Frederic Mishkin

The Federal Reserve’s monetary policy actions under Alan Greenspan have probably also been quite consistent with what would have been done under an inflation-targeting regime. Furthermore, as I have pointed out elsewhere (Mishkin, 2000), the United States has a nominal anchor that has been very effective in recent years—it is Alan Greenspan. Thus it is not at all clear that adoption of inflation targeting in the United States would have improved recent monetary policy performance. However, there is still a strong argument for adoption of inflation targeting by the United States. No matter how good a nominal anchor Alan Greenspan is, he won’t be around forever.

The analysis in our study suggests that although Iceland's economy does have some imbalances that will eventually be reversed, financial fragility is currently not a problem, and the likelihood of a financial meltdown is low.

The most important indicator of the success of a central bank is the performance of inflation itself; for that variable, a central bank must, over the long term, be held accountable.

The way I look at the forecast and the situation with the economy is quite positive in the sense that what we’re seeing, really, is a return to normalcy and a more balanced economy. The excesses in the housing sector seem to be unwinding in an acceptable way, so I think it is quite reasonable in terms of the Greenbook forecast to think that the spillover here is not going to be a big problem because we’re actually moving resources from a sector that had too much going into it, into sectors that need to have more resources at the present time. So in that sense, I’m actually quite positive.

[C]entral bank transparency can go too far if it complicates communication with the public. Announcing a policy path may confuse the public if it does not sufficiently convey that the path is conditional on events in the economy. The public may then see a deviation from this path as a central bank failure, and the central bank would then be vulnerable to attacks that it is flip flopping which could undermine the support for its independence and focus on price stability. This objection does not mean that providing information about the future policy path in some form has no value. It does mean that there are nuances as to how this could be done. Providing information about the future policy path in more general terms or in terms of fan charts that emphasize the uncertainty about the future policy path might achieve most of the benefits of increased disclosure and still make clear how conditional the policy path is on future events.

The central banks in New Zealand, Colombia, and most recently Norway have been announcing projections of their policy path for future interest rates. Publication of forecasts and policy projections can help the public and the markets understand central bank actions, thus decreasing uncertainty and making it easier for the public and markets to assess whether the central bank is serious about achieving its inflation goal.

Although economic globalization has come a long way, in one particular dimension--finance--it is very far from complete...

We have seen that the repression of the financial system is a great obstacle to economic growth and the reduction of poverty in poorer countries...

Government is often the primary source of financial repression in developing countries. Strong property rights, a crucial element in financial development, severely constrain a government's ability to expropriate land, factories, or ideas whenever it wants to profit from them.

Another key issue is that we need to greatly improve the quality of the written documents that go with this process. The current Monetary Policy Report is really terrible. It’s dull; it’s sex made boring. I don’t want to criticize too much, but it is. ... If it were a textbook, and I can tell you I know a lot about this, you wouldn’t sell one copy. [Laughter] So it’s a problem.

In fact, I think we’re seeing the economy evolve very much along the lines that we discussed at the past couple of meetings...I think there’s a smidgen more weakness on the real side, but it doesn’t alter my basic view that the economy is evolving along the lines of having slightly below potential GDP growth. I don’t see any indications that we will have big spillovers into other sectors from weak housing and motor vehicles. In that sense, there’s a slight concern about a little weakness, but the right word is I guess a “smidgen,” not a whole lot.

[T]here is a further reason why I believe that a central bank should not put too much focus on asset prices. Such a focus can weaken its public support, making it harder for it to successfully conduct monetary policy to stabilize inflation and employment.

A central bank that focuses intently on asset prices looks as if it is trying to control too many elements of the economy. Part of the recent successes of central banks throughout the world has been that they have narrowed their focus and have more actively communicated what they can and cannot do. Specifically, central banks have argued that they are less capable of controlling real economic trends in the long run and should therefore focus more on price stability and damping short-term economic fluctuations. By narrowing their focus, central banks in recent years have been able to increase public support for their independence. A central bank that expanded its focus to asset prices could potentially weaken its public support and may even cause the public to worry that it is too powerful and has undue influence over all aspects of the economy.

A special role for asset prices in the conduct of monetary policy requires three key assumptions. First, one must assume that a central bank can identify a bubble in progress... A second assumption needed to justify a special role for asset prices is that monetary policy cannot appropriately deal with the consequences of a burst bubble, and so preemptive actions against a bubble are needed... A third assumption needed to justify a special focus on asset prices in the conduct of monetary policy is that a central bank actually knows the appropriate monetary policy to deflate a bubble Because I doubt that any of the three assumptions needed to justify a special monetary policy focus on asset prices holds up, I am in the camp of those who argue that monetary policy makers should restrict their efforts to achieving their dual mandate of stabilizing inflation and employment and should not alter policy to have preemptive effects on asset prices.

Mishkin earlier told the audience that the current yield curve inversion "is not signalling a recession."

     "When you look at the yield curve it does have potential information," he said, but one needs to remove the unusually low "term premium" and then compare long-and short-term rates. That comparison "does not tell you there is a recession."

From Q&A session, as reported by Market News 

Despite the favorable results attained by inflation-targeting countries over time, our evidence generally does not suggest that countries that adopt inflation targeting have improved their monetary policy performance beyond that of our control group of nontargeters, all of which are industrial countries with a successful monetary policy...

Nevertheless, the adoption of inflation targeting can have advantages even for industrial countries. Industrialized countries that have not adopted inflation targeting face four problems (see Bernanke and others, 1999; Mishkin, 2005). First, the strong nominal anchor that produced a successful monetary policy is often based on individuals, and their replacements may not be strongly committed to the nominal anchor. Second, the focus on the long run exhibited by successful nontargeters may weaken in the future. Third, the lack of transparency about the goals of monetary policy increases uncertainty. Fourth, the lack of accountability in the absence of inflation targeting could undermine central bank independence in the future, thereby weakening the nominal anchor.  Inflation targeting has the potential to ensure that the successful monetary policy performance of our control group of industrial nontargeters in recent years continues in the future.

[T]he data suggest to me that long-run inflation expectations are currently around 2 percent.  That said, I think it should be clear that the evidence points to a range of estimates; moreover, this range is itself uncertain because of the assumptions needed to tease point estimates from the available data.  So, although I think that 2 percent is a reasonable estimate of current long-run expectations, I don’t want to overstate the precision of this figure.  We still face some uncertainty in this regard, and policymakers must be cautious about placing too much confidence in any one estimate.  

The evidence from these so-called autoregressions with U.S. data suggests that inflation may have grown less persistent over time...  Finally, it’s worth noting that this is not just a U.S. phenomenon, as some studies have found similar results for a number of other countries.

In other words, the evidence suggests that the Phillips curve has flattened.

