Kevin Warsh

One of the most striking financial developments since 2001 has been the rapid increase in corporate holdings of cash and short-term securities.  Since the end of 2001, the ratio of cash holdings to assets has risen sharply (see exhibit).  This increase is even more pronounced when (on a consolidated basis) cash is measured relative to investment, defined as the sum of capital spending and research and development (R&D) spending during the preceding twelve months.  The ratio of cash to investment has averaged about 60 percent during the past few decades.  Generally, it is higher in recession periods, consistent with a strong precautionary savings motive by firms that face costly external financing (Almeida, Campello, and Weisbach, 2004).  And, in 2001, the ratio of cash to investment was already somewhat elevated.  But the ratio then soared to more than 150 percent by year-end 2004, as investment fell far short of cash flow from operations and net financing.  This juxtaposition is unusual when the economy is expanding. 

It is difficult to determine whether a corporation’s cash is held at home or abroad, but we know that significant holdings of cash are concentrated at large multinational firms.  In particular, the Board staff’s analysis (of Standard & Poor’s Compustat data) indicates that the ratio of cash to total assets at domestic-only companies rose slightly less than 20 percent between year-end 2001 and 2004.  At the same time, the cash intensity of balance sheets at multinational companies increased more than 50 percent.  Moreover, recent research has demonstrated a strong statistical link between the accumulation of cash and the estimated tax burden from repatriating foreign earnings (Hartzell, Titman, and Twite, 2006).

As a means of unlocking those offshore cash holdings, the Congress and the President provided U.S. companies a one-time opportunity--through the American Jobs Creation Act of 2004--to repatriate foreign profits at a much reduced statutory tax rate.  Indeed, Wall Street estimates indicate that many companies have capitalized on this opportunity: An extra $250 billion may have been repatriated during the past four quarters.  That estimate appears consistent with the recent pattern of distributions from foreign income reported in the Commerce Department’s international transactions data.

Many signs point to a continuation of this high pace of equity retirements. Valuations for many firms appear attractive to private equity sponsors. (Although, as I noted earlier, stock prices have risen quite a bit since 2002, their gains have been far outstripped by the boom in earnings.) Lower valuations for firms in industries that are in the throes of downsizing also provide opportunities for LBOs.

Market discipline, however, may not always be fully effective in this context. The development of the federal safety net--deposit insurance, the discount window, and access to Fedwire and daylight overdrafts--has inevitably impeded the workings of market discipline in the regulatory arena. That is, the various elements of the safety net provide depository institutions and financial market participants with a level of safety, liquidity, and solvency that was far less prevalent before the advent of the Federal Reserve and the subsequent establishment of federal deposit insurance. By deterring liquidity panics, the safety net shields the overall economy from some of the worst effects of instability in the financial system. These benefits, however, are not without costs. The prospect of government intervention distorts market prices and may also engender excessive risk-taking.

Inflation, though down somewhat from its level earlier this year, remains uncomfortably elevated. Financial market prices imply that inflation will continue its gradual but persistent downward track during the forecast period. There remain, I believe, clear upside risks to that inflation outlook.

Our own policies and actions affect market prices. As a result, when we look to financial markets for information, the information we seek may be shaped in part by our own views. The more that "market information" reflects our own actions, the less it is useful as a source of independent information to inform our policy judgments.

We need to be alert to this "mirror problem," in which markets can cease to provide independent information on current and prospective financial and economic developments. In the extreme case, financial markets keenly follow the Federal Reserve, the Federal Reserve is equally attuned to the latest financial quotes, and fundamentals of the economy are obscured. Under such circumstances, asset prices might teach us only about our skills as communicators.

The shape of the yield curve is not overly convincing in telling us the economy will soften.

From audience Q&A session.

Prices on federal funds futures and Eurodollar futures suggest that market participants expect the FOMC to cut the target federal funds rate about 50 basis points during 2007, a view consistent with expectations of a "soft landing." At the same time, market-based options prices on these interest rate futures indicate that implied volatilities are quite low, suggesting a surprising degree of certainty regarding policy expectations. Taken at face value, market participants appear to be reasonably certain of a benign outcome for both economic growth and inflation. In contrast, my own judgmental forecast includes a wider range of possible outcomes than is implicit in these market-based measures.

In recent quarters, we witnessed very strong credit markets, bulging pipelines for leveraged loan and high-yield bond issuance, and near-record low credit spreads...

Fund managers of private pools of capital seized upon this opportunity to acquire more-permanent sources of capital: extending lock-up periods; using retail platforms and co-investment funds to increase ‘stickiness’ of contributed capital; securing greater financing flexibility from prime brokers; accessing the private placement markets; and selling public shares of limited and general partnership interests to new investors; to name just a few.

