Thomas Hoenig

The second lesson that I would draw from our experience in combating inflation over the past 30 years is: you cannot rely on any single indicator to guide monetary policy. Just as portfolio diversification is the hallmark of a prudent investment strategy, central bankers need to look at a variety of indicators of economic activity and inflationary pressures..

Over the past three decades, we have seen a number of examples of once-reliable indicators whose performance has been affected by the changing structure of financial markets and the economy. One example is the monetary aggregates. Prior to the mid-1970s, the relationships between inflation and the two primary measures of money—MI and M2—were generally stable. The M1 relationship began to break down in the mid-1970s, and after several attempts to redefine M1 to fix the relationship, in 1987 the Federal Reserve de-emphasized MI in favor of M2. M2’s relationship with inflation lasted for a few more years, but eventually deteriorated also, leading us in 1993 to drop M2 as a formal indicator.

...in discussions of the monetary aggregates, I believe that the key issue is not whether excessive money growth causes inflation. Rather, the key issue is which measure of money is most useful in gauging inflationary pressures. Our experience in recent years confirms the difficulty of finding a single and consistently reliable measure of money in a rapidly changing financial and economic environment.

A second example of a seemingly stable indicator that lost some of its reliability is the unemployment rate at which inflation remains stable, also known as the natural rate of unemployment. According to natural-rate theories, inflation will rise when the actual unemployment rate is below the natural rate and inflation will fall when the unemployment rate is greater than the natural rate.

The key to using the natural rate in policy analysis is to identify what the natural rate is, or at a minimum, a fairly narrow range surrounding it. As recently as three years ago, for example, the consensus view was that the natural rate was around 6 percent. As it turned out, the unemployment rate is now 4.7 percent and has been less than 6 percent for 3 ½ years. Over the same period, however, inflation has steadily declined, suggesting that the natural rate is substantially less than 6 percent. Whether the apparent decline in the natural rate is just a temporary change or more permanent is still an open question. In any event, like the monetary aggregates, the natural rate has not proved to be as reliable a gauge to inflationary pressures as was once thought.

The issue of the Chairman's authority to make intermeeting policy moves is a tough one, Al, and I have some sympathy for your point of view. But it is related to a longstanding practice and this amendment to the Authorization does codify that practice. To my mind, in some ways it sets the boundaries more clearly. If some future chair abuses the authority, that is something the Committee will have to deal with. But the way the Authorization reads now gives me a sense of confidence that it would be used only in the most dire circumstances, and I think the Chairman has to have some flexibility to act in a crisis.

The fifth and final lesson that I would take from the events of recent years is that there is significant value to having a diversified system of financial intermediation. Historically, most countries have relied heavily on the banking system as the principal source of intermediation. As we know, troubles in the banking system can weaken the intermediation process, with severe macroeconomic consequences. When intermediation is more broadly based, however, with capital markets as well as banks, the resulting system may be more stable and robust in times of crisis.

It is a distinct pleasure to be invited to speak at this year’s Hyman Minsky conference. Throughout his career, Hy Minsky emphasized the importance of understanding the linkages between the institutional structure of the financial system and the macro economy. For many years, such an emphasis was, shall we say, out of fashion, both in macroeconomic modeling and in policy discussions. In recent years, however, dramatic changes in financial markets and a wave of financial crises around the world have brought renewed interest in the role that the financial system plays in economic growth and in macroeconomic stability.

It should not be too surprising, then, that the Federal Reserve’s response to the Asian financial crisis, like the response to the 1987 stock market crash, was to provide liquidity through open market operations by lowering the federal funds rate target rather than by using the discount window. However, using open market operations rather than the discount window has potential implications for the overall stance of monetary policy. When the Federal Reserve provided extended credit to the banking system in the 1980s and early 1990s, discount window borrowing was generally offset by open market operations to keep overall liquidity in the banking system unchanged. As a result, the stance of monetary policy was kept independent of liquidity provision via the discount window.

In contrast, when the Federal Reserve uses open market operations without the discount window, the stance of monetary policy is changed. This raises two concerns. First, what if the appropriate monetary policy stance conflicts with the need to provide liquidity to individual institutions or to financial markets? Second, if open market operations are used to provide additional liquidity in times of crisis, when is the appropriate time to remove this liquidity to prevent a buildup of inflationary pressures? These are important questions deserving further research and analysis.