The finding that inflation is less responsive to the unemployment gap, if taken at face value, suggests that fluctuations in resource utilization will have smaller implications for inflation than used to be the case. From the point of view of policymakers, this development is a two-edged sword: On the plus side, it implies that an overheating economy will tend to generate a smaller increase in inflation. On the negative side, however, a flatter Phillips curve also implies that a given increase in inflation will be more costly to wring out of the system. We can quantify this latter consideration using the so-called sacrifice ratio--the number of years that unemployment has to be 1.0 percentage point greater than its natural rate to reduce the inflation rate 1.0 percentage point. Averaging estimates obtained from a comprehensive battery of equation specifications suggests that the sacrifice ratio may be 40 percent larger--that is, it may be 40 percent more costly to reduce inflation than it was two decades ago.

In contrast, unpublished empirical work by the staff at the Federal Reserve Board suggests that, once we take the rising share of imports into account, the influence of import prices on core inflation in the United States has not changed much in the context of reduced-form forecasting models.⁶ At the same time, the influence of exchange rate movements on import prices--the so-called pass-through effect--may have fallen substantially, at least according to some studies.

Anchoring of inflation expectations is not a deus ex machina. It must come from somewhere, and since Milton Friedman’s adage that “[i]nflation is always and everywhere a monetary phenomenon” is still true, monetary policy must be the source of the change in the evolution of long-run inflation expectations.

On the other hand, as Christy and David Romer (2002) have pointed out, the Federal Reserve in the 1970s overestimated the cost of reducing inflation because estimates of sacrifice ratios by Arthur Okun and other economists at that time proved to be too high.¹² As a historical note, this provides one explanation for the Federal Reserve’s tolerance of such high inflation at the time. The disinflation after October 1979, carried out by the Federal Reserve under the leadership of Paul Volcker using words, procedures, and actions that were a sharp break from the past, produced a much lower cost of disinflation than policymakers had anticipated during the 1970s.

If long-run expectations are in fact about 2 percent, where is actual inflation likely to be headed in the next year or two? While recognizing how embarrassingly wrong such prognostications often turn out to be, I think that we can be reasonably optimistic that core PCE inflation will gradually drift down from its latest twelve-month reading of 2-1/4 percent...

Looking to the medium term, I am less optimistic about the prospects for core PCE inflation to move much below 2 percent in the absence of a determined effort by monetary policy. For the most part, this assessment--which I should stress is subject to considerable uncertainty--flows from my view that long-term expectations appear to be well anchored at a level not very far below the current rate of inflation. If so, a substantial further decline in inflation would require a shift in expectations, and such a shift could be difficult and time consuming to bring about, as I noted earlier.

Unforeseen shocks to the economy--an adverse supply shock, for example--might lead to inflation that is temporarily above levels consistent with price stability at the same time that employment is growing more slowly than its maximum sustainable pace. In such a situation, returning inflation too quickly to levels consistent with price stability might unnecessarily exacerbate the economic weakness. Instead, while restoring price stability remains critical, the central bank should do so at a pace that does not do undue harm to the economy.

Finally, central banks should respond aggressively to output and employment fluctuations on those (hopefully rare) occasions when the economy is very far below any reasonable measure of its potential. In this case, errors in measuring potential output or the natural rate of unemployment are likely to be swamped by the large magnitude of resource gaps, so it is far clearer that expansionary policy is appropriate. Furthermore, taking such actions need not threaten the central bank's credibility in its pursuit of price stability.

``The inflation rate is higher than what I would like to see,'' Mishkin said in response to a question following a speech today in Bridgewater, Virginia. While it's likely that price gains will moderate, he warned that ``if we don't see that happening, we would have to do something about it.'' 

From audience Q&A, as reported by Bloomberg News

"The inflation rate is higher than what I would like to see," Mishkin said in response to a question following a speech today in Bridgewater, Virginia.  While it's likely that price gains will moderate, he warned that "if we don't see that happening, we would have to do something about it."

As reported by Bloomberg News

In particular, over the past few decades the natural unemployment rate and the path of potential output have apparently moved around quite substantially. If we do not recognize the potential for such shifts, they can pose serious pitfalls for the conduct of monetary policy...

To be sure, central banks need to form some views about the economy's potential to produce on a sustained basis. After all, as I have already noted, the amount of slack in the economy is a key determinant of inflation. But, rather than focusing on fixed estimates of potential output or the natural rate of unemployment, central banks should take an eclectic approach in assessing the overall balance of economic activity relative to productive capacity. In other words, in pursuing the dual mandate, the central bank should recognize that a wide variety of indicators drawn from labor, product, and financial markets provide information about the overall balance of supply and demand in the economy. In addition, central banks should use information from various price indicators to tell them whether the economy is overheating or running well below productive capacity.

The best way to achieve the mandate is for the Federal Reserve to have a strong commitment to a nominal anchor to promote price stability, but with a focus on keeping employment as close as possible to its maximum sustainable level.  

Given my estimate of the current level of long-run inflation expectations as well as the likelihood of some easing of resource pressures in labor and product markets, I expect that core inflation will slow to around 2 percent over the next couple of years.    

More recently, developments in the subprime mortgage market have raised some additional concern about near-term prospects for the housing sector. The sharp rise in delinquencies on variable-interest-rate loans to subprime borrowers and the exit of a number of subprime lenders from the market have led to tighter terms and standards on such loans. While these problems have caused undeniable hardship for many families and communities, spillovers to other segments of the mortgage market or to financial markets in general appear to have been minimal. Variable-interest-rate loans to subprime borrowers account for a bit less than 10 percent of all mortgages outstanding, and at this point the expected losses are relatively small. Moreover, because most subprime mortgages are securitized, the risks associated with these loans are spread widely. Banks and thrift institutions that hold mortgages are well-capitalized, and exposures of individual banks to possible subprime losses do not appear to be large. On the whole, some borrowers may find credit more difficult to obtain, but most borrowers are not likely to face a serious credit constraint.

The second major area of concern in the near-term outlook, and one that perhaps could pose noticeable downside risks, is business investment. Real outlays for new equipment and software weakened in the final quarter of 2006, and the recent data on orders and shipments of nondefense capital goods suggest that the softness in demand has extended into early this year. Part of the weakness can be clearly traced to a decline in demand for investment goods that are used heavily in residential construction. In addition, demand for goods used by the motor vehicle industry also has softened of late. But, demand for other types of non-high-tech business equipment also appears to have slowed recently, raising more fundamental questions about business views on the current and prospective environment for capital spending.

My forecast of a gradual slowing in inflation reflects my view that making further progress in lowering inflation is desirable. Although I expect that core inflation will drift down, I recognize that achieving further reductions in inflation may take time. In the near term, the recent rebound in prices for gasoline and other petroleum-based goods is likely to put upward pressure on the costs of many non-energy goods and services.

