Gary Stern

I must say I am a little puzzled by the fascination with NAIRU. I thought work done by Stock and Watson and others suggested that if there is a NAIRU, it lies somewhere between 4 to 7 percent or some range like that, which is quite wide. If that is right, it is not a terribly useful concept for policy. So, I have been reluctant for some time to go down that path very aggressively.

But my reservation is that we could find ourselves from time to time in a somewhat awkward position of having changed policy but not changed where we think the risks lie. That is quite likely and in some cases appropriate. But it may also raise the question: If the Committee thinks that's where the risks are, why didn't we move more aggressively?

I think we soon ought to consider putting at least one nail in the NAIRU coffin. Not only has the economy failed to perform according to that framework in the last five or six years but, so far as I'm aware, going back 15 or 16 years there just is no evidence of an empirical relation between labor market conditions and inflation.

Also on the income front, we have the issue of the minimum wage. Proposals to increase the minimum wage abound, and they are usually “sold” as beneficial to people with low incomes. But economic analysis suggests that this is not the whole story. It is more accurate to say that an increase in the minimum wage is helpful to low-income workers who remain employed; however, an increase in the minimum wage will decrease employment, other things equal, because labor will have become more expensive, and hence employers will use less. Straightforward supply and demand analysis produces this conclusion.

But the incentive effects of an increase in the minimum wage also ought to raise concern. An increase in the minimum wage may induce some to drop out of high school earlier than otherwise to seek employment, since returns to work have gone up. This outcome may not be desirable. After all, we know that the economic and other returns to education are substantial, and in general education is something we want to encourage. An increase in the minimum wage seemingly does not contribute to this objective.

I think the economy is fundamentally sound, fundamentally resilient.  It doesn't require policy-makers getting things precisely correct, indeed it has a great ability to absorb shocks and surprises, positive and negative, and continue to advance.

I personally don't have the sense that there is excessive risk-taking in US financial markets.

Policies abroad and growth abroad also matters and there's little doubt that...our current account would be smaller if some of our large trading partners had economies that were growing faster.

Interest rates are clearly not at restrictive levels...If we keep inflation low, I don't see any reason why interest rates should reach particularly high levels.

Market participants, I think, are confident, and I hope they are correct, and I believe they are, that inflation is going to stay low in this country.  It's going to stay low, in part, in large part, because we in the Federal Reserve are committed to maintaining low inflation.

Inflation will stay subdued...I don't expect inflation to accelerate in any meaningful way.  I wouldn't rule it out, but I wouldn't bet much on it.

If I thought there was some fundamental deterioration in prospect on the inflation front, I might change my assessment of the pace at which we need to move...[But I do] not see that as the most likely outcome.

In the long run inflation is a monetary phenomenon,a nd as long as we adhere to sound monetary policy we shouldn't have any long run inflation problem.

Outside of a few specific commodities, there hasn't been much in the way of price increases in the past few months.  I'm not hearing when I talk to business people that there are a lot of additional price increases coming along.

It's always possible and maybe likely that we haven't gotten the impact [of higher oil prices] precisely correct...[But] economic growth was respectable last year despite higher oil prices.

I don't think we have to get policy precisely correct for the economy to do well...The economy is not so fragile that unless the Federal Reserve or other policy makers do precisely the correct thing, something is going to fall apart on either the inflation side or on the growth side.

We've been talking about getting policy back to a neutral stance...It's been pretty accommodating for a while...The fed-funds rate target certainly has to be higher than it is right now, but exactly how high I'm not willing to be pinned down on at the moment.

I believe inflation will continue to remain subdued, it will be modest in the year ahead.

I just don't see the signs--the ingredients--that would perhaps contribute to higher inflation...There may be a few things around the edges that are worth worrying about if you really want to, but the preponderance of evidence suggests that inflation is going to stay modest.

It is possible that the decline of the dollar changes the competitive landscape and makes foreign producers less competitive, and that could be inflationary.  But as long as the Fed pursues a low inflation policy, we should achieve low inflation.

The stage is set for further economic expansion and I expect inflation will remain modest as it has for a good number of years now.

What are we trying to accomplish with [Social Security]?...We don't want the elderly living in poverty, and right now much of the elderly is not living in poverty.  One thing we might think about is a much more narrow program.

As consumer debt has increased, so have consumer asset holdings...What that says to me is that the average consumer household is in good financial shape.

It looks like core inflation will continue to run in the 1.5 to 2 percent range.  That, in historical context, remains a low rate of inflation.

[Inflation] leads to resource misallocation.  With resource misallocation will come sub-par economic growth, and what really matters to economic well-being over time is the trend rate of growth.

Low inflation is the most important contribution the Fed can make to sustained economic expansion and living standards...[Unchecked inflation causes] arbitrary distribution of incoming wealth--the winners are lucky, the losers are unfortunate.

[The economy has been growing] close to 4% at an annual rate, and that's a perfectly respectable pace and, frankly, the pace that I think will continue; something in that rough neighborhood.