Therefore, I wish to advance a simple proposition: Liquidity is confidence. That is, powerful liquidity in the U.S. capital markets is evidenced when the economic outcomes are believed to be benign. When the “tail” outcomes are either highly improbable or, at the very least, subject to reasonably precise measurement, the conditions are ripe for liquidity to be plentiful.

Third, liquidity in U.S. markets also increased significantly in recent years due to increased international capital flows. These flows to the United States from global investors lead to higher liquidity by increasing capital available for investment and facilitating greater transfer and insurability of risk. A recent report by McKinsey & Company estimated that aggregate international capital flows amounted to $6 trillion in 2005--almost triple the volume a decade earlier--and that one-quarter of the worldwide volume flowed through the United States.

Indeed, when different measures of the money supply were established, it was with an eye toward determining the liquidity of the underlying assets; as an example, components of M1 were considered more liquid than those in M2. It is in this sense that some observers view the stock of money as a measure of liquidity, and changes in these measures as roughly equivalent to changes in liquidity. I doubt, however, that traditional monetary aggregates can adequately capture the form and structure of liquidity many observe in the financial markets today.

The U.S. economy continues to demonstrate extraordinary resilience, no doubt supported by the ability of financial markets to absorb substantial shocks. Financial markets have been buffeted by a number of significant events, including a spate of corporate accounting scandals, the bond rating downgrades of Ford Motor Company and General Motors Corporation to speculative-grade status, the failure of Refco, (at the time the largest broker on the Chicago Mercantile Exchange), and the imposition (and pullback) of capital controls in Thailand. But the effects on broader markets appear to have been remarkably contained. Even the episode last year involving the hedge fund, Amaranth, which accumulated losses of $6 billion in a few short weeks, seemingly had little impact beyond its direct stakeholders.

Liquidity exists when investors are confident in their ability to transact and where risks are quantifiable. Moreover, liquidity exists when investors are creditworthy. When considered in terms of confidence, liquidity conditions can be assessed through the risk premiums on financial assets and the magnitude of capital flows. In general, high liquidity is generally accompanied by low risk premiums. Investors’ confidence in risk measures is greater when the perceived quantity and variance of risks are low.

Some market participants tell me that the very low bond default rates seen recently, realized and expected, are themselves a reflection of liquidity. That is, excess market liquidity may have allowed less than creditworthy firms to refinance their obligations, thereby only deferring their financial difficulties. Other observers note the rise in the second half of last year in the share of new bond issuance that is rated highly speculative, and an increase in purchase and debt-multiples for leveraged buyouts, suggesting some pickup in risk-taking that may be indicative of overconfidence.

Complacent investors also may be willing to buy new debt offerings that are light on traditional covenants if they come to believe that outcomes are assuredly benign.  Moreover, without strong covenants on existing debt, firms can raise additional funds without triggering defaults, which may decrease defaults in the short run, but perhaps increase them in the long run.  In these cases, this “gloss” of confidence could cause a misallocation of resources, if companies or consumers without compelling prospects for full repayment nonetheless readily obtain credit. 

There is little doubt, then, that liquidity in most financial markets is high today and that investors seem willing to take risks, even at today’s market-prevailing prices. In the United States, term premiums on long-term Treasury yields are very low, corporate bonds appear to be nearly “priced for perfection,” and stock prices are setting new records. Credit markets are highly accommodative for issuers, and the volume of loans to finance highly leveraged transactions is escalating rapidly. These prices, terms and credit conditions may reflect solid economic fundamentals--low output and inflation uncertainty, healthy corporate balance sheets, and corporate profits that exceed market expectations--and if so, they may help to ease the effects of fluctuations in liquidity should they occur. The prices and conditions may also reflect increased appetite for risk; or, far less auspiciously, they may be indicative of investor overconfidence.

Community banks today--to a somewhat greater degree than their larger money-center brethren--most clearly retain the traditional commercial banking approach to financial intermediation.  Community banks finance relatively opaque entities, such as private companies and households.  They raise funds primarily by issuing demand deposits.  They deploy capital by underwriting loans, monitoring borrowers, and retaining some loans in portfolio as long-term investments. 

Perhaps because of more complete markets, shocks to liquidity are less likely to become self-fulfilling and less likely to impose more lasting damage. That hypothesis seems particularly credible when the shock is based neither on rapidly changing economic fundamentals nor a genuine breakdown in market infrastructure. In the recent episode [in Febryary 2007], opportunistic capital apparently viewed large movements in asset prices as trading opportunities. Or, perhaps, striking as it was, we have not yet witnessed a scenario that subjects the latest product innovations and behavior of market participants to a sufficiently stringent stress test.