More fundamentally, I believe that long-run inflation expectations remain a key determinant of the path of inflation. But what are the current expectations for long-term inflation? Unfortunately, that is not an easy question to answer. The results from the Survey of Professional Forecasters, readings on household opinion such as the Reuters/Michigan survey, and the spread between standard Treasury securities and Treasury inflation-protected securities--taken together--suggest that long-term inflation expectations are currently around 2 percent, although this guess is far from certain.

Given my estimate of the current level of long-run inflation expectations as well as the likelihood of some easing of resource pressures in labor and product markets, I expect that core inflation will slow to around 2 percent over the next couple of years. Although I believe that inflation expectations will play a primary role in determining the course of inflation, I want to emphasize that neither economists nor policymakers understand the expectations-formation process very well.

Demand for high-tech equipment appears to have picked up early this year after leveling off in the final quarter of 2006. Demand for computers, which was likely boosted by the introduction of the Windows Vista operating system, seems to be advancing at a healthy pace.

Globalizing the domestic financial system by opening financial markets to foreigners encourages financial development and growth in wealth in two ways.  First, opening financial markets to foreign capital directly increases access to capital and lowers its cost for those with productive investments to make.  ....  [The] second benefit of financial globalization:  Opening markets to foreign financial institutions promotes reforms to the financial system that improve its functioning.     

[T]he level of output relative to potential output, which is referred to as the output gap, plays an important role in the inflation process.  When the actual level of output is above potential output--so that the output gap is positive--labor and product markets are excessively tight; then, if things such as expected inflation and temporary supply factors are held constant, inflation will tend to rise.  Conversely, when the output gap is negative and labor and product markets are slack, inflation will tend to fall. 

Indeed, many economists criticize the Phillips curve, with some even declaring it dead.⁶ 

For example, the estimates of Staiger, Stock, and Watson (1997a and b) of the 95 percent confidence interval for the NAIRU were as much as 3 percentage points wide.    Thus estimates of the NAIRU, in isolation, provide policymakers with little real-time insight for assessing the effect of labor markets on inflation pressures.

For better or worse, we cannot escape the need for information on output gaps so that we can forecast the future path of inflation and evaluate the current setting of our monetary policy instruments.  However, we also need to recognize that because measures of potential output and output gaps are so uncertain, we must always be aware that they might be providing misleading signals as to the future course of inflation and the appropriateness of the stance of policy.  In assessing whether there is slack in the economy, we at central banks look not only at our estimates of output gaps but also at a wide range of indicators drawn from the labor, product, and financial markets to provide us with a perspective on the balance of supply and demand in the economy...

The bottom line is that we must never take our eye off of the inflation ball. 

More complex pricing and continuous change in the marketplace make the task of writing rules for effective disclosure challenging. Nevertheless, the combination of extensive review, substantial public input, and systematic consumer testing has enabled us to propose changes that we believe will further the original goals of the Truth in Lending Act to promote economic stability and competition through the informed use of credit.

Large run-ups in asset prices present serious challenges to central bankers. The analysis of the role of housing in the monetary transmission mechanism argues against a special role for house prices in the conduct of monetary policy and in favor of a policy response to them only to the extent that they have foreseeable effects on inflation and employment. Nevertheless, central banks can take measures to prepare for possible sharp reversals in the prices of homes or other assets to ensure that they will not do serious harm to the economy.   

Recently, we have watched the deterioration in financial conditions extend beyond the subprime market.  Investors appear to have reassessed their outlook and their tolerance for risk, especially for structured financial products and for securities of highly leveraged firms.  Bond spreads--especially those for speculative-grade debt--widened substantially in June and July, and the volatility of equity prices increased as well.  In mid-August, following several events that led investors to believe that credit risks might be larger and more pervasive than previously thought, the functioning of financial markets, including short-term and interbank funding markets, became increasingly impaired.  Notably, many asset-backed commercial paper programs found rolling over their paper increasingly difficult.  To help restore orderly conditions, the Federal Reserve in recent weeks has increased the provision of reserves, cut the discount rate, and changed its usual discount-window lending practices in order to facilitate term borrowing, together with other measures. 

As best we can tell thus far, the imprint of these developments on economic activity appears likely to be most pronounced in the housing sector.  However, economic activity could be affected more severely in other sectors should heightened uncertainty lead to a broader pullback in household and business spending.  That scenario cannot, in my view, be ruled out, and I believe it poses an important downside risk to economic activity.

However, as has been the case in previous instances of rapid financial innovations, adequate mechanisms to control excessive risk-taking may not have been in place during the subprime market’s greatest growth.  One innovation, further development of securitized products, gave mortgage lenders greater access to the capital markets and spread risks more broadly.  However, securitization also widened the separation of the originators from the ultimate holders of the loans--that is, those who bought securities backed by loans.  In this setup, a classic principal-agent problem can arise if originators (the agents) do not have a sufficient incentive to shield the owners of the securities (the principals) from suffering higher-than-expected losses. 

As I look at the incoming inflation data, I would judge them to be consistent with expectations in this range; moreover, I believe that having expectations reasonably well anchored in this range has been a helpful influence on the path of actual inflation.  However, let me be clear: I do not subscribe to a deus ex machina view of the inflation process, in which inflation is driven solely by inflation expectations and is little influenced by the balance of aggregate demand and aggregate supply.  Indeed, I take the view that expectations of future resource utilization are also an important factor affecting inflation outcomes.

If households and businesses believe that the Federal Reserve will set monetary policy in a way that keeps aggregate demand in reasonable alignment with aggregate supply over time, then expectations of future resource utilization will be stable, and current resource utilization will provide less information about future inflation movements.  In that situation, which I believe describes the current environment, inflation expectations will be a key driver of inflation dynamics.

In the second quarter, however, demand for these other types of equipment bounced back strongly, and the gains were extended in July--as reported in the most recent data on orders and shipments of capital goods.  

We have no direct readings on capital spending in August, but the limited indicators currently in hand--such as the Institute for Supply Management’s survey of purchasing managers--have held up reasonably well and remain at levels consistent with modest growth in manufacturing production and business investment. 

I will review the progress that the science of monetary policy has made over recent decades. In my view, this progress has significantly expanded the degree to which the practice of monetary policy reflects the application of a core set of "scientific" principles. Does this progress mean that, as Keynes put it, monetary policy will become as boring as dentistryi.e., that policy will be reduced to the routine application of core principles, much like filling cavities?¹ I will argue that there remains, and will likely always remain, elements of art in the conduct of monetary policy; in other words, substantial judgment will always be needed to achieve desirable outcomes on both the inflation and employment fronts.

The answer is that Fed Chairman Greenspan guessed correctly that something unusual was going on with productivity. For example, he was hearing from businesspeople that new information technologies were transforming their businesses, making it easier for them to raise productivity. He was also a big fan of the historical work by Paul David (1990), which suggested that new technological innovations often took years to produce accelerations in productivity in the overall economy (Meyer, 2004). Chairman Greenspan was led to the conclusion that the trend in productivity growth was accelerating, a conclusion that the Board staff's forecast did not come to fully accept until late 1999 (Svensson and Tetlow, 2005). Moreover, he appeared to be convinced that the acceleration in productivity would cap inflationary pressures, implying that inflation would not accelerate even with rapid economic growth. His view prevailed in the FOMC (Meyer, 2004).