I don't see inflation pressures building in the near term.

My guesstimate is that long rates haven't moved because inflation expectaions are so well anchored.

I'm considering, and considering ever more seriously, the benefits of going to an inflation targeting approach...I'm not suggesting we go down this path to fix something that's broken, rather to lock in the benefits of the past.

It looks like the economic expansion is on solid ground and will continue this year and next year as well...Interest rates are still at comfortable levels that should sustain economic expansion.

The pass through [of import costs] has diminished...But the weaker dollar does change the competitive landscape. It means foreign producers are not as competitive as they...were and, other things being equal, that may contribute to more [US] inflation.

Employment gains have started to pick up, and with that, there is good reason to believe disposable income gains will continue to grow.

Consumer balance sheets are in good shape on average and interest rates are still at comfortable levels...Employment gains have started to pick up.

Lending standards are being relaxed a bit.  That does not give me a lot of concern.

The best single explanation that I personally have is that expectations of inflation have remained very well anchored.  So that's why in my judgment long term rates have held as low as they have for as long as they have...And if I'm right, or am at least aprtially correct, that's a gratifying result not only because it siggests a fair amount of credibility in Federal Reserve monetary policy, but a fair amount of redibility in a low inflation outlook, which is at least as important.

I'm not anticipating a significant acceleration in inflation this year, or even a significant building of inflationary pressures...[But] I do think that anecdotes, which I think line up pretty much with the decline in the dollar we've seen over the past few years, suggest to me the environment maybe isn't quite as competitive as it was, say a couple of years ago.  And that may mean that there's more possibility for raising prices.  It doesn't mean that it's actually going to happen.

When [the "measured pace" wording] will change, I don't know...My view is that we will try damn hard to be pretty clear, or as clear as we can be, about what we are up to.

The heart of the TBTF [Too Big to Fail] problem is the fear of spillovers that motivates bailouts...Creditors know policymakers fear spillovers and, on the basis of this knowledge, expect bailouts—protection. Unless and until creditors come to understand that policymakers’ concern about spillovers has diminished, they—the creditors—will assume the status quo persists.

There is no doubt that payments system change continues apace. It is preferable from my perspective that such change be driven by market forces, and it appears that largely has been the case. Central bank intervention should be reserved for cases characterized by broad and compelling societal benefits.

From a public policy perspective the payments system does not appear to be facing serious, fundamental problems. It largely does what it is supposed to do and does it well, and it seems able to adapt effectively to the changing needs of end users.

Given the current state of the payments system, the role of markets in achieving this outcome, and the limitations on a central body to address perceived problems, the Federal Reserve should be quite careful before intervening in these markets.

Stern...told Reuters in an interview that since official interest rates now are at or near neutral, policy decisions have become more complex than earlier in the tightening cycle.  "I'm comfortable with it as of March 3," said Stern when asked about the view the Fed did not need to go beyond neutral to a contractionary stance, which would slow economic growth.   "This is going to be data-driven and I try to be receptive to incoming information. If the incoming data turned out to provide some surprises, or caused me to become more concerned about price stability than I am right now, that could change," Stern said.  "We are now in a place where decisions are somewhat more complex because we have covered a lot of ground and we are closer to, if not at, neutral," said Stern.

I don't want rates to go too far. Obviously, you don't want to make a series of bad judgments.

In terms of neutrality or equilibrium or whatever...[p]resumably there is a range, and we're close to and likely within the range of where it should be in my opinion.

It's important to avoid big policy errors, and it's important to get this as right as we can, but in an economy as big and complex and flexible as ours, a quarter point more or less on the federal funds rate is unlikely to be all that big a deal at the end of the day... because I don't think the economy is that sensitive to quarter percent age points on the federal funds rate.

I've consistently argued that increases in deposit insurance coverage are unwise...

I also have concerns that deposit insurance reform didn't go far enough in reforming the pricing of deposit insurance. Now, this is a tricky topic, with much detail to it, but the crux of the issue is straightforward. I think the Federal Deposit Insurance Corp. should charge premiums based on the riskiness of banks.

I should briefly reiterate my concerns about the safety net for the creditors of the largest banks, as these concerns shape my views on the ILC issue. As I have noted before, I worry that some of these creditors believe they will be bailed out in the event of institutional insolvency because their bank is viewed as “too big to fail.”

But because I believe we should strive to limit protection for creditors of large banks, additional combinations of banks and nonbanking firms that potentially expand the safety net to cover activities not currently in scope are particularly troubling. As a matter of public policy, it would be far preferable from my perspective to take steps to limit the existing safety net.

In my view, limitations on GSE mortgage holdings are a necessary, but probably not a sufficient, reform, because this step addresses one, but not both, of the fundamental flaws of the housing GSEs, which primarily relate to the safety net the firms enjoy. The first current problem is that policymakers have virtually no direct control over the amount of safety net subsidy the GSEs receive. The second flaw is that the primary tool the GSEs use to achieve their main mission of increasing homeownership does little in practice to encourage or permit renters to become owners.