During the past few decades--particularly the last few years--we have witnessed an escalating supply of new financial instruments scarcely able to match surging demand. Through the technique of unbundling risks--dividing them by category and tranche--financial instruments proliferated to enable risks to be borne by those most willing to accept them. And with the benefit of ample liquidity, which I described in previous remarks as broadly equal to confidence, financial products quickly found deep markets, ensuring robust trading.

“[L]iquidity” in the sense of “trading liquidity” reflects the ability to transact quickly without exerting a material effect on prices. Underlying this concept is the fact that although the many buyers and sellers have different views on the most likely outcomes, the distributions of possible outcomes for which they demand risk-based compensation can be quantified. Liquidity exists when investors are confident and willing to take risks. Liquidity, then, can be viewed as confidence on the part of buyers and sellers of securities. By disaggregating a security into its constituent risk components, financial innovation can unlock this liquidity.

Strong global economic performance provides another important support for the high liquidity and levels of confidence in today’s capital markets. Many economies have achieved a marked reduction in the volatility of real output and core inflation in the past twenty years or so. Liquidity can flourish if investors interpret strong performance to mean that future economic outcomes will be benign and that “tail” realizations are either highly improbable or, at the very least, quantifiable and, hence, can be traded upon.

The Board believes that the increased scale and scope of hedge funds has brought significant net benefits to financial markets. Indeed, hedge funds have the potential to reduce systemic risk by dispersing risks more broadly and by serving as a large pool of opportunistic capital that can stabilize financial markets in the event of disturbances. At the same time, the recent growth of hedge funds presents some formidable challenges to the achievement of public policy objectives, including significant risk-management challenges to market participants. If market participants prove unwilling or unable to meet these challenges, losses in the hedge fund sector could pose significant risks to financial stability.

The Board believes that the "Principles and Guidelines Regarding Private Pools of Capital" issued by the President's Working Group on Financial Markets (PWG) in February provides a sound framework for addressing these challenges associated with hedge funds, including the potential for systemic risk.¹ The Board shares the considered judgment of the PWG: the most effective mechanism for limiting systemic risks from hedge funds is market discipline; and, the most important providers of market discipline are the large, global commercial and investment banks that are their principal creditors and counterparties.

Although there is no precise legal definition, the term "hedge fund" generally refers to a pooled investment vehicle that is privately organized, administered by a professional investment manager, and not widely available to the public..  By the end of 2006, more than 9,000 funds managed more than $1-1/2 trillion of assets.³ Assets managed in the United States are estimated to account for about 60 percent of the total. The hedge fund industry remains small relative to the U.S. mutual fund industry, which included more than 8,000 funds with about $10-1/2 trillion of assets under management at the end of 2006.⁴ Hedge funds, however, can make greater use of leverage than mutual funds. Their market impact is further magnified by the active trading of some funds. The aggregate trading volumes of hedge funds reportedly account for significant shares of total trading volumes in some segments of the financial markets.⁵

In the immediate aftermath of the episode, the PWG studied the implications for financial stability and published its conclusions in April 1999 in a report entitled "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management."⁶ The report concluded that the episode had posed a threat to financial stability as a result of a breakdown in market discipline by its creditors and counterparties, which allowed LTCM to become leveraged excessively. The report concluded that the most effective means of limiting systemic risk from hedge funds was to reinvigorate market discipline. To that end, the PWG made various recommendations, which were directed primarily at enhancing credit risk management by hedge funds' creditors and counterparties.

In recent months, many market participants have expressed concern that a widening of credit spreads from relatively narrow levels could lead to hedge fund losses that would make funds unwilling or unable to maintain their existing positions, thus potentially eroding market liquidity. Such circumstances could pose significant challenges to hedge funds' counterparties and creditors and perhaps to other market participants. Thus far, however, the repricing of credit risk does not appear to have imposed significant strains on the financial system.

The Federal Reserve is focusing on the risks to U.S. bank holding companies from leveraged lending activities--that is, from lending to relatively higher risk corporate borrowers, often to finance acquisitions or leveraged buyouts. The largest U.S. banks typically distribute a large share of the loans that they originate to other banks and institutional investors. Nonetheless, the banks can be exposed to significant risks, and the review is intended to assess the scale of these risks and the effectiveness of the banks' associated risk-management practices. The Federal Reserve's efforts in this area are being coordinated with the OCC and the SEC.

The Federal Reserve's supervision of counterparty risk management practices is part of a broader, more comprehensive set of supervisory initiatives. The goal of these initiatives is to assess whether global banks' risk-management practices and financial market infrastructures are sufficiently robust to cope with stresses that could accompany a deterioration of market conditions, including a deterioration that might result from the rapid liquidation of hedge funds' positions.