Financial Headwinds in the Early 1990s... 

[C]apital shortfalls meant that banks had to either raise new capital or restrict their asset growth by cutting back on lending. Because of their weak condition, banks could not raise much new capital, so they chose the latter course. The resulting slowdown in the growth of credit was unprecedented in the post-World War II era (Reifschneider, Stockton, and Wilcox, 1997). Because banks have informational advantages in making certain loans (e.g., Mishkin, 2007a), many bank-dependent borrowers could no longer get access to financing and thus had to cut back on their spending.

Active, and sometimes bitter, debates about which modeling approaches are the right ones are ongoing in macroeconomics, and there often is not a consensus on the best model. As a result, central banks must express some degree of humility regarding their knowledge of the structural relationships that determine activity and prices. This humility is readily apparent in the practice at central banks, which involves looking at many different modelsstructural, reduced-form, general equilibrium and partial equilibrium, and continually using judgment to decide which models are most informative.

The most severe business cycle downturns are always associated with financial instability, not only in advanced countries but also in emerging-market countries.... Minimizing output fluctuations thus requires that monetary policy factors in the impact of financial frictions on economic activity.

As reported by MarketNews.

In a democracy, the public exercises control over government actions, and policymakers are accountable, which requires that the goals of monetary policy be set by the elected government. Although basic democratic principles argue for the government setting the goals of monetary policy, the question of whether it should set goals for the short-run or intermediate-run is more controversial. For example, an arrangement in which the government set a short-run inflation or exchange rate target that was changed every month or every quarter could easily lead to a serious time-inconsistency problem in which short-run objectives would dominate...

 Whether the central bank or the government should set medium-term inflation targets is therefore an open question.

This conclusion came to be known as the "Taylor principle" (Woodford, 2001) and can be described most simply by saying that stabilizing monetary policy must raise the nominal interest rate by more than the rise in inflation. In other words, inflation will remain under control only if real interest rates rise in response to a rise in inflation. Although, the Taylor principle now seems pretty obvious, estimates of Taylor rules, such as those by Clarida, Gali, and Gertler (1998), indicate that during the late 1960s and 1970s many central banks, including the Federal Reserve, violated the Taylor principle, resulting in the "Great Inflation" that so many countries experienced during this period

Indeed, the management of expectations about future policy has become a central element of monetary theory, as emphasized in the recent synthesis of Michael Woodford (2003).

Over time, this research, as well as Friedman's predictions that expansionary monetary policy in the 1960s would lead to high inflation and high interest rates (Friedman, 1968), had a major impact on the economics profession, with almost all economists eventually coming to agree with the Friedman's famous adage, "Inflation is always and everywhere a monetary phenomenon" (Friedman 1963, p. 17), as long as inflation is referring to a sustained increase in the price level (e.g., Mishkin, 2007a).

General agreement with Friedman's adage did not mean that all economists subscribed to the view that the money growth was the most informative piece of information about inflation, but rather that the ultimate source of inflation was overly expansionary monetary policy. In particular, an important imprint of this line of thought was that central bankers came to recognize that keeping inflation under control was their responsibility.

The scientific principle that financial frictions matter to economic fluctuations has led to increased attention at central banks to concerns about financial stability. Many central banks now publish so-called Financial Stability reports, which examine vulnerabilities to the financial system that could have negative consequences for economic activity in the future.

Tighter monetary policy and a commitment to price stability by central banks throughout the world have led to lower inflation and an anchoring of inflation expectations.  These policies have had huge benefits--not only the achievement of low and stable inflation but also an improvement in the overall performance of the economy. ...  Globalization, however, may have helped reduce inflation in more-subtle ways.  By fostering increased interactions among central banks, academics, and the public in many different countries, globalization has helped spread a common culture that stresses the benefits of achieving price stability.  The resulting increased focus on price stability has been a key reason for the reduction of inflation worldwide.   

When a systemic financial crisis occurs, the emergency lender's most crucial task is to restore confidence in the financial system...  Speed is critical. Experience shows that the faster the lending, the lower the amount of lending necessary.³

To illustrate the benefits of acting quickly, I will use a canonical example, the Federal Reserve's operations in the aftermath of the stock market crash in October 1987. What is remarkable about this episode is that the Federal Reserve did not need to lend directly to the banks to encourage them to lend to the securities firms that needed funds to clear their customers' accounts. ecause the Federal Reserve acted promptly (within a day) and reassured banks that the financial system would not seize up, banks knew that lending to securities firms would be profitable. They saw that making these loans immediately was in their interest, even if they did not borrow from the Federal Reserve. anks thus began lending freely to securities firms, and, as a result, confidence was restored and the fear of crisis diminished almost immediately. The Federal Reserve did not have to increase its lending to the banking system at all, and the actual amount of liquidity that it injected into the banking system through open-market operations in the immediate aftermath of the crash was around $12 billion, which at the time was notable but not exceptional. And the Federal Reserve was able to remove this liquidity almost immediately, within weeks of the crash.

For emerging-market economies, the most prominent international institution to act as a lender of last resort has been the International Monetary Fund (IMF). However, demand for IMF lending has dropped more than 80 percent since 2005 as emergency lending has almost ceased and most borrowers have repaid their loans. Such developments have led some to speculate that an international lender of last resort is no longer needed.  

However, it would be naïve to think that we will never again see situations where an international lender will be indispensable.  

``Clearly the exchange rate is a sort of asset price, and this can have important effects on the aggregate demand in an economy.''  

``What happens to the exchange rate is going to tell you about something that's going to happen to net exports.'' ...

In general, the exchange rate is ``something that you do want to pay attention to,'' though, as with other asset prices, not ``over and above'' other issues, Mishkin said.

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

Note:  prepared text is identical to Mishkin's September 21 speech.

The Federal Reserve, for example, pays particular attention to the rate of growth of the core personal consumption expenditure (PCE) deflator, which excludes food and energy prices.  Indeed, in the presentation of its twice yearly Monetary Policy Report to the Congress, the Federal Reserve Board reports the projections of Federal Open Market Committee participants regarding core PCE inflation, not headline inflation, the latter of which includes all items in the price index.  Here in Canada, unlike in the United States, the central bank maintains an explicit inflation target.  The Bank of Canada states its target in terms of the headline consumer price index, and although this choice of inflation measure contrasts with the Federal Reserve's preferred index, the difference is not nearly as great as it appears on the surface.  In fact, the Bank of Canada monitors a number of inflation measures and uses core inflation as an "operational guide" in coming to its monetary policy decisions and discussing these decisions with the public. 