Stern, speaking at the conclusion of a two-day conference on financial journalism sponsored by the Minneapolis Fed and the University of Minnesota, said It is "worth considering a more rule-based approach to policy."

Stern is part of a Fed subcommittee that is examining ways to improve Fed transparency.

As reported by Dow Jones Newswires

Some of my earlier concerns about the core CPI have diminished, in part because my concerns about the core PCE have increased.

As reported by the Wall Street Journal

There seems to be something of a public perception that {1% to 2%} is a semiofficial range, and from my perspective there's nothing remotely official about it.

As reported by the Wall Street Journal

Federal Reserve Bank of Minneapolis President Gary Stern said Friday that recent problems in subprime mortgage markets haven't had any spillover effects yet, but cautioned those types of forces haven't been fully 'stress tested.'

Stern was speaking at a monetary policy conference in Washington with other officials.

As reported by DJ Newswires

To the extent that Federal Reserve communications leave the impression that high frequency observations are of great value, then this is something which I think we need to address.  In my experience, a considerable accumulation of evidence usually is required before it is wise to change your view.
  

In this country, we have become accustomed to (net) increases in employment of at least 150,000-160,000 workers per month on average, roughly equal to the average monthly addition to the labor force. But labor force growth is projected to slow appreciably over the next ten years as the baby boom generation retires; depending on which reputable set of projections you select, we should probably expect monthly increments to the labor force of 110,000 on the low end to 150,000 on the high side. Increases in employment will adjust down similarly, other things equal, since people who are not available cannot be hired. Moreover, to the extent that labor force participation rates level off or decline—and this is widely anticipated in part because of the end of the run-up of participation rates of women—increases in the labor force will be even smaller than the estimates I just cited, probably by several tens of thousands per month.

My comments this morning are not intended to defend the regulatory and financial status quo, although I can understand that some may interpret them in that way. Rather, they are meant to suggest that there is likely little, if any, “low hanging fruit” to harvest and that, specifically, reforms may well impose inefficiencies and other costs of their own. The message is thus one of caution but not of inaction:  we should take considerable care in drawing conclusions about the origins of the recent bout of financial turbulence and about the implications for public policy.    

Its always hard to know how much to do and when. That's not to say we're doomed to get it wrong or partially wrong, but it's not easy to get it right. The economy is sound and flexible and resilient underneath it all, so monetary policy doesn't have to be exactly precisely correct month by month for the economy to do well.

From press Q&A as reported by Market News International

"A key factor in low long-term interests rates is that inflation
expectations have been anchored at low levels, so lenders are not
concerned about finding their returns wiped out by an acceleration of
inflation," Stern said. "That is one reason why I think it's important
(the Federal Reserve) remain committed, as I have suggested we are, to
low inflation."

     Despite the economic downturn, Stern doesn't see a return to the
environment of the early 1980s, when the Federal Reserve sharply
increased interest rates. He says people at that time felt nothing could
be done about double digit rises in inflation and expected it to
continue for years to come. "I think (current) inflation expectations
are pretty well anchored at low levels. ... I don't foresee a return to
that environment at all," he said.

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

We have a big inventory problem in the residential area and until that inventory gets worked out I think activity in that sector is going to be subdued and the financial difficulties will persist.

From audience Q&A as reported by Market News International

It does seem to have helped more psychologically than anything else, but I would say yes it does seem to have helped.

From press Q&A, when asked to assess the Term Auction Facility program, as reported by Market News International

To the extent that people think consumer attitudes have soured, I think just going out there and trying to reassure people, I don't think that in and of itself is effective ...

I think actions speak louder than words and I think people will experience things on the ground that will either confirm their concerns or diminish them. We have a limited number of policy tools. I think we've used them, we could continue to use them, that remains to be seen.

From press Q&A as reported by Market News International

The estimates I have are reported in the 2007 Financial Report of the United States Government and therefore should be in the ballpark; they are for the next 75 years and reveal a Social Security shortfall of about $15-16 trillion and a Medicare gap of approximately $29 trillion. I think it fair to say that shortfalls of these magnitudes are considered both unsustainable and difficult to address.

Of the topics I have covered this morning, this fiscal imbalance is likely to matter most for the long-run performance of the economy. If debt financed, such deficits are likely to restrain growth over time through their effects on interest rates and, in turn, the consequences for investment, capacity, and productivity. If tax financed, there could be disincentives to work and/or to invest depending on the form of the increases, and the implications for growth would likely be negative. Finally, if program benefits are to be scaled back, it is far preferable to take this step sooner rather than later so that potential beneficiaries can plan appropriately and adjust.

I think there's a lot of inertia to (core) inflation. It's hard to get it to decelerate or
accelerate, ... My own view is core inflation will diminish over the next several years.