The adjustment process by private investors has increased the risk that banks may increasingly be called upon as backup providers of funding.  The Federal Reserve responded to these developments by providing reserves to the banking system; it announced a cut in the discount rate of 50 basis points and adjustments to the Reserve Banks' usual discount window practices to facilitate the provision of term financing.  In addition, earlier this week, the FOMC lowered its target for the federal funds rate by 50 basis points.  The action was intended to help forestall some of the adverse effects on the broader economy that might arise from the disruptions in financial markets and to promote moderate growth over time.  Recent developments in financial markets, including impaired price discovery, have increased the uncertainty surrounding the economic outlook.  What originated as a liquidity shock could potentially give rise to increases in credit risk.  The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to meet our dual mandate, fostering price stability and economic growth.  

There are also important reasons to be concerned about the outlook for inflation.  Although recent readings on core inflation have been favorable, prices of crude oil and other commodities have increased.  These changes most likely will put upward pressure on overall inflation in the short run.  Moreover, the decline in the foreign exchange value of the dollar could lead to higher prices for imported goods.  If these same forces cause inflation expectations to become less reliably anchored, then inflation could increase in the longer run as well. 

London, Hong Kong, Singapore, and Shanghai increasingly seek to challenge New York as the center of global financial markets. Competitive national ambitions, perhaps, have demanded an embrace of economic liberalism to build wealth even among those regimes that may prefer something closer to autocracy in their non-economic dealings.

The consequences of the liquidity shock of 2007 on the financial markets and the real economy are still playing out in real time. It is premature to delineate lessons learned with complete assurance. The facts, nonetheless, can perhaps be placed in some narrative context, drawing on the experience of prior bouts of financial instability. History, of course, is far from a perfect teacher. After all, history does not repeat itself; it only appears to do so. In that regard, the causes and consequences of market turmoil are still insufficiently understood for the end of history to be declared

Warsh said in response to a question afterward that any central bank, including the Fed, cannot be ``indifferent to the value of its currency.'' Three days ago, finance chiefs from the U.S. and other Group of Seven nations signaled concern on the dollar's slide and said the global economic slowdown may worsen amid an ``entrenched'' credit squeeze.

As reported by Bloomberg News

 

If you've seen one financial crisis, you've seen one financial crisis ... This does appear to be different.

From Q&A as reported by Reuters

What I can tell you is that no central banker ... can be indifferent to the value of his currency.

From Q&A as reported by Market News International

Consistent with our dual mandate of promoting maximum employment and stable prices, we also need to be alert to risks to price stability. Increases in food and energy prices have pushed up overall consumer prices and are putting upward pressure on core inflation and inflation expectations. We will continue to monitor the inflation situation closely. And, more broadly, in my view, as financial intermediation channels reset, monetary policy will become still more efficacious.

Fed policy--both with respect to liquidity tools and monetary policy--is partially offsetting the consequences of the liquidity and credit pullback on real activity. But we must be careful to not ask policy to do more than it is rightly capable of accomplishing. The problems afflicting our financial markets are indeed long-in-the-making. Correspondingly, the curative process is unlikely to be swift or smooth. Time is an oft-forgotten, yet equally essential, tool of our policy response.

Volatility is generally a friend, not a foe, of market functioning. It should not be treated as an externality from which we suffer. Volatility, absent destabilizing moves, should be allowed to effectuate change in the financial architecture of private markets. Only then, I suspect, will a more robust recovery in market liquidity, investor confidence, and real economic activity be achieved.

The central bank's responsibility is not to individual firms but to financial markets, and only then, to the extent that financial market stresses affect the real economy. Given the fragility evidenced in financial markets, and the toll it is taking on real activity, the Federal Reserve agreed to take center stage. This is a role for which we did not volunteer, but one in which we are prepared to serve. The role has been thrust upon us by a loss of confidence in our existing financial architecture. Hence, we should remain at center stage as long as is necessary, but no longer.

The case for opportunistic capital is improving. Some curative steps by incumbent financial institutions are in the offing. Financial institutions should continue to reassess their sources and uses of funding, their risk-management systems, risk tolerance, and human capital. Generally, they should not hesitate to pare their dividend and share repurchase programs. And, they should raise new capital to strengthen their balance sheets. These actions, in my view, are important signs of strength, and will ensure that financial institutions thrive in the emerging financial architecture replete with new opportunities. These actions will have concomitant benefits on real economic activity.

More fundamentally, in my view, funding market disruptions reflect a striking decline in confidence in the financial architecture itself. Perhaps an analogue to banking systems without deposit insurance is appropriate: Depositors withdraw funds if they believe others will act similarly. In short-term credit markets with minimal liquidity support, investors balk if they lose confidence in other investors' willingness to roll maturing paper. Even when liquidity support exists, it may well prove insufficient to address market-wide concerns. ... After all, a loss in confidence can be completely rational: Illiquidity forces issuers to sell assets into distressed markets.