[R]ecent research done at the Federal Reserve Bank of New York on U.S. data finds that no one particular core measure, including the standard one, dominates the others:  The relative performance of different core measures varies depending on the choice of the price index, the sample period, and the criteria for evaluating their performance (Rich and Steindel, 2007).  Research on Canadian and U.K. data comes to similar conclusions (Hogan, Johnson, and Laflèche, 2001; Mankikar and Paisley, 2002).

Does the lack of empirical support for any one particular type of core measure suggest that our focus on the standard core measure should be abandoned?   I think not.  The simplicity and long history of the standard core measure that excludes food and energy gives it several major advantages.  Its simplicity makes it straightforward to explain and thus more understandable to the public--assuming, of course, that we successfully communicate that we recognize the importance of food and energy items in people's consumption. 

Unfortunately, as noted above, empirical research suggests that no one measure of core inflation will work in all situations.  Therefore, central banks do not focus solely on core inflation; rather, they devote considerable resources to understanding inflation developments in an effort to distinguish signal from noise in the incoming data

The need to limit moral hazard by not lending to insolvent institutions indicates that central banks must have information sufficient to determine whether an institution with access to the discount window is indeed healthy.  That consideration is one reason that central banks benefit from having some supervisory responsibility for institutions with access to the discount window (Mishkin, 1994; Bernanke, 2007).   

I noted a moment ago that periods of financial instability are characterized by valuation risk and macroeconomic risk. Monetary policy cannot have much influence on the former, but it can certainly address the latter--macroeconomic risk. By cutting interest rates to offset the negative effects of financial turmoil on aggregate economic activity, monetary policy can reduce the likelihood that a financial disruption might set off an adverse feedback loop. The resulting reduction in uncertainty can then make it easier for the markets to collect the information that enables price discovery and to hasten the return to normal market functioning. To achieve this result most effectively, monetary policy needs to be timely, decisive, and flexible. Quick action is important for a central bank once it realizes that an episode of financial instability has the potential to set off a perverse sequence of events that pose a threat to its core objectives. Waiting too long to ease policy in such a situation would only risk a further deterioration in macroeconomic conditions and thus would arguably only increase the amount of easing that would eventually be needed.

The combined 75 basis points of policy easing put in place at the past two meetings should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and should help promote moderate growth over time.

Going into the meeting, I was comforted by the lack of direct evidence to date of serious spillovers of the housing weakness and of tighter credit conditions on the broader economy. But with an unchanged policy interest rate, I saw downside risks to the outlook for growth. I was mindful, in particular, of the risk that still-fragile financial markets could be particularly exposed to potential adverse news on the housing situation, or on the macroeconomy more generally, and that renewed strains in financial markets could feed back adversely on economic performance. My vote to ease policy at the meeting was motivated by my wish to reduce those risks. The FOMC perhaps could have waited for more clarity and left policy unchanged last week, but I believe that the potential costs of inaction outweighed the benefits, especially because, should the easing eventually appear to have been unnecessary, it could be removed.

In voting to ease policy, I carefully considered the effect of that decision

In voting to ease policy, I carefully considered the effect of that decision on our other objective--price stability. I reasoned that the anticipated softening of economic growth and perhaps the emergence of some slack in the labor market might reduce those pressures, and I judged that a cut of 25 basis points in the target federal funds rate would not materially alter that modal outlook. However, I recognized the risk that, even if readings on core inflation have improved modestly this year, recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. Consequently, in considering appropriate future adjustments to policy, I will monitor inflation developments carefully.

Overall, I think that the cumulative policy easing the FOMC put in place at its past two meetings reduced significantly the downside risks to growth so that those risks are now balanced by the upside risks to inflation. In these circumstances, I will want to carefully assess incoming data and gauge the effects of financial and other developments on economic prospects before considering further policy action. As always, my colleagues on the FOMC and I will act to foster our dual objectives of price stability and sustainable economic growth.

[T]he Federal Reserve has a responsibility to take monetary policy actions to minimize the damage that financial instability can do to the economy.  I hope I was clear in communicating to you that policies to achieve this goal are designed to help Main Street and not to bail out Wall Street.  Pursuing such policies does help financial markets recover from episodes of financial instability, and so it can help lift asset prices.  But this does not mean that market participants who have been overly optimistic about their assessment of risk don't pay a high price for their mistakes.  They have, and that is exactly what should happen in a well-functioning economy--which, after all, is what the Federal Reserve is seeking to promote. 

By cutting interest rates to offset the negative effects of financial turmoil on aggregate economic activity, monetary policy can reduce the likelihood that a financial disruption might set off an adverse feedback loop.  The resulting reduction in uncertainty can then make it easier for the markets to collect the information that enables price discovery and to hasten the return to normal market functioning.  

To achieve this result most effectively, monetary policy needs to be timely, decisive, and flexible.  Quick action is important for a central bank once it realizes that an episode of financial instability has the potential to set off a perverse sequence of events that pose a threat to its core objectives.  Waiting too long to ease policy in such a situation would only risk a further deterioration in macroeconomic conditions and thus would arguably only increase the amount of easing that would eventually be needed. 

[W]e would expect that the direct effect of current events on small businesses would be limited.  Indeed, the data we have on business lending at small banks show that such loans have continued to expand at a fairly robust pace through mid-October.  Such data and our conversations with bankers suggest that, at least to date, the supply of credit to small businesses remains healthy.  

... [M]onetary policy works only with a lag and hence cannot offset these near-term effects; rather, the recent cuts in the federal funds rate are intended to help bring economic activity back to maximum sustainable levels over time, and such an outcome can be seen in the broad contours of the FOMC projections.

Now let us take a brief look at the Federal Reserve's macroeconomic projections for 2007 through 2009. These projections are useful for understanding the Federal Reserve's near-term policy strategy, and again, I would like to highlight how this strategy fulfills the dual mandate and embeds key implications of the modern science of monetary policy.

The science emphasizes that monetary policy makers need to think in terms of a plan for the appropriate paths for inflation and economic activity that best promotes the dual mandate of price stability and maximum sustainable employment. If economic activity is well below its maximum sustainable level, then monetary policy should aim at increasing output and employment toward sustainable levels. If inflation is above the mandate-consistent rate, monetary policy should aim at reducing inflation to that rate. Providing projections for the short run as well as for the longer run encourages FOMC participants to think in terms of desirable paths for inflation and output, a discipline that the science suggests will produce better policy outcomes. In addition, the projections provide households and businesses with information that can help them understand what the monetary authority is trying to achieve, thereby increasing the likelihood of good economic outcomes.

Most of the quantitative studies of optimal monetary policy have also assumed that the shocks hitting the economy have a time-invariant Gaussian distribution, that is, a classical bell curve with symmetric and well-behaved tails. In reality, however, the distribution of shocks hitting the economy is more complex. In some instances, the uncertainty facing the economy is clearly skewed in one direction or another; again, this is likely when there are significant financial disruptions. The Federal Reserve often reports on our judgments regarding the degree of skewness and the associated economic costs by giving assessments of the “Balance of Risks” in the press releases that are issued following FOMC meetings.