From press Q&A as reported by Market News International

The potential for headwinds is integral to thinking about economic prospects over the next year or two. To the extent that these headwinds gain momentum, they suggest relatively modest growth for a time and the likelihood of increases in the unemployment rate. Their implications for inflation are not so clear, although I would note that the pace of inflation diminished in the early 1990s relative to its performance over the preceding several years.

And while I think the term “debt overhang” is overly broad, a significant number of homeowners are experiencing considerable strain. Finally, in view of my earlier comments about impaired markets and institutions, the possibility of a credit crunch, and its attendant effects on economic performance, cannot be ruled out.

To my knowledge, there is not a precise definition of a credit crunch, but I would describe it as an environment in which quality borrowers find credit either unavailable or available only on very expensive terms. To the extent that such a situation develops, its economic impact is that some investment projects and planned spending will be deferred or delayed for a time because of the difficulty of obtaining financing, resulting in more modest economic growth than would otherwise occur.

These issues are clearly weighing on policy. While such an environment will not be permanent, it could well persist for an extended period because, if credit is in fact restricted by some institutions and in some markets, it will likely take time for potential borrowers to find alternatives and substitutes.

I think the Federal Reserve has taken appropriate policy steps to respond to a financial shock, a shock that may well produce parallels to the headwinds episode of the early 1990s. In this environment, we need to remain sensitive to evolving financial conditions and to incoming information on business activity in order to further determine the relevance of that earlier experience. And the aftermath of that episode may also prove relevant, in that it illustrates the underlying resilience of the American economy and the value of policy adherence to the dual mandate.

Still, without putting too fine a point on it, I would expect economic growth in the long run to average somewhere around 2 ½ percent per year, given my expectations for productivity and for hours. Such a performance is likely to exceed the pace of population increase, implying a further rise in standards of living over time

While governments cannot and should not uniformly avoid public support for creditors of failing banks, they should seek to minimize that support because of the distortions it produces. Such public support—even when it passes a benefit-cost test at the time of provision—encourages future risk-taking by institutions whose creditors expect to benefit from future support. Such risk-taking can even contribute to the specific financial conditions that prompt further government support. The key to addressing these costs is, when times are good, to act to reduce creditors’ expectations of receiving protection.

...

Policymakers should also undertake steps to better understand the potential for spillovers before large institutions get in trouble, as this would allow them to target any support they provide, or perhaps make it more likely that support could be avoided. Because I believe spillovers drive the provision of after-the-fact government support, I am not convinced that other approaches are as likely to alter creditors’ expectations.

Recent events have likely reaffirmed and strengthened some creditors’ expectations of support, or have created those expectations for the first time. I think one would be hard pressed to dismiss our analyses or proposals by claiming that such expectations do not exist. On the opposite end of the spectrum, some might dismiss our suggestions, arguing that we cannot influence creditors’ expectations. I reject that view as equally untenable. We simply cannot allow widespread perceptions of government support to pervade the financial system. Experience in other countries suggests that such a strategy is quite costly. And, in any case, our proposals seek to reduce systemic risk, an outcome presumably shared by policymakers regardless of their views on TBTF per se.

While I have not yet changed my opinion that asset-price levels should not be an objective of monetary policy, I am reviewing this conclusion in the wake of the fallout from the decline in house prices and from the earlier collapse of prices of technology stocks. To be sure, it is challenging at best to identify when asset prices have reached excessive levels, to build support for action once identification has occurred, and to implement corrective policy successfully. These are all significant obstacles, and thus it may well be that containing damage as and after prices correct is, in the end, the preferable alternative.

However, I think it is important to consider these conclusions in light of recent events, where it has proven to be neither easy nor costless to deal with the aftermath of unsustainably high asset prices.

The potential for headwinds is integral to thinking about U.S. economic prospects over the next year or two. To the extent that headwinds gain momentum, they suggest relatively modest growth for a time and the likelihood of increases in the unemployment rate.

People should be under no illusions that even if policy is reasonably effective and reasonably timely that given the disruptions we've had with the financial sector and implications for the outlook...some of this (weakness) is now baked in the cake.

From Q&A as reported by Reuters

I have been a bit disappointed by the incoming inflation data because they have been a bit above what I earlier thought.

From Q&A as reported by Market News International

It's not top of the list of my concerns.

From Q&A as reported by Reuters. Stern was asked if he was worried the Fed was running out of room to maneuvre.

There is no way to put the genie back in the bottle ... Even if we were to announce that we're never going to lend to investment banks again, would that be credible given what we've done.

As reported by Bloomberg News

To be sure, Bear Stearns’ equity holders—including many employees of the firm—took significant financial losses. This was an appropriate outcome. And doesn’t this action sufficiently curtail expectations of government support in the future and thus fix whatever problem such expectations create? The short answer is no.