[L]et me explore three of the most trenchant and overlapping plot lines, none of which seem to avail themselves readily to a speedy resolution. First, a striking loss of confidence is affecting financial market functioning. Second, the business models of many large financial institutions are in the process of significant re-examination and repair. Third, the Federal Reserve is exercising its powers to mitigate the effects of financial turmoil on the real economy. This third plot line, however necessary, will not, in and of itself, ensure a more durable return of trust to our financial architecture. In my view, public liquidity is an imperfect substitute for private liquidity. That is, only when the other plot lines advance apace--meaning that significant, private financial actors return to their proper role at center stage--will credit market functioning and support for economic growth be fully restored. And for that to happen, as I am confident it will, we will find that the financial markets and financial firms are outfitted quite differently.

Credit is threatening to displace liquidity as the primary antagonist. A credit crunch, particularly for small businesses and consumers, poses meaningful downside risks to the real economy. And market participants are struggling to assess the possibility that the narrative turns into a multi-act, macroeconomic drama.

[W]e should recognize that Fed-supplied liquidity is a poor substitute for private-sector-supplied liquidity.  When liquidity flows among private-sector participants, the players can more judiciously assess risk and reward, more adroitly learn from the recent turmoil to strengthen the resiliency of credit intermediation, and more ably allocate capital to its most productive uses in the real economy.  Moreover, Fed-provided liquidity should not be mistaken for capital.  

Market participants now seem to be questioning the financial architecture itself. The fragility of short-term credit markets is a powerful manifestation of that loss of confidence. There are some encouraging, early signs of repair, but regaining the confidence that markets require will take time, and perhaps uncomfortably to some, patience. It may also require new forms of credit intermediation.

The costs [of Sarbanes-Oxley] are relatively easy to delineate. The benefits are harder to delineate, but that doesn't mean they don't exist.

As reported by Market News International

Consistent with Munger's admonition, the Fed saw it necessary to expand our toolkit beyond the proverbial hammer of the policy rate in the last nine months. And as I discussed in remarks last month, the Fed's nontraditional policy response included the use of innovative liquidity tools to counter the market turmoil and improve the functioning of financial and credit markets.⁴

In my remarks today, I would like to discuss the use of the hammer--the setting of the federal funds rate--particularly in extraordinary times. Of course, determining the proper level of the federal funds rate is rarely simple, given typical imprecision on key economic variables and relationships. It is far more challenging still when the financial architecture is in the early stages of redesign, the economy is adjusting to the aftermath of a credit bubble (witnessed most acutely in the housing markets), and inflation risks are evident.

The Federal Reserve has employed the hammer with considerable force in the last nine months, lowering the federal funds rate by 3-1/4 percentage points, with wide-ranging implications for the economy. Of substantial import, we have filled the toolkit with other implements to provide liquidity and improve the provisioning of credit during the turmoil. But now, policymakers may be well served encouraging a new financial architecture to emerge, aided, in part, by the actions we have taken. Even if the economy were to weaken somewhat further, we should be inclined to resist expected, reflexive calls to trot out the hammer again.

Policy actions should reinforce the notion with stakeholders that further hammering needs to be done, but it needs to be accomplished by the financial institutions themselves in retooling their businesses and rebuilding the credit channel to help ensure a stronger, more durable economy.

The Taylor rule provides a convenient rule-of-thumb for setting monetary policy.⁶  The rule posits that the appropriate setting of the real federal funds rate incorporates three components. The first component is the economy's natural rate of interest. This is the real federal funds rate consistent with output equal to potential, on average, over the medium- to long-run. If policymakers set the real federal funds rate at this level, the Fed would be neither artificially boosting nor restricting the real economy over long periods. Holding the federal funds rate at the natural rate, however, may yield an undesirably slow return of real activity to normal, particularly if shocks have a persistent effect on aggregate demand and supply.

To expedite the process, the Taylor rule adds a second component to the real federal funds rate, one that purports to be proportional to the size of the current output gap. By setting the real federal funds rate below the natural rate when resource utilization is loose--and, correspondingly, above the natural rate when resource utilization is tight--policy purports to help move the real economy back to normal at a speedier pace. The third component responds to the gap between actual inflation and its desired rate, pushing real rates up when inflation is too high and pushing rates down when inflation is too low.

The Taylor rule provides a reasonable description of actual monetary policy behavior on average over the past 20 years. The reasonably good macroeconomic performance of this period suggests that central banks should pay some heed to its prescriptions. By design, however, the Taylor rule focuses largely on what can be observed in real-time, without accounting for some factors that influence monetary policy.