In addition, at least in some circumstances, the shocks hitting the economy may exhibit excess kurtosis, commonly referred to as tail risk because the probability of relatively large disturbances is higher than would be implied by a Gaussian distribution. In that light, one element of the recent enhancements to the Federal Reserve’s communication strategy is that FOMC participants now provide assessments of the relative degree of uncertainty. For example, in the “Summary of Economic Projections”issued in late November, FOMC participants indicated that the degree of uncertainty regarding the economic growth outlook was relatively high compared to the average degree of uncertainty over the past two decades. This account could be interpreted as a statement that the Committee perceived the tail risk as unusually large.

With a nonquadratic objective function (consistent with the importance of uncertainty for the course of monetary policy) as well as nonlinear dynamics and non-Gaussian shocks, optimal monetary policy will also be nonlinear and will tend to focus on risk management.

[S]trains in financial markets can spill over to the broader economy and have adverse consequences on output and employment. Furthermore, an economic downturn tends to generate even greater uncertainty about asset values, which could initiate an adverse feedback loop in which the financial disruption restrains economic activity; such a situation could lead to greater uncertainty and increased financial disruption, causing a further deterioration in macroeconomic activity, and so on. In the academic literature, this phenomenon is generally referred to as the financial accelerator (Bernanke and Gertler, 1989; Bernanke, Gertler, and Gilchrist, 1996, 1999).

In such circumstances, the most likely outcome ... for the economy may be fairly benign, but there may be a significant risk of more severe adverse outcomes. In such circumstances, the central bank may prefer to take out insurance by easing the stance of policy further than if the distribution of probable outcomes were perceived as fairly symmetric...

...

However, it is important to recognize that financial markets can also turn around quickly, thereby reducing the drag on the economy as well as the degree of tail risk. Therefore, the central bank needs to monitor credit spreads and other incoming data for signs of financial market recovery and, if necessary, take back some of the insurance; thus, at each stage of the episode, the appropriate monetary policy may exhibit much less smoothing than would be typical in other circumstances.

[T]he Federal Reserve has been acting and will continue to act decisively, in the sense that our policy strategy reflects the evolution of the balance of risks and not simply a change in the modal outlook for the macroeconomy. The disruption in financial markets poses a substantial downside risk to the outlook for economic growth, and adverse economic or financial news has the potential to cause further strains. In that light, the Federal Reserve’s policy strategy is aimed at providing insurance to help avoid more severe macroeconomic outcomes.

I believe that the Federal Reserve has been acting and will continue to act decisively, in the sense that our lowering of the federal funds rate target has reflected the evolution of the balance of risks to the macroeconomy. The disruption in financial markets poses a substantial downside risk to the outlook for economic growth, and adverse economic or financial news has the potential to cause further strains. In that light, the Federal Reserve's policy strategy is aimed at providing adequate insurance to help mitigate the risk of more-severe macroeconomic outcomes.

To achieve this result most effectively, monetary policy needs to be timely, decisive, and flexible. ... [I]n my view, the Federal Reserve's recent monetary policy actions--reducing the target federal funds rate by 1 percentage point last fall and by a further 1-1/4 percentage points in January--have been consistent with these principles for coping with macroeconomic risk.    

In recent weeks, the Federal Reserve has conducted three more auctions (most recently, last Monday) for amounts of $30 billion each. The spread over the minimum bid rate was about 7 basis points for the January 14 auction, 2 basis points for the January 28 auction, and 15 basis points for the February 11 auction; these spreads were much lower than in December, apparently reflecting some subsequent easing in the pressures on banks' access to term funding.

The TAF appears to have been quite successful in overcoming the two problems with conventional discount window lending. Thus far, the TAF appears to have been largely free of the stigma associated with borrowing at the discount window, as indicated by the large number of bidders and the total value of bids submitted.9 Furthermore, because the Federal Reserve was able to predetermine the amounts to be auctioned, the open market desk has faced minimal uncertainty about the effects of the operation on bank reserves; hence, the TAF has not hampered the Federal Reserve's ability to keep the effective federal funds rate close to its target.

Isolating the impact of the TAF on financial markets is not easy, particularly given other recent market developments and the evolution of expectations regarding the federal funds rate. Nonetheless, the interest rates in term markets provide some evidence that the TAF may have had significant beneficial effects on financial markets.

Subprime lending is going to come back. Right now, subprime lending is as dead as a doornail.  The informational idea that changed things is still around. Without human beings interacting you can actually get a lot of information about whether someone is going to pay you back. This is data mining.

The problem was they said, `Oops, we made a mistake with the business model.'

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

The rating agencies did a good job on the plain vanilla type of ratings. That was not the problem. 

There were these securities which people were using that were using very complicated financial engineering, and very complicated legal documents, to basically, supposedly, decrease risk by diversification.

It turns out that people then realized that the rating agencies were not able to rate these things properly.  There is obviously now a recognition that depending completely on rating agencies without doing due diligence yourself may be problematic.'

From the audience Q&A as reported by Bloomberg News

What you're really concerned about is what's going with the long run or underlying trend in inflation, and that's what we need to focus on.

From Q&A as reported by Reuters.

One critical precondition for effective central-bank easing in response to adverse demand shocks is anchored long-run inflation expectations. Otherwise, lowering short-term interest rates could raise inflation expectations, which might lead to higher, rather than lower, long-term interest rates, thereby depriving monetary policy of one of its key transmission channels for stimulating the economy.

Financial disruptions have an important impact in terms of lending, and they actually have an impact in terms of spending ... These issues are something that we have to pay attention to and have been paying a lot of attention to.

From Q&A as reported by Reuters 

The basic point from these simulations is that monetary policy that responds to headline inflation rather than to core inflation in response to an oil price shock pushes unemployment markedly higher than monetary policy that responds to core inflation. In addition, because this policy has larger swings in the federal funds rate that must be reversed, it leads to more pronounced swings in unemployment. On the other hand, monetary policy that responds to core inflation does not lead to appreciably worse performance on stabilizing inflation than does monetary policy that responds to headline inflation. Stabilizing core inflation, therefore, leads to better economic outcomes than stabilizing headline inflation.

[W]e make better decisions if we are better informed, and the whole economy benefits. That's the promise of economic education--to get back to the title of this session--that it not only improves the lives of individual consumers, but that it also makes for more-effective policy and a better economy.     

As has been true of many financial innovations in the past, the benefits of this disaggregated originate-to-distribute model may have been obvious, but the problems less so.  ... Originators had every incentive to maintain origination volume, because that would allow them to earn substantial fees, but they had weak incentives to maintain loan quality.  When loans went bad, originators lost money, mainly because of the warranties they provided on loans; however, those warranties often expired as quickly as ninety days after origination.  Furthermore, unlike traditional players in mortgage markets, originators often saw little value in their charters, because they often had little capital tied up in their firm.  When hit with a wave of early payment defaults and the associated warranty claims, they simply went out of business.  While the lending boom lasted, however, originators earned large profits.  