If spillovers lead to government support, then policymakers who want to reduce creditors’ expectations of such support should enact reforms that make spillovers less threatening. Reforms that fail to address this fundamental issue will not change policymaker behavior and will not convince creditors that they face real risk of loss....Policymakers should:

• reduce their uncertainty about the potential magnitude and cost of spillovers through tools like failure simulation.
• augment policies that manage the losses one firm’s failure imposes on its counterparties.
• enhance payments system reforms that limit the exposure that payment processing creates for financial firms.

Our approach contrasts with some other alternatives policymakers might adopt. Some observers suggest that policymakers try to manage the expanded safety net, for example, by extending rules that procedurally make it more difficult for policymakers to support creditors.

For it is the reduced vigilance of depositors and other debt holders—lulled by implied government support—that leads large financial institutions to take on too much risk and underlies TBTF {To Big to Fail problem}.

Q:  Some of your colleagues have said that maybe it wasn’t wise to keep rates as low or for as long as the Fed’s policy committee did earlier this decade. Do you agree?

A:  It’s hard to separate what I think now from what I thought at the time. I think with the benefit of hindsight, rates may have stayed too low for too long. But if you put yourself back in that environment, don’t forget: There was concern about we were heading toward deflation … and that it might be very difficult to execute effective policy in that environment. We look to bring as much economic science to this as you can, but you’re always making judgments, there’s no getting around it.

Q:  How do you prevent the perception that the Fed, after doing whatever it takes in cutting rates, would be measured and gradual in raising them?

It’s not impossible. … We have to be prepared to put some weight on forecasts. You can’t wait until you’re 100% confident that all the problems are behind us, the economy’s now growing robustly and it’s time to change policy. … Maybe we’ll be dealt that hand where that actually plays out, but I don’t know that we will be. So you have to put some weight on forecasts. You’ve got to be prepared to say, yes there are still some problems, the current environment isn’t all that we might like it to be, but we really think the outlook is pretty good and it’s time to act. The other part of it is to remind ourselves how flexible and resilient the economy is.

I do think that was a major step in providing credit to investment banks and primary dealers. Personally I don’t think there’s any going back from that. That’s not to say that the current facilities are going to be permanent or anything. But the precedent’s been set. I’ve written a lot and expressed a lot of concern about too big to fail and moral hazard and so forth. And I think those issues, once we get some of the current turmoil and strain behind us, I think some of those issues are going to require a very, very careful look….

Right now, I think we are seeing challenges on both sides of that (dual mandate) and I think we are simply going to have to navigate the minefield...We have to take care that the policies we have pursued to date do not compromise the achievement of our dual mandate, and in particular, our objective of sustained low inflation.

As reported by Reuters.

The potential for headwinds is integral to thinking about U.S. economic prospects over the next year or two. To the extent that headwinds gain momentum, and we have seen a few squalls already, they suggest relatively modest growth for a time and the likelihood of increases in the unemployment rate.

As reported by Market News International

So-called 'headline inflation,' boosted by outsize increases in energy and food prices, is clearly too rapid for comfort.

Core measures of inflation, which abstract from fluctuations in prices of food and energy, have been better-behaved, perhaps because real incomes and spending have been restrained by the run-up in food and energy costs.

As reported by Market News International

The implications of the headwinds for inflation are not so clear, although I would note that the pace of inflation diminished in the 1990s relative to its performance over the preceding several years.

As reported by Market News International.

One of the first rules you learn if you're working for the Federal Reserve is to leave comments about the dollar to the Treasury. I'm more
than happy to adhere to that rule ... Having said that, I'd be careful about mistaking correlation and causation. Just because energy prices and the dollar seem to move together -- pick any two prices or [indistinct] you happen to be interested in -- just because they happen to move together doesn't mean there's a causation there.

From Q&A as reported by Market News International

I think the Federal Reserve has taken appropriate policy steps to respond to a significant financial shock, the shock that rendered some markets illiquid, and which has affected the economic outlook negatively.

In this environment, policy needs to remain sensitive to evolving financial conditions and to incoming information on business activity.

As reported by Reuters.

Inflation expectations have remained reasonably well-anchored so far, which is encouraging -- but the key to maintaining low inflation and inflation expectations is likely to be the timeliness and the magnitude of decisions we make to reverse course.

We are highly sensitive to this issue and I am confident that we will conduct policy in an appropriate and timely manner.

As reported by Market News International and Reuters.

"We can't wait until we clearly observe the financial markets at normal, the economy growing robustly, and so on and so forth, before we reverse course,'' Stern, president of the Federal Reserve Bank of Minneapolis, said in an interview today.  ``Our actions will affect the economy in the future, not at the moment.''

As quoted by Bloomberg News

My guess is, it's going to pay to be patient at this point, especially with the developments we've seen on the energy side, where, at least from my perception, some of the concerns about inflation and some inflation expectations seem to have diminished.

...

I think it will be some time before we see growth at or above trend in this economy.

