that we have too many banks in the U.S. and that we cannot go back to less-complex and more-straightforward regulation and rules and greater supervisory judgment. I'm not convinced. One of the best responses to that assertion was from Sir Mervyn King, the former governor of the Bank of England. Although his reference was made in the context of finding a solution to the issue of too big to fail, the same might be said for addressing the regulatory environment more generally. He said, There are those who claim that such proposals are impractical. It is hard to see why. What does seem impractical, however, are the current arrangements.

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

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

Taken together, the economic data generally point to an economy that is moving in the right direction and has consistently sustained growth over the past five years. This is not to say the economy is issue-free… Unfortunately, although we might wish it so, monetary policy is not the proper tool to address all of these issues. The aggressive monetary actions over the past few years were intended to support economic activity, help labor markets heal and move inflation toward the Fed’s target. I view the considerable progress in labor markets and the relatively steady inflation rate as encouraging. However, keeping interest rates near zero to achieve still further progress toward labor market improvement and higher inflation is risky in my view. In a protracted period of exceptionally low rates, investors seeking out higher returns are willing to take on more risk or seek out more creative financing approaches. When the economy is expanding and rates remain low, adverse events may appear less likely or far into the future, potentially resulting in the mispricing of risk and financial assets. Waiting too long to adjust rates, as we’ve seen in the past, can leave policymakers with few and possibly poor options. … The FOMC has been talking about its exit strategy since 2011. And since March of this year, the Committee has been emphasizing that a decision to raise interest rates would be data dependent. In other words, economic data that confirms further gains in the economy’s performance will drive the timing of the Committee’s actions. So, why hasn’t the FOMC yet raised rates? There are of course different views on the economic data we receive and analyze that lead to legitimate, differing views about what is best for the economy… The continued improvement in the labor market, combined with low and stable inflation, convince me that modestly higher short-term interest rates are appropriate. Current guideposts, or “policy rules,” often used to inform monetary policy decisions also have been signaling that interest rates should be higher. I recognize that a rate increase, however, would be the first one in nearly a decade. So I am not suggesting rates should be normalized quickly or that policy should be tight. Although the economy has improved, economic fundamentals could well mean an accommodative stance of policy is appropriate for some time. I would like to avoid the cost of waiting for more evidence and further postponing liftoff, drawing on a valuable lesson from monetary policy decisions in 2003.

“A 25-basis-point increase in the fed-funds rate should not have an adverse effect on the economy” given the growth that has happened, and is likely to happen in the future, Ms. George said. She explained that while inflation has been short of the Fed’s 2% price target it has been weak largely on temporary factors related to oil and the strength of the dollar.

Ms. George said Fed officials have to be forward looking and start moving rates higher before inflation takes off, because price dynamics can change quickly and force a more aggressive and potentially disruptive response from policy makers.

“You have to have some dose of courage” in your forecast and be willing to act, even when the future is uncertain, Ms. George said.

In my own view, the normalization process needs to begin and the economy is performing in a way that I think it is prepared to take that.

"I think the conditions are there" for the Fed to begin to lift rates from near zero, George said in Omaha, Nebraska at the Aksarben Stock Show and Rodeo. "Waiting for perfect conditions is not a realistic approach to making decisions about interest rates ... You cannot afford to get into a state of paralysis around looking for data that might continue to reassure you. So when conditions warrant, as I believe they do today, I think interest rates need to adjust."

I’m encouraged by the recent progress that we’ve made with the current effort [to improve our national payment system], and it is my own conviction that the prospects for achieving the goals we’ve set out are best realized by working together. The organizers of this conference used the right word in naming it. It is imperative that we modernize the payments system, and also that the Federal Reserve and the industry join together in this effort.

When we balance out for the year as a whole, we are continuing on a trajectory of trend growth in this country.

Federal Reserve Bank of Kansas City President Esther George said recent financial-market turmoil should not have been surprising and is no reason to delay further interest-rate increases.

“While taking a signal from such volatility is warranted, monetary policy cannot respond to every blip in financial markets,” George, who votes on policy this year, said in prepared remarks in Kansas City, Missouri. “The recent bout of volatility is not all that unexpected, nor necessarily worrisome, given that the Fed’s low interest rate and bond-buying policies focused on boosting asset prices as a means of stimulating the real economy.”

While I view the gradual approach as appropriate, postponing the removal of accommodation when the economy is near full employment and inflation is rising toward the 2 percent target could promote alternative risks that would decrease the likelihood of achieving our longer-run objectives. In the long run, a failure to keep interest rate policy in line with improving fundamentals can distort the allocation of capital toward less fruitful—or perhaps excessively risky—endeavors. Within the last two decades we have faced episodes of accelerating equity prices, housing prices and, most recently, commodity prices. Currently, commercial real estate markets, where prices have continued to drift higher, bear watching. When these types of imbalances tip, the entire economy can face the consequences of their fallout, with some sectors and populations more impacted than others. My concern for some time has been that extending monetary policy too far beyond its scope of capability risks undesirable financial, economic and
political distortions.

In the current environment, waiting to make additional adjustments to monetarypolicy may seem costless in the face of benign inflation pressures. Some argue that we have the ability to make more rapid adjustments later if inflation moves higher than currently projected. From a technical standpoint, it is true that the Fed has the ability to steer short-term rates and could raise them quickly if needed. But such actions are likely to be costly, inducing financial market volatility and slowing economic activity. Historically, rapid increases in interest rates end poorly, resulting in economic recessions.

I support a gradual adjustment of short-term interest rates toward a more normal level, but I view the current level as too low for today’s economic conditions. The economy is at or near full employment and inflation is close to the FOMC’s target of 2 percent, yet short-term interest rates remain near historic lows. Just as raising rates too quickly can slow the economy and push inflation to undesirably low levels, keeping rates too low can also create risks. Interest-sensitive sectors can take on too much debt in response to low rates and grow quickly, then unwind in ways that are disruptive. We witnessed this during both the housing crisis and the current adjustments in the energy sector. Because monetary policy has a powerful effect on financial conditions, it can give rise to imbalances or capital misallocation that negatively affects longer-run growth. Accordingly, I favor taking additional steps in the normalization process.