To the extent that the meltdown in the mortgage market has revealed even deeper problems in the financial system, the negative impact on economic activity could be even larger. 

Mishkin said he believes that long-run inflation expectations will remain consistent with increases in PCE; "in the neighborhood of 2% per year." Accordingly "over time core PCE inflation will move back to around 2%," he said.

From Q&A as reported by Market News International

It is anticipated that investment spending should receive some help in the second half of this year from the accelerated depreciation provisions in the fiscal stimulus bill; however, based on experience with a similar tax provision in 2002 and 2003, the magnitude and timing of these effects is very uncertain.

As for inflation compensation derived from spreads between yields on nominal and inflation-indexed Treasury securities (known as Treasury Inflation-Protected Securities, or TIPS), the implied rate of inflation compensation from five years ahead to ten years ahead (the so-called five-to-ten-year-forward rate) has risen somewhat since the beginning of the year.  Does this rise in forward inflation compensation indicate that long-run inflation expectations have risen by a similar amount?  My best guess is that much of the rise in inflation compensation reflects other factors.

To begin, recall that inflation compensation measured by using TIPS yields is not the same thing as inflation expectations.  Rather, movements in inflation compensation reflect not only changes in inflation expectations, but also changes in an inflation risk premium and in the relative liquidity of TIPS and similar maturity nominal Treasuries.  To see that these components are distinct, recall that during the period of heightened concerns about deflation in 2003 and 2004, forward inflation compensation rose substantially to an unusually high level amid concerns about an unwelcome fall in inflation; that earlier episode, in particular, underscores the fact that we must be careful in using the forward rates of inflation compensation as a gauge of long-run inflation expectations. 

The empirical evidence also indicates that pass-through from exchange rates to import prices is low and has declined markedly over the past two decades. This evidence suggests that there may be a weaker relationship between exchange rate fluctuations and nominal demand than prevailed in the past, which may make it easier for monetary policy to stabilize inflation and real activity. Nevertheless, exchange rate fluctuations can still have an effect on inflation and economic activity; hence, monetary policy must continue to take these fluctuations into account to ensure that inflation expectations remain well anchored and that fluctuations in economic activity are minimized.

Exchange rate fluctuations are not a problem unless they actually lead to reallocation of resources...Fluctuations in exchange rates are something that you have to deal with, but as you know sometimes the media make a huge deal of fluctuations that is way over the top.

The issue that is extremely important is the preservation and commitment to a nominal [inflation] anchor. ... I see no tendency from central banks to want to deviate from this world of price stability ... A commitment to keeping inflation low and stable is something I don't see any wavering from in the world, which is the key. But we have to be vigilant.

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

Sizeable depreciations of the nominal exchange rate exert fairly small effects on consumer prices across a wide set of industrial countries, and these effects have declined over the past two decades.  Exchange rate depreciations are thus likely to have less adverse effects on inflation than they have had in the past.  

Comfort zones, shmumfort zones.

...

An explicit point objective anchors inflation expectations more effectively than a comfort zone.  

Even if policymakers are relatively indifferent about the level of inflation within a comfort zone, research on the optimal design of monetary policy indicates that they shouldn't be: The central bank should actively seek to bring inflation back to the midpoint of its comfort zone, thereby minimizing the probability that inflation wanders outside the boundaries of that zone. In effect, the optimal policy strategy takes into account the benefits of insurance, and hence the midpoint of the zone becomes the point objective for inflation

Furthermore, confusion about inflation objectives might make it harder for a committee of policymakers to decide on the appropriate course of monetary policy. When one member advocates a more accommodative policy stance than other members, it may not be clear whether that reflects a more negative outlook for the economy or a greater willingness to allow inflation to settle in or near the top of the comfort zone. Thus, the comfort zone approach might lead to greater confusion in policy deliberations and hence produce a less effective decisionmaking process.

What is very important is that the central bank not control inflation in the very short run, or try to hit very narrow ranges. And the reason for this is that a lot of movements in underlying inflation have to do with things that are out of the monetary policy control. What is particularly important in this regard is supply shocks, for example, sharp rises in energy prices.

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

What do we mean by price stability?  A widely cited definition is that the inflation rate is sufficiently low so that households and businesses do not need to take inflation into account in making everyday decisions.³  Broadly speaking, I believe this definition of price stability is a reasonable one, and in practice, central banks around the world have chosen average levels of inflation between 0 and 3 percent as consistent with this criterion. However, this range can be narrowed a bit further by considering the implications of economic theory and empirical evidence about the average inflation rate that produces the best economic outcomes...

In contrast, given shocks like those seen over the past several decades, an average inflation rate higher than about 1 percent substantially reduces the frequency with which the economy hits the zero lower bound. An inflation objective of about 2 percent implies that monetary policy is rarely constrained by the zero lower bound and thereby minimizes the adverse consequences for macroeconomic stability.

As my mother often told me when I was growing up, "The road to hell is paved with good intentions." Similarly, discretionary monetary policy, even though well intended, can lead to poor economic outcomes.

Another interesting example, which I do not have time to discuss in detail here, occurred with the granting of operational independence to the Bank of England in May 1997 after it had adopted an explicit numerical inflation objective.²³ In explaining the decision to grant operational independence to the Bank of England, the government specifically pointed to the Bank's successful performance in providing forecasts and clear explanations of the likely effects of a range of policy alternatives, thereby increasing accountability and making the central bank more responsive to political oversight.

I think it's worthwhile to see exactly how well the packages that have been passed work.

The stimulus package is not going to kick in for a couple of months. We're hopeful that in fact it will help the economy get through this period of slow growth.

When we see what happens there, then we'll have a little bit better idea of what we might need to do in the future.

From Q&A as reported by Reuters

... [T]he health of the U.S. economy depends importantly on the vitality of the small business sector, and continued access to credit on competitive terms is necessary for that vitality. On balance, since last fall credit supply conditions have almost surely tightened for the vast majority of small businesses. Credit appears to be generally available, but at a higher cost. Only a small fraction of small business owners report that credit is their main business concern. Demand for their products is much more problematic.

Looking forward, continuing declines in the value of small businesses' real estate assets have the potential to substantially affect the ability of those small businesses to borrow. Similarly, declines in the value of real estate may affect the ability and willingness of banks and other lenders to supply loans. Indeed, this is likely already occurring to some extent at some banks across the full spectrum of bank sizes. Lastly, because of interdependencies between small business and household finance, declines in the financial condition of households can also affect both the terms of those households' small businesses loans and their ability to borrow.  