Munger, the proud non-economist, recounts another lesson born of his investment career that I find particularly heartening in considering the calculation of the neutral rate: Avoid the error of false precision.⁸ Most monetary policy frameworks, while fiercely debated in the academy, tend to suffer from a common and unavoidable weakness--relying on provisional estimates in a complex and uncertain world. This weakness argues in favor of being persistently inquisitive in search of a keener understanding of the economy. This consideration applies to the making of monetary policy in normal times; in times of turmoil, the case for humility is stronger.

And how about when the real economy is operating below-trend in large part because financial markets are impaired, many financial intermediaries are undercapitalized, and risk and liquidity premiums are large and especially volatile? What happens when banks and other financial institutions that stand between the Fed and the real economy restrict the supply of credit beyond that implied by higher premiums or, potentially, economic fundamentals? Should markedly higher doses of monetary medicine (read: lower rates) be proffered to compensate fully for the reduced efficacy of the transmission channels?

Financial turmoil lowers real activity expected to accompany a given level of the federal funds rate. Such a development is equivalent to a fall in the neutral rate. But policymakers should recognize that financial market turmoil is not a garden-variety shock to output. It is different than, say, a demand shock caused by a change in exports. Financial market turmoil can lower output growth and limit the efficacy of the transmission mechanism concurrently. The federal funds rate, I maintain, will generally need to be lowered, and by more than in normal circumstances, to achieve an operative monetary policy rate that helps to restore the economy expeditiously to equilibrium. But policymakers need to think carefully about two issues: the degree of reduction in the federal funds rate and the pace at which the rate returns to normal.

The wisdom of emphasizing a forward-looking strategy over the Taylor rule approach may depend in part on policymakers' forecasting acumen. To estimate the neutral rate, central bankers must forecast how the forces affecting aggregate demand and supply will reconcile during the forecast period. Moreover, policymakers must project how changes in the federal funds rate--past and anticipated--will interact with asset prices, credit provision, and real-side variables. Under the best of circumstances, these forecasts are subject to meaningful uncertainty. Thus, peering into the future and acting on what we think we see will invariably lead to some mistakes, certainly with the benefit of hindsight. Ignoring the future altogether, however, hardly seems the wisest course.

Moreover, the Taylor rule approach does not remove uncertainty.

Determining appropriate policy necessarily involves more than figuring out the neutral real federal funds rate. This reality is especially obvious at present. Inflation has been elevated for some time and prices of commodities are surging. I find these trends particularly vexing at a time when global demand growth, most likely, has slowed.

What about the role of the federal funds rate when the real economy is performing smartly but financial markets are functioning with exceptionally low volatility, and liquidity and credit spreads are extremely narrow? In these periods, the relationship between the federal funds rate and real activity is more difficult to decipher. If abundant credit availability is perpetuated by investor overconfidence, I would submit, policymakers may need to target a higher federal funds rate than otherwise to help the economy attain a sustainable equilibrium. That is, a federal funds rate that is satisfactory in times of normal market functioning may turn out be lower than required to ensure that the economy performs at potential through the horizon. Making that judgment represents an important, but difficult task for policymakers.

Whether the economies of the rest of the world have successfully decoupled from the United States is a judgment we will have to leave to the economic historians. What I do believe, however, is that our financial markets at the center of this turmoil have not decoupled, not even a little bit. In fact, our financial institutions and financial markets have never been more integrated. Policy differences, thus, should not be taken lightly.

Returning the economy to equilibrium requires actions more befitting than changes in the federal funds rate alone. The lending facilities created and employed by the Fed are likely proving useful in this regard. Increasing liquidity by having a central bank lower the federal funds rate can reduce the risk of a more severe financial crisis, but is imperfectly suited to compensate for declines in liquidity arising from retrenchment in the financial sector for long periods.

Today's introduction of the Treasury Covered Bond Framework may be illustrative of the benefits of product innovation in globally connected financial markets.

Treasury's discussions with market participants suggest that a covered bond framework may attract investor interest and facilitate greater access to mortgage credit. High-quality assets might be financed if banks are allowed to manage pools of loans, substituting new loans into the pool as others become delinquent.  Newly issued covered bonds backed by high quality mortgage loans and issued by strong financial institutions may find a growing investor base in the United States.

The Federal Reserve has long accepted a broad range of high-quality collateral from depository institutions at its discount window. Highly rated, high-quality covered bonds would generally fall within that broad range as eligible collateral.  Private lenders also are likely to find such bonds attractive as collateral for credit extensions.

There are some notable signs of improvement. Short-term funding spreads are retreating from extremely elevated levels. Funding maturities are being extended beyond the very near term. Money market funds and commercial paper markets are showing signs of stabilization. And credit default swap spreads of banking institutions are narrowing significantly.