I think that today’s circumstances align well, although certainly not perfectly, with the experience of the early 1990s.
...
It is important to bear in mind, however, that many “initial conditions” prevailing prior to this financial shock were perceptibly better than in the early 1990s. Unemployment, interest rates, and inflation were all lower at the outset of the latest period of turmoil than in the previous headwinds episode. Equally important, the financial condition of both banking and nonfinancial businesses was healthier at the onset of recent problems.

Overall, while there is considerable uncertainty about the outlook and while the policy environment is challenging to say the least, my view is that the early 1990s headwinds episode remains a valuable guide at this juncture. Specifically, it would imply a continuation of only modest expansion in the economy, the likelihood of further increases in unemployment for a time, and a diminution of inflation, absent a resurgence in energy and other commodity prices.

In considering these prospects, it is worth recalling that, despite early challenges, the 1990s turned out to be an excellent decade for the U.S. economy by almost all metrics. The economy is fundamentally flexible and resilient, and these characteristics should ultimately prevail.

We have long had a list of specific reforms to address TBTF, but we have not prioritized those proposals. So of the many recommendations we made, where would we have policymakers start? We would begin the effort to manage TBTF with an approach we call systemic focused supervision (SFS).

I earlier described SFS in general as an effort to apply a focus on spillover reduction to supervision, regulation, and communication as well, but let me now detail its three pillars: they are stress testing; enhanced prompt corrective action (PCA); and stability-related communication.

I have been convinced for some time that financial conditions in the wake of the shock are reminiscent of, although certainly not identical to, those prevailing during the “headwinds” episode of the early 1990s. At the least, that experience provides a useful framework for analysis of the current state of the credit markets, the economy, and intermediate-term prospects.

Making progress against the turmoil at hand is certainly the top priority at this stage. But soon enough policymakers will want to identify fundamental reforms that reduce the likelihood that we will face another period of financial instability.

I think that today's circumstances align, although not perfectly, with the experience of the early 1990s. There is no doubt that a variety of potential borrowers are finding funding more difficult and expensive to obtain. Moreover, while there was a significant contraction in residential construction activity in the late 1980s and early 1990s, the recent correction in this sector has been more severe, especially with the decline in housing values, and is continuing.

It is important to bear in mind, however, that many “initial conditions” prevailing prior to this financial shock were perceptibly better than in the early 1990s. Unemployment, interest rates, and inflation were all lower at the outset of the latest period of turmoil than in the previous headwinds episode. Equally important, the financial condition of both most banking and nonfinancial businesses was relatively healthier at the onset of recent problems.

In my judgment, the 1990s headwinds episode continues to provide a valuable reference point for thinking about economic prospects. For the near-term, I think that this framework suggests further declines in employment and likely softness in consumer spending, with a diminution of inflation, absent a resurgence in energy and other commodity prices.

In view of what we have seen at some large financial institutions and in some funding markets, the need to address TBTF through a framework which reduces spillovers is critical, and we propose systemic focused supervision as a constructive first step in this process...Given the headwinds associated with the financial shock, the economy appears likely to be restrained until these conditions improve, and that will take some time.

I have proposed, and I have spoken previously at some length about, a program called 'systemic focused supervision' (SFS) to begin to accomplish this objective. That is a topic for another day, except for two points that I want to reiterate here: First, at the end of the day SFS is all about preparation and timely action. The underlying idea is, before severe problems arise, to identify potential vulnerabilities and spillovers - that is, to try to determine how the weakness of one large or systemically important financial institution will affect other financial firms and the real economy before the former actually gets into difficulty... Second, policies with the ingredients of SFS are likely to be essential if we are to restore a stable, market-driven financial system.

Indeed, in view of the scope and severity of the recent financial shock, the restraint on economic activity stemming from credit market headwinds could exceed the experience of the 1990s.

I would, however, be cautious about this conclusion, for several reasons. First, many 'initial conditions' prevailing prior to the current financial shock were perceptibly better than in the early 1990s...

Second, the policy response, including the Treasury program to purchase troubled assets from financial institutions and to inject capital into banking firms, as well as the extension of deposit insurance, is substantial and far-reaching...

The Treasury program, properly implemented, will improve capital positions and help to establish values for assets currently locked up...

While policymakers have acknowledged that asset price excesses and their subsequent correction can potentially have meaningful consequences for the economy, they generally have preferred to try to cushion the repercussions of an asset price collapse rather than to address an asset price run-up in its early stages. There are, to be sure, good reasons for this attitude, having to do with the difficulty of identifying asset 'bubbles' in a timely way, the need to build public support for action, and the challenge of weighing the costs and benefits of action for the broad economy. Nevertheless, in view of the damage resulting from the decline in housing values, as well as the aftermath of the collapse of prices of technology stocks earlier this decade, I think it essential to revisit these issues.