Thus, the question emerges; can the Federal Reserve respond to "financial crises" in the same way that it responded to "banking crises" in the past?

My own view is that the Federal Reserve now has less flexibility in responding to crises as this relates to its operation of the discount window. Historically, the discount window has been the Federal Reserve’s principal facility for providing liquidity in times of crisis. Indeed, going back to the 1980s and early 1990s, the Federal Reserve provided extensive lending through its extended credit program to banks experiencing prolonged liquidity problems. Going forward, however, the discount window is less likely to be used for several reasons.

First, use of the window is now circumscribed by the provisions of FDICIA designed to minimize FDIC exposure if the Federal Reserve lends to institutions that ultimately fail. Second, banks have become reluctant to use the window in normal times and so may not be willing to approach the window in difficult times for fear of signaling changes in their condition. Third, to the extent that crises now originate outside the banking system, nonbank institutions do not have direct access to the discount window to meet their liquidity needs.

You want to move your policy towards neutral so you don't shoot through the [growth] trend line and ignite inflationary prices.  And that's the challenge of monetary policy as we go forward.

We will add jobs again in 2005.  I think a number in the order of two million net new jobs in 2005 is in the realm of possibility.

We should be able to move forward without significant increases in inflation.

I think that we will see our GDP growth will once again be in the neighborhood of 3.5 to 4 percent, perhaps a little more modest than 2004, but still very healthy growth above our long-run potential growth rate.

The US economy is so large that the deficit over three to five years will have a marginal negative impact...Debt will have a tendency to raise the cost of capital and slow growth.

In the year ahead, the U.S. economy should continue its solid performance, growing nearly 4 percent with productivity growing more than 2.5 percent. Taking a longer view, we will continue to achieve such strong levels of performance if we provide fiscal, monetary, and regulatory policies that encourage an open, competitive, progressive, and noninflationary economy—an economy in which the entrepreneur and the American worker can thrive.

I think the dollar is a reflection of our economy and our deficit...as we address these issues, it will remain and is the world's reserve currency, and should be.

The dollar has declined.  If you look in a historical context, it is lower.  That has been a benefit to much of US manufacturing in terms of global competition.

[I do not] expect energy prices to drop precipitiously, but I think they have slowed...That will allow the economy to breathe again, and we'll see some strengthening of the economy as we move through the summer and into the fall.

[In response to the accidental ommission of "longer-term inflation expectations" sentence in the May FOMC statement]: It just was a doggone mistake and well, oops.  I don't know what else to say.

In my view the economy is generally healthy and should continue to experience good growth over the remainder of this year and into 2006.  My focus remains with the fact that, in an environment where monetary policy has been accommodative for some time, inflationary risks may begin to rise.

Taken individually, higher energy costs, increases in labor costs, and stronger import prices are not especially alarming.  Taken together, however, they suggest to me an environment where risks to inflation are increasingly on the upside, especially with an accommodative monetary policy.  Thus, going forward, I think it will be especially important to position US monetary policy so that it can respond if inflation pressures emerge and prevent these pressures, even if temporary, from affecting inflation expectations.

While an accommodative policy is quite appropriate when the economy is operating significantly below its potential, I am sure you would agree that the same policy could be highly inflationary if maintained as the economy approaches its potential.  Ideally, then, we would like to unwind policy accommodation in pace with the rebound in aggregate demand that moves the conomy back toward its potential.

In the long term, we would want to be somewhere in that [neutral 3.5% to 4.5%] range...As the economy has grown well, we want to be in that range sooner rather than later.

I would not try to manage the yield curve as a policy maker...I think that our goal...is to focus on the real economy and make sure the environment of stable prices stays in place.

If you look at any one of those factors [rising energy prices, higher import prices, and increases in labor costs] you are able to deal with it without any issue.  But when you start seeing them combine, then I think you have to be even more sensitive to the kinds of inflation pressures that might be out there...And remember that that is in a context where we have had monetary policy very accommodative over the last several years.  That is being removed, but we have that effect that's being carried through that we have to be aware of.

The emergence of new players in the world economy has increased the competitive pressures facing US firms--both exporters and those that compete with imports.  To address this issue, we must insure that we remain competitive in those sectors in which we have a comparative advantage.  I would suggest that those sectors involve capital-intensive technologies and skilled labor.  In this regard, a strong general and advanced education system is important.  In addition, incentives for R&D (but not industrial policy) may also play an important role in enhancing our comparitive advantage.