While housing may well have been the trigger for the onset of the broader financial turmoil, I have long believed it is not the fundamental cause.⁵ Indeed, recent financial market developments strongly indicate that housing, as an asset class, does not stand alone. Indeed, the problems associated with housing finance reveal broader failings, including inadequate market discipline, excessive reliance on credit ratings, and poor credit and liquidity risk-management practices by many financial firms.

Financial stability demands policy stability. The official sector's policy preferences must be communicated clearly, credibly, and consistently and backed by concrete action.

Characterizing the current period as a "recession" is still wanting, insufficient in some important respects. In my view, this period should equally be considered a panic, one that preceded, if not made more pronounced, the official recession. Hence, the Panic of 2008, which preceded the calendar year, is a more revealing description of the recent economic and financial travails.

Stability is a fine goal, but it is not a final one. Long after panic conditions have ended, stability threatens to displace economic growth as the primary macroeconomic policy objective. But we must recognize that the singular pursuit of stability, however well intentioned, may end up making our economy less productive, less adaptive, and less self-correcting--and in so doing, less able to deliver on its alluring promise. This fate, however, does not have to be ours. The U.S. economy is capable, in my judgment, of delivering more.

I will leave it to economic historians to assess whether the Panic of 2008 was more anomalous than the period of prosperity that preceded it. I believe that the categorization of recent events as deviant, ultimately, will depend on what happens next. That is, if policy changes cause future economic performance to suffer, then the boom of the last generation may, regrettably, turn out to be more exceptional than the bust.

Exceptional fiscal expenditures, by their own terms, are intended to replace shortfalls in aggregate demand. And recent extraordinary monetary policy actions are intended to lower risk-free rates and grow balance sheet capacity to help offset the pullback by private financial intermediaries. But financial markets may extract penalty pricing if fiscal authorities are unable to demonstrate a credible return to sustainable budgets. And they are unlikely to look kindly on monetary authorities unless they decidedly and unambiguously chart their own independent paths. The Federal Reserve should not--and will not--compromise another kind of stability--price stability--to help achieve other government policy objectives.

[U]nemployment rates, in my judgment, are likely to remain higher and linger longer than in recent recessions. The "jobless recovery" may prove to be a familiar and vexing refrain.

Looking ahead, I could well imagine that the natural rate of unemployment trends higher.

Output per hour, or productivity, is the secret sauce to U.S. economic growth and to rising living standards, but I fear that the recipe may have lost some key ingredients. Growth in labor productivity arises when a firm's workers use more and better physical capital, or when firms become more efficient at converting inputs into output. Innovation plays a key role, both because it directly boosts efficiency and because firms' decisions to invest in physical capital tend to depend on the underlying pace of innovation. In addition, in today's economy, the productivity of many firms relies heavily on intangible, or intellectual, capital; although hard to measure, intangible capital appears to also be tied to innovation.

I would hazard the view that prudent risk management suggests that policy will likely need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary, and taking proper account of the policies being instituted by other authorities.

In my view, if policymakers insist on waiting until the level of real activity has plainly and substantially returned to normal--and the economy has returned to self-sustaining trend growth--they will almost certainly have waited too long. A complication is the large volume of banking system reserves created by the nontraditional policy responses. There is a risk, of much debated magnitude, that the unusually high level of reserves, along with substantial liquid assets of the banking system, could fuel an unanticipated, excessive surge in lending. Predicting the conversion of excess reserves into credit is more difficult to judge due to the changes in the credit channel.

Ultimately, when the decision is made to remove policy accommodation further, prudent risk management may prescribe that it be accomplished with greater swiftness than is modern central bank custom. The Federal Reserve acted preemptively in providing monetary stimulus, especially in early 2008 when the economy appeared on an uneven, uncertain trajectory. If the economy were to turn up smartly and durably, policy might need to be unwound with the resolve equal to that in the accommodation phase. That is, the speed and force of the action ahead may bear some corresponding symmetry to the path that preceded it. Of course, if the economy remains mired in weak economic conditions, and inflation and inflation expectation measures are firmly anchored, then policy could remain highly accommodative.

"Whatever it takes" is said by some to be the maxim that marked the battle of the last year. But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns. If "whatever it takes" was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Fed's institutional credibility. The asymmetric application of policy ultimately could cause the innovative policy approaches introduced in the past couple of years to lose their standing as valuable additions in the arsenal of central bankers.

Government interventions during the past couple of years, however necessary, revealed a set of policy preferences. These expectations must be unlearned by market participants. Eradicating the too-big-to-fail problem should be the main policy goal.

If it cannot be achieved, the next-best regime may involve choosing a point between two competing models: regulating what financial institutions can do, and regulating how they do it (as Paul Tucker at the Bank of England set out). Clear rules – more focused on the what than the how – could free them to depart Washington’s lobbies and get back to business.