Although our actions appear to have helped stabilize the situation, financial markets remain under considerable stress. For example, many lenders have been reluctant to provide credit to counterparties, especially leveraged investors, and have increased the amount of collateral they require to back short-term security financing agreements. Credit availability has also been restricted because some large financial institutions, including some large commercial and investment banks, have reported substantial losses and asset write-downs, which reduced their available capital. The capacity and willingness of some large banks and other financial institutions to extend new credit has also been limited by the reduced availability of external funding from the capital markets for originated assets. The resulting unplanned increases in their balance sheets have strained their capital, thus reducing lending capacity. The good news is that several of these firms have been able to raise new capital, and others are in the process of doing so. However, market stresses are likely to continue to weigh on lending activity in the near future.

Clearly you can't get interest rates below zero ... but we actually have interest rates now at 2-1/4 percent and clearly there is some room to lower them if it's needed.

... Furthermore, we are continually looking at steps to make the markets function better and I think we've been quite creative in terms of the steps we've taken so far, but in fact we will continue to look at the steps that we can take to in fact make the functioning of the financial markets get back to a more normal situation

From Q&A as reported by Reuters

In the extreme, the interaction between asset prices and the health of financial institutions following the collapse of an asset price bubble can endanger the operation of the financial system as a whole.⁶

To be clear, not all asset price bubbles create these risks to the financial system. For example, the bubble in technology stocks in the late 1990s was not fueled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. But potential for some asset price bubbles to create larger difficulties for the financial system than others implies that our regulatory framework should be designed to address the potential challenges to the financial system created by these bubbles.

To be clear, I think that in most cases, monetary policy should not respond to asset prices per se, but rather to changes in the outlook for inflation and aggregate demand resulting from asset price movements. This point of view implies that actions, such as attempting to "prick" an asset price bubble, should be avoided.

I take this view for (at least) three important reasons.¹⁰ First, asset price bubbles can be hard to identify. As a result, tightening monetary policy to restrain a bubble that has been misidentified can lead to weaker economic growth than is warranted...

Second, even if asset price bubbles could be identified, the effect of interest rates on asset price bubbles is highly uncertain... Another way of saying this is that bubbles are departures from normal behavior, and it is unrealistic to expect that the usual tools of monetary policy will be effective in abnormal conditions...

Third, there are many asset prices, and at any one time a bubble may be present in only a fraction of assets. Monetary policy actions are a very blunt instrument in such a case, as such actions would be likely to affect asset prices in general, rather than solely those in a bubble.

In retrospect, the breakdown in underwriting can be linked to the incentives that the originate-to-distribute model, as implemented in this case, created for the originators. Notably, the incentive structures often tied originator revenue to loan volume rather than to the quality of the loans being passed up the chain. This problem was exacerbated by the bubble in house prices: Lenders began to ease standards as further appreciation in house prices was expected to ensure that risk was low, and investors failed to perform the research necessary to fully appreciate the risks in their investments, instead relying on further house price appreciation to prevent losses. The interaction between lenders' and investors' views and house prices illustrates the pernicious feedback loop I highlighted earlier.

There are clearly going to be issues going forward in terms of the regulatory structure. Clearly, we are in a different world now.

From Q&A as reported by Reuters.

Just as doctors take the Hippocratic oath to do no harm, central banks should recognize that trying to prick asset price bubbles using monetary policy is likely to do more harm than good.

U.S. inflation has risen recently, largely because of these sharp increases in global commodity prices. However, thus far, the high costs of energy and other primary commodities have not led to much increase in core inflation, partly because of slackening domestic demand, and there is little evidence that these costs are feeding a wage-price spiral. Nevertheless, the latest spike up in energy and food prices has raised the upside risk to inflation and inflation expectations, which we are closely monitoring and seeking to contain.

The recent financial turmoil has brought the Federal Reserve into uncharted waters. We found it necessary to build some lifeboats, but we seem to have steered clear of the worst weather. The measures taken by the Federal Reserve and other central banks seem to have helped keep the economy afloat.

The economy has been quite resilient to the adverse shock from the recent financial turmoil, but the analysis of its sources I outlined earlier suggests that it will take a substantial amount of time to complete the cleanup of the financial mess and to get the financial system fully back on its feet...The resulting slow recovery of financial markets that I think is likely suggests that the U.S. economy will be subject to substantial headwinds for some time. Indeed, the situation may be comparable to what happened in the early 1990s when the weakened condition of the banking industry in the United States led to a relatively slow recovery in economic activity. Thus, growth could continue to be quite weak, though I would hope it would pick up next year.

A strong nominal anchor can be especially valuable in periods of financial market stress, as we have been experiencing recently, when prompt and decisive policy action may be required to minimize the risk of a severe contraction in economic activity that could exacerbate uncertainty and financial market stress.¹²  Thus, the establishment of an explicit numerical inflation objective can play an important role in promoting financial stability as well as the stability of employment and inflation.
...
I would like to suggest several specific modifications to the Federal Reserve's current communication strategy.

• First, the horizon for the projections on output growth, unemployment, and inflation should be lengthened.  This change might involve simply an announcement of FOMC participants' assessment of where inflation, output growth, and unemployment would converge under appropriate monetary policy in the long run.  Alternatively, the horizon for the projections could be extended out further, say to five or more years.
• Second, FOMC participants should work toward reaching a consensus on the specific numerical value of the mandate-consistent inflation rate, and this consensus value should be reflected in their longer-run projections for inflation.²⁵
• Third, the FOMC should emphasize its intention that this consensus value of the mandate-consistent inflation rate would only be modified for sound economic reasons, such as substantial improvements in the measurement of inflation or marked changes in the structure of the economy.

I interpret the available economic theory and empirical evidence as indicating that a long-run average inflation rate of about 2 percent, or perhaps a bit lower, is low enough to facilitate the everyday decisions of households and businesses while also alleviating the risk of debt deflation and other pitfalls of excessively low inflation.

In my view, the length of the forecast horizon is particularly relevant at the current juncture in considering the projections for output growth and unemployment.  Because of the recent adverse shocks to the economy--including turmoil in financial markets and the sharp increase in the prices of oil--output growth in recent quarters has fallen below potential, and the unemployment rate is, as best as I can judge, above the natural rate.  Similarly, sharp increases in the prices of many commodities have driven inflation above rates consistent with price stability.  Even under appropriate monetary policy, Committee forecasts of inflation, output growth, and unemployment might not settle at their respective long-run rates within the three-year horizon, obscuring Committee participants' views about these key parameters.

This problem may currently be somewhat less acute for the current set of inflation projections, because inflation is projected to moderate to about 2 percent or below by the end of the projection period.  Nevertheless, to the extent that some slack in economic activity is projected to persist through 2010, that slack might well induce a modest further decline in inflation, implying that policymakers' projections for inflation in 2010 might be a bit higher than their assessments of the mandate-consistent inflation rate. 

"Financial stability in Iceland" Clip, from Inside Job: http://www.youtube.com/watch?v=8lHvTKzfu8Q