We cannot ignore the fact that some workers will lose their jobs as the result of intense foreign competition.  I believe the proper policy response is to ease the trasition costs through retraining, upgrading, and aquisition of new skills.

We can also take steps to ensure that increased financial market integration does not lead to financial instability.  In this regard, it is particularly important to help developing and emerging market economies create strong and resilient banking systems so that they do not become a source of systemic instability.

Labor costs may increase for firms as the pool of available workers continues to shrink.  Thus far in the current economic expansion, firms have benefited from strong increases in productivity that have allowed them to offer higher wages to workers without affecting their profitability.  But as the labor market has tightened and as productivity growth has slowed, further efforts to expand may result in faster wage growth.

Given the positive momentum of the economy, it is much less likely that a regional shock will have an overall negative impact.  And should additional policy accommodation be added, there is a much greater chance that the economy will overheat and result in strong inflationary pressures.

In the case of hurricanes, the negative effects are most likely to be felt over the next six months.  If monetary policy were to increase the level of accommodation, the benefits would not likely be felt until next year.  By that time, the rebuilding effort would be well underway, and there might be a danger that monetary policy stimulus could combine with the sizeable fiscal stimulus to overheat the economy and lead to higher inflation.

In the case of the hurricanes, the largest impact is likely to be of a regional nature: the need to rebuild businesses, homes, and infrastructures along the affected Gulf Coast regions.  If monetary policy was redirected to provide more accommodation to the rebuilding efforts, such policy could lead to excessive stimulus in the rest of the country.  The overall result would likely be an economic boom and rising inflation.

The concern is that in an environment in which monetary policy has been accommodative, the joint effect of several inflationary pressures could erode price stability.  The FOMC will need to be alert and diligent as it works to maintain future price stability.

A negative supply shock leads to higher prices and decreased demand for goods and services.  As we have learned from the experience of the 1970s, a more accommodative monetary policy that attempts to offset decreased demaing during a negative supply shock leads to higher inflation that can be very costly to remove in the future.

As economic growth returned [in the latest recovery], firms found that they could meet the increased demand for goods and services without hiring additional workers.  This resulted in strong gains to productivity, which is an important source of long-term growth for the economy, but it meant that employment gains were weaker than in prior recoveries.

Despite the uncertainties that exist, I believe that these unfortunate events [Hurricanes Katrina and Rita] do not pose a persistent threat to national economic activity.  My overall assessment is that the national economy, while not without challenges, is in reasonably good shape and that conditions should allow for solid growth in the future.  In context, I believe that the Federal Reserve should continue to focus on having a neutral monetary policy which reflects its commitment to price stability.

I would expect that employment will grow between 1.5 and 2 million in 2006.

My own view is that we will see growth in the 3 1/4 to 3 1/2 percent range, which encompasses the consensus estimate.

Looking ahead, I expect the favorable performance of the economy to continue.  Most private forecasters expect the momentum from the solid growth in 2005 to continue into 2006.  Although monetary policy has become less accommodative, it will continue to support economic activity.  Because of the lags with which monetary policy affects the economy, monetary policy accommodation over the past year will continue to act as an economic stimulant, though clearly far less so than in the past several years...My own view is that we will see growth in the 3 1/4 to 3 1/2 percent range, which encompasses the consensus estimate.

As in 2005, consumer spending is expected to be a primary contributor to growth in 2006.  In recent months, consumer confidence measures have sharply rebounded from the hurricane-related decline last fall.  More importantly, consumer expectations of the future are positive.  One possible drag on consumption lies in the persistence of high energy prices, especially for natural gas.  High utility prices for heating are expected to constrain spending somewhat during the winter months...Overall, I expect to see consumption growth of around 3 percent for 2006.

Despite the upheavals in several sectors of the economy, such as the auto industry, business investment is also expected to contribute to growth in 2006.  Strong growth of corporate earnings combined with low borrowing costs over the past two years have led to marked improvements in firms' balance sheets...Looking ahead, while there may be some slowing from recent performance, most private sector forecasters expect profit growth will provide fundamental support for investment spending.