Identification of excesses in asset prices, although challenging, does not appear to be beyond the realm of possibility. There is some work in academic circles, and at least some practitioners agree, that when common ratios (the ratio of stock prices to earnings or dividends, for example, or the ratio of housing values to rents) exceed the bounds of historical experience, it is likely that a price correction will follow, although its timing is unpredictable. It would seem likely that misidentification will occur occasionally and, in particular, that some events may be classified as bubbles when they are not.  The implication of this possibility is, in my view, to ensure that the policy response to a perceived excess in asset prices is measured, so that even if in error the ramifications for the economy will be modest.

This consideration illustrates, perhaps, the critical issue in addressing asset price excesses. When all is said and done, will the benefits outweigh the costs, assuming policymakers have made the correct identification? Monetary policy, for which we in the Federal Reserve are responsible, is a blunt instrument with economy-wide effects. We should not pretend that actions taken to rein in those asset price increases which seemingly outstrip economic fundamentals won't in the short run curtail to some extent economic growth and employment; after all, such actions are likely to require raising interest rates earlier and probably more than otherwise would be the case.

We have long recommended that policymakers evaluate policies to address TBTF against their ability to appropriately reduce the likelihood that government will provide support to nominally uninsured creditors of large financial institutions. I believe that policymakers provide such support in order to limit the fallout, or spillovers, that arise when a large financial institution gets into trouble. So effective TBTF policies are ones that allow policymakers to better manage the spillovers from the collapse or failure of a large financial firm.

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I'm skeptical of claims that the Federal Reserve or anyone else should have foreseen the situation as it actually played out. I also strongly support the actions the Federal Reserve has taken in response to these events, even with the undesired side effect of intensifying the TBTF problem. A significant issue, though, is what reforms should policymakers introduce to address the magnified TBTF problem? One criterion is that we consider reforms that would have helped prepare policymakers for the financial fallout they have faced over the last year or so, and it is my conviction that several reforms I have previously articulated fit that bill.

Asked whether there would be FOMC concern about running out of room to cut rates or about running into the "zero bound" on rates, Stern replied, "Personally, I think the bigger issue is that when you get short-term rates that low, for some institutions like money market funds it's very hard for them to be in the business, because there's no room between the cost of their funds and the return on their assets.  So there are some structural or institutional issues that might come into play, but beyond that I'm not sure I see much."

"If you think that the economic outlook requires a lower target, then I think that you should implement it, in my judgment, but with the caveat that I just gave: bearing in mind that there may be institutional reasons why you may prefer to avoid reducing rates," Stern said.

"So you have to weigh those things," he said. "Otherwise, I would say that if the outlook seems to require it then you should do it."

Asked whether the doubling in size of the balance sheet represents "quantitative easing," Stern said "I don't think that's a bad statement.   I think the world is a little more complicated than that, but I don't think that's a bad statement." 

But Stern said the so-called "money multiplier" effect of the expanded Fed balance sheet is less than it otherwise would be because of banks reluctance to lend in an uncertain economic and financial environment.

     "There certainly are a lot of excess reserves around, no question about that," he said. "That's a testimony to the caution and the desire to preserve liquidty and capital" among financial institutions.   "And uncertainty is very high," he continued. "People are concerned about the value of assets; that means for transactions the value of collateral. They're worried about the positions of their counterparties."

(T)here is reason to think that improvement is not too far off. Interest rates are low and financial conditions are improving, albeit unevenly. A major fiscal stimulus package is in the offing, which seems likely to add to aggregate demand in a timely way unless consumers and businesses turn exceedingly cautious. Moreover, adjustments which typically occur in a contraction ultimately help to lay the foundation for renewed growth.

Observers have rightly noted that the financial sector suffers from various market failures around issues of information and misaligned incentives, and supervision and regulation can help address those concerns. At the same time, we have to be careful to avoid two potentially serious pitfalls: 1) excessive reliance on supervision and regulation, essentially asking more than can be delivered; and 2) excessive regulation, resulting in an inefficient financial sector with negative consequences for economic performance.

Once under way, the pace of the expansion is likely to be subdued for a time. There is historical precedent for this, since the recovery of the early 1990s was initially quite modest, as was the recovery earlier this decade. More importantly, in view of the state of the credit markets, it seems a fair bet that it will take time for momentum to build. But with the passage of time—as we get into the middle of 2010 and beyond—I would expect to see a resumption of healthy growth.

It seems likely that, going forward, there will be increased emphasis on tight regulation of financial institutions and their activities, especially of large, complex, “too-big or too-interconnected-to-fail” institutions. Clearly, there will be a role for conventional supervision and regulation in the future. Observers have rightly noted that the financial sector suffers from various market failures around issues of information and misaligned incentives, and conventional supervision and regulation can help address those concerns. At the same time, we have to be careful to avoid two potentially serious pitfalls: (1) excessive reliance on conventional supervision and regulation, essentially asking more than can be delivered; and (2) excessive regulation, resulting in an inefficient financial sector with negative consequences for economic performance.

[T]he track record of S/R does not suggest it prevents risk-taking that seems excessive ex post. True, long shots occasionally come in, and perhaps a regime dependent on conventional S/R would succeed, but it is NCAA tournament time, and we know that a 15 seed rarely beats a number two.