If real reform were chiefly about the number of financial regulators in Washington--or even the precise relationships between financial regulation and the role of the central bank--we should find an institutional design among major financial centers around the world that lived up to its promise. We find no such example. Policymakers, in my view, should be more focused on what constitutes effective prudential supervision, rather than be diverted to the less consequential discussion as to who should perform it.

The Fed's greatest asset is its institutional credibility. This institutional credibility is rooted in its inflation-fighting credibility, but it is broader still. It is tied up in the full range of Fed actions and balance sheet commitments. This credibility is essential. It increases the heft of our communications. It gives weight to our economic assessments. It amplifies the effect of announced changes in the short-term policy rate on longer-term rates. It is, in some sense, the real money multiplier in the conduct of policy.

Some suggest that central bankers themselves should choose to modify their definitions of price stability. If inflation persisted at higher levels during normal times, the theory goes, central bankers could cut rates more substantially in response to economic weakness. The theory, in my view, fails the real test of experience.

Central banks that desire just a little more inflation may well end up with a lot more. Some point to a strategy to accept a little more inflation for less unemployment as a primary basis for the great inflation of the 1970s in the United States.¹⁰ By definition, an increase in an implicit inflation target would lead to an upward shift in inflation expectations. And how would a central bank make credible its promise that such a shift would be only a one-time event?

What stage are we in now? I would say we are, in different forms, in an exit stage... [The Fed has] for quite some time now (been) exploring the exit, describing the exit from the liquidity facilities and differentiating that from exit from our core monetary policy functions.

In my view, any judgment to expand the balance sheet further should be subject to strict scrutiny. I would want to be convinced that the incremental macroeconomic benefits outweighed any costs owing to erosion of market functioning, perceptions of monetizing indebtedness, crowding-out of private buyers, or loss of central bank credibility.

[F]acts, not force, should be the predominant policy response. Prevailing wisdom has it that policymakers must overreact when markets do. In my view, this is an uncertain proposition. If a problem were unique or isolated, game theory suggests that overwhelming force might serve policymakers' interests. But, these problems are not isolated. And it is no game. Markets will continue to clamor for more explicit government commitments. Better to feed the proverbial beast with more facts than force. The Federal Reserve-led stress tests are but one example where the balance was reasonably struck.

We will soon give notice to the third anniversary since the onset of the global financial crisis. As we mark this occasion--and continue to witness shocks arising intermittently and unevenly--it might be worth debunking some popular views that have become part of the crisis narrative. In their stead, I will begin with what I believe are some truths, perhaps hiding in plain sight all along.

Subprime mortgages were not at the core of the global crisis; they were only indicative of the dramatic mispricing of virtually every asset everywhere in the world. The crisis was not made in the USA, but first manifested itself here. The volatility in financial markets is not the source of the problem, but a critical signpost. Too-big-to-fail exacerbated the global financial crisis, and remains its troubling legacy. Excessive growth in government spending is not the economy's salvation, but a principal foe. Slowing the creep of protectionism is no small accomplishment, but it is not the equal of meaningful expansion of trade and investment opportunities to enhance global growth. The European sovereign debt crisis is not upsetting the stability in financial markets; it is demonstrating how far we remain from a sustainable equilibrium. Turning private-sector liabilities into public-sector obligations may effectively buy time, but it alone buys neither stability nor prosperity over the horizon.

Warsh said a reliable currency is a “great historical strength” for the U.S. that allows investment from sources outside the country. In general, having “certainty” over foreign-exchange rates is “useful” for businesses, he said. Economic outcomes tend to be worse when governments are preoccupied with foreign-exchange policy, he said.

Monetary policy can surely have great influence--most notably by establishing stable prices and appropriate financial conditions--on the real economy. By my way of thinking, the risk-reward ratio for Fed action peaks in times of crisis when it has a full toolbox and markets are functioning poorly. But when non-traditional tools are needed to loosen policy and markets are functioning more or less normally--even with output and employment below trend--the risk-reward ratio for policy action is decidedly less favorable. In my view, these risks increase with the size of the Federal Reserve's balance sheet. As a result, we cannot and should not be as aggressive as conventional policy rules--cultivated in more benign environments--might judge appropriate.

And overseas--as a consequence of more-expansive U.S. monetary policy and distortions in the international monetary system--we see an increasing tendency by policymakers to intervene in currency markets, administer unilateral measures, institute ad hoc capital controls, and resort to protectionist policies. Extraordinary measures tend to beget extraordinary countermeasures. Second-order effects can have first-order consequences. Heightened tensions in currency and capital markets could result in a more protracted and difficult global recovery. These, too, are developments that the FOMC must monitor carefully.