In the international sector, continued strong growth in the rest of the world will slow the growth of the trade deficit.  An expanding world economy is expected by many economists to generate increasing demand for U.S. exports.  Such growth, however, is also likely to further increase global demand for natural resources.  This implies that prices for commodities such as oil may remain at elevated levels for an extended period of time.

The solid growth forecast for the economy also should translate into steady growth in employment.  The increases will be somewhat less than employment gains seen in the past two years due to two factors.  First, as growth slows and converges toward the economy's trend growth rate, fewer additional workers will be needed.  And second, strong productivity growth over the past few years is expected to continue, sggesting that the existing workforce will be able to produce a sozeable portion of the projected increase in output.  Based on these factors, I would expect that employment will grow by between 1.5 and 2 million jobs in 2006.  That translates into an increase of 125,000 to 167,000 jobs per month.

While I don’t think there is much risk of a housing price collapse on a nationwide basis, we could see a decline in prices in certain markets.

As a result of these actions, the funds rate now (4 ¾%) has returned to a more normal level and is within the range most analysts would associate with neutrality. In fact, the funds rate now may be at the upper end of the range I would associate with neutrality.

Another risk to output growth is the current low savings rate in the United States. For the last three quarters of 2005, the personal savings rate was negative. That means that personal consumption spending exceeded disposable income. So while businesses have be en improving their balance sheets as a result of strong earnings growth, consumer debt has been increasing. The picture for government savings is not any better due to the current large federal budget deficit. Combined, strong consumer and government demand have caused imports to exceed exports, resulting over time in the large U.S. trade deficit, now approaching 7 percent of nominal GDP. To finance this trade deficit, foreigners have acquired large holdings of U.S. securities.  At some point, the domestic savings rate will need to increase to reduce this trade imbalance. Many economists expect that the transition to a higher savings rate will occur smoothly, but with an imbalance of this magnitude, there is a chance that a rapid transition could lead to a downturn in the economy through a sharp falloff in consumption.

Although monetary policy is less accommodative, it will continue to support economic activity in the near term.  Because of the lags with which monetary policy affects the economy, monetary policy accommodation over the past year will continue to act as an economic stimulant in the near term, though clearly not as much of one as in the past several years.  Over the second half of this year, our moves to remove monetary accommodation should help ensure the economy settles into a growth rate that is consistent with the economy’s long-run growth potential....

...However, as the funds rate has entered the neutral range and risen to the upper end of that range as estimated by most analysts, it has become more difficult to know in advance what the next move is likely to be or when the next move should occur.

My view is similar to the consensus of private sector forecasters. I would expect growth of around 3 ½ percent (Q4/Q4) for 2006, which is just slightly above most estimates of trend GDP growth. That said, growth in the first quarter may come in well above 3 ½ percent, as the economy rebounds from the sluggish fourth quarter. But over the course of the year, I would expect to see GDP decelerate to around its trend growth rate...

The solid growth forecast for the economy also should translate into steady growth in employment. The increases will be somewhat less than employment gains seen in the past two years due to two factors.  First, as growth slows and converges toward the economy’s trend growth rate, fewer additional workers will be needed. And second, strong productivity growth over the past few years is expected to continue, suggesting that the existing workforce will be able to produce a sizeable portion of the projected increase in output.  Based on these factors, I would expect that employment will grow by between 1.5 million and 2 million jobs in 2006. That translates into an increase of 125,000 to 167,000 jobs per month.

Generally speaking, a change in the federal funds rate today may take an estimated 12 to 18 months to affect inflation measures.

I believe a reasonable case can be made that the current stance of monetary policy is likely to be consistent with a reduction in inflation pressures over the next few quarters as energy costs moderate and economic growth slows.  At the same time, I recognize that further policy tightening could be warrented should the expected slowing in inflation not materialize.

The Federal Reserve should only respond to high current inflation to the extent that inflation is expected to be very persistent.  Indeed, to the extent inflation pressures are seen as temporary and policy is currently restrictive, maintaining the current policy stance may be consistent with a reduction in inflation over time.  Of course, the other aspect of this is that if inflation pressures remain elevated, then they will affect inflationary expectations requiring more forceful actions later.

Central banks in a number of other industiralized countries are currently tightening policy, and slower growth abroad could limit some of the anticipated improvements in US exports over the next year.

As to inflation risks, the main concern is that inflation could stay elevated for a considerable period of time and could feed into higher inflation expectations in financial markets and labor markets.  If so, the Federal Reserve might have to tighten policy further to insure that inflation expectations are contained and price stability is maintained over the long term.  Thus far, inflation expectations have remained fairly subdued, but they will require continued scrutiny in coming months.

Many economists believe that the US economy's potential growth rate is around 3.25%, so a 3% growth rate, while somewhat below potential, may be a desirable development to keep the economy from overheating.

Amid signs of slower growth, recent inflation news has been somewhat distrubing.  While higher energy costs have caused broad inflation measures to rise over the past few years, most core measures of inflation, which exclude volatile energy and food prices, have remained low.  In the past few months, however, we have seen sizeable increases even in core measures of inflation...If these recent elevated inflation readings persist, they could make it difficult for the Federal Reserve to maintain price stability over a medium-term time horizon.

Since June 2004, the Federal Reserve has systematically raised its federal funds target from 1% to its current level of 5 1/4%.  Over this period, as credit costs have increased, the stance of monetary policy has moved from being extremely accommodative to a setting I would characterize as somewhat restrictive.

Recently, however, we have seen increasing signs that economic conditions are becoming less favorable.  Continuing high energy costs and rising interest rates appear to be slowing economic growth.  At the same time, inflationary pressures are beginning to emerge.  These developments have been associated with increased volatility in commodity markets and in financial markets around the world.

The Federal Reserve's 12-bank system was not established as simply a check-processing system.   It was designed to serve multiple interests across a variety of regional and financial institutions.   It was designed to assure broad input to decision and to provide a mechanism to build national policy consensus across broad regional, economic and cultural differences.  And it was designed as a public-private partnership, accountable to, and yet independent of, the government.  To miss these connections is to incorrectly tie the Federal Reserve’s structure to its processing activities rather than to its efforts of assuring trust in the institution.  

'The outlook for the U.S. economy is for some slowing as we move through the fourth quarter' amid 'adjustments' in a housing sector that's clearly been cooling off, Hoenig told a local group in Lincoln, Neb. He added that falling energy prices are 'favorable for the outlook' and will aid what is likely to be a 'move back towards our potential as we move into 2007,' he said. 

Hoenig also said a drop in resource utilization means that inflation will 'systemically ratchet down...to lower levels this year and into next.' The bank president said his projection is a 'fairly optimistic outlook, and it's a reasonable outlook.' 

From a Dow Jones Newswire report

We have moved policy from a very accommodative level of a 1% fed funds rate to 5.25%.  This I judge as modestly restrictive.  It's not tight, but modestly restrictive.

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

Monetary policy must be forward-looking because policy influences inflation with long lags.  Generally speaking, a change in the federal funds rate may take an estimated 12 to 18 months to affect inflation measures. 

The existence of lags in monetary policy has two important implications.  First, the Federal Reserve should only respond to high current inflation to the extent that it is expected to be highly persistent.  if inflation pressures are seen to be temporary and policy is currently restrictive, maintaining the current policy stance may be consistent with a reduction in inflation over time.  Second, given the existence of policy lags, the actions that the Federal Reserve took over the past year in raising the federal funds rate have not yet had their full effects on the economy or inflation.

Many economists believe the potential growth rate for the U.S. economy is around 3% to 3 1/4%.

Most forecasters believe that growth slowed further in the third quarter because of another decline in residential investment and more moderate business investment in structures and inventories....

While hiring has slowed, the unemployment rate was quite low in August at 4.7% of the labor force.  This unemployment rate is below the level that many economists believe is consistent with full employment and stable prices. 

In my view, real GDP growth is likely to gradually rise from 2 percent to 2.5 percent annually in the second half of last year to around 2.5 percent to 3 percent in 2007.

Recent research conducted at our Bank suggests the trend growth rate for employment over the next 10 years may be around 120,000 jobs per month.  Thus, it should not be too surprising that last year’s employment growth has kept labor market conditions fairly tight.

Should these recent trends in compensation and productivity continue, there is a risk that businesses may be under pressure to raise prices.  Although a risk, there are forces in play that may restrain increased labor cost pressures from contributing to a rise in inflation in 2007.  Some companies, for example, may absorb increased cost pressures through reduced profit margins rather than raise prices and risk losing valued customers.  

In my opinion, there has been a discrepancy lately between the views of the FOMC members, as summarized in the Committee’s public statements, and the views of many financing market participants.  Although there is a wide range of views in the market, some participants have jumped to the conclusion that monetary policy will be eased in the near future.  Surveys of financial market economists show that many expect an easing in monetary policy sometime this year.  In addition, the yield curve and financing futures prices incorporate some expected easing of monetary policy later this year.

In contrast, the FOMC has continued to express its concern about upside inflation risks. After its last meeting on December 12, the FOMC stated that “some inflation risk remain” and that “the extent and timing of any additional firming” would depend on how incoming data affected the outlook for growth and inflation.  

In my view, the easing of monetary policy that market participants expect would be appropriate only if inflation clearly subsided from recent elevated levels, and if the incoming data implied the inflation outlook would remain favorable in the future.  In my judgment, it is premature to conclude that current conditions define a clear path for policy.

One result of this changing financial environment is to make a risk-based approach to capital requirements more essential, particularly as countries deregulate their financial markets and remove provisions that once served to limit risk taking.

It has been in some ways a difficult year.  We've seen that the U.S. economy has slowed and at the same time we've seen inflation pressures rise.  We will see the economy strengthen.  And if we do it in the right sequence, we have the opportunity to see inflation that will recede further.

As reported by Bloomberg News

I feel very confident at this point that the economy will strengthen.  I am hopeful that the inflation numbers that we've seen of late will continue to decelerate as we move forward through the rest of this year and into next.

As reported by Bloomberg News

Right now our policy rate ... is moderately restrictive. Not severely, but modestly so. And that allows for the economy to continue to grow ... and slowly, hopefully, bring down the inflation rates for CPI, the core CPI, to levels even closer to 2 percent as we move forward.

As reported by Reuters

The economy should grow back towards the 3 percent that I estimate to be our long-term potential.

As reported by Bloomberg News 

Federal Reserve Bank of Kansas City President Thomas Hoenig said he's ``optimistic'' about the U.S. economy, though it's important to remain ``alert'' because of risks posed by the housing slump.

``The U.S. economy still has a lot going for it,'' Hoenig said in a speech yesterday in Tulsa, Oklahoma, citing continued job and consumer spending growth and gains in exports, helped by a weaker dollar. At the same time, ``I want to also remain alert as we move through this tender time,'' he said.

As reported by Bloomberg News

At present, Hoenig said he is "not at all opposed to necessary action either way." 

"So when I say, and I always do in my speeches, it is a matter of waiting watching and seeing, I really mean it this time," he said.

As reported by MarketWatch

Pulling this altogether, I expect GDP growth for the year to be in the range of 2 percent to 2.5 percent measured on a Q4-over-Q4 basis.  I also expect the rise in overall inflation to moderate as the U.S. economy slows, but I do not expect any quick reversal of inflation trends, and therefore I expect core inflation to remain above 2 percent. 

When times are good, as they have been for many years and banks appear well-capitalized, it is very difficult for bank supervisors to convince bankers to heed warnings that they need to behave differently. Indeed, in many situations, there may be no legal basis for requiring a change in business or lending practices. Thus I don't think we can expect expanded supervision to prevent the types of financial excesses we have seen in recent years.

We need to consider whether some of the changes that the Federal Reserve has implemented, such as the Term Auction Facility, should be made permanent.

In the area of supervision, I would offer two thoughts. First, the current financial crisis reinforces the importance for a central bank to have accurate and timely information on the conditions of all institutions that might make use of its liquidity facilities. Personally, I believe this is most likely to happen when the central bank has ongoing supervisory responsibilities for all institutions eligible to use its liquidity facilities. Thus, I am not a supporter of the removal of supervisory responsibilities from central banks as has happened in a number of countries. If this separation is in effect, or segmented as it is in the United States, I believe a central bank must have the legal authority to require this information from the supervisory agency on terms set by the central bank. A voluntary exchange of this information is no more likely to be effective in a financial context than it was in the U.S. intelligence community prior to 9/11.

In the current situation, monetary stimulus is facing significant headwinds from the weak condition of some of the interest-sensitive sectors, as well as restrictions in credit availability and a repricing of risk. In these circumstances, a central bank may have to ease policy more