[M]arket discipline is not now a credible check on the risk-taking of these firms; indeed, a critical plank of current policy is to assure creditors of TBTF (too-big-to-fail) institutions that they will not bear losses. Given the magnitude of the crisis, I have supported the steps taken to stabilize the financial system by expanding the safety net, but I am also acutely sensitive to the moral-hazard costs of these steps and have no illusion that losses experienced by equity holders and management will somehow resurrect market discipline.

The bottom line of our analysis is that creditors of large, complex financial institutions expected protection if failure threatened. As a consequence, they had little incentive to be concerned about the condition and prospects of such institutions, leading to underpricing of risk-taking. With risk underpriced, large institutions took on excessive amounts of it, leading eventually to the precarious position of some of them. And policymakers, fearing massive, negative spillover effects to other institutions, financial markets more generally, and the economy itself, validated creditor expectations by providing protection.

[P]roposals which purport to address TBTF but which fail to correct incentives are unlikely to succeed. In particular, proposals to “shrink” the largest financial institutions or to rely on heightened regulation and supervision of and increased capital for such institutions do not address the fundamental problem and must therefore be viewed as unlikely to effectively curb TBTF.

[I]f economic growth resumes in the United States as I expect, the threat of deflation should diminish commensurately... As for liquidity provision and inflation, it is important to emphasize that the relation between growth in the money supply and the path of prices holds in the long run, over periods of at least five and more likely 10 years. Thus, there is ample time for the Federal Reserve to withdraw excess liquidity as appropriate.

Once the economic recovery begins, the pace of the expansion is likely to be subdued for a time. There is historical precedent for this, since the recovery of the early 1990s was initially quite modest, as was the recovery earlier this decade. More importantly, in view of the state of the credit markets, it seems a fair bet that it will take time for momentum to build. But with the passage of time—as we get into the middle of 2010 and beyond—I would expect to see a resumption of healthy growth.

Based on direct observation, I am not convinced that supervisors can consistently and effectively prevent excessive risk-taking by the large firms they oversee in a timely fashion, absent draconian measures that tend to throw out the good with the bad. For this reason, I am not confident that traditional S&R can reduce risk sufficiently such that it addresses the problems associated with TBTF status.⁶   While policymakers should improve S&R by incorporating the lessons learned over the last two years, it cannot be the bulwark in addressing TBTF.

I do see clear benefits in increasing the scope of bank-like resolution systems to entities such as bank holding companies....I have long argued that the resolution regime created by FDICIA would not, by itself, effectively limit after-the-fact protection for creditors of systemically important banks.

The key to addressing TBTF is to reduce substantially the negative spillover effects stemming from the failure of a systemically important financial institution.
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I see three general approaches to addressing concerns over spillovers and thus increasing market discipline (and reducing moral hazard). First, enact reforms that make policymakers more confident that they can impose losses on creditors without creating spillovers that would justify government protection. Second, reduce the losses that failing firms can impose on other firms or markets, which helps reduce spillovers. Third, alter payments systems to reduce their transmission of losses suffered by one firm to others.

I think it pays to keep your options open. Conditions have clearly improved, and that’s gratifying, and so I think those numbers look reasonable to me at the moment, but the last 21 months have been very challenging months, to put it mildly… So I think we need to keep an open mind.

In response to a question about what would make him favor increasing the scale for Treasury purchases above the initial $300 billion target.

Right now, the financial system remains impaired, and there is considerable rhetoric about a so-called credit crunch. To be sure, some borrowers are encountering substantial difficulty in obtaining funding, but conversations with numerous bankers and their customers reveal a diverse set of circumstances, ranging from “business as usual” on the one hand to appreciable credit restriction on the other. One size clearly does not fit all, and it is important to recognize that the demand for credit from some sectors appears to have diminished, and its composition has shifted as well.

Despite a fairly continuous stream of negative news, I continue to think that improvement in the economy is close at hand. At economic turning points—when activity moves from recession to positive growth, for example—the data are inevitably mixed, and there now are in fact positive signs of stabilization

It is…likely to take a considerable period for the labor market to recover, as employment may well continue to decrease in finance, autos, and construction, for example, even as it picks up elsewhere. It is worth recalling in this regard that the unemployment rate peaked 15 months into the expansion of the 1990s and 19 months into this decade's expansion. In any event, with the passage of time—as we move into the middle of next year and beyond—I would expect to see a resumption of healthy growth.

If one examines the inflation record of the United States, and of many other industrial economies for that matter, since the early 1980s, it appears that central banks have largely succeeded in delivering diminishing and, ultimately, low inflation. I can think of no reason why this cannot continue.

In my view, asset prices should play a greater role in policy deliberations and decisions than currently is the case…in view of the damage resulting from the decline in housing values, as well as the aftermath of the collapse of prices of technology stocks earlier this decade, I think it essential to revisit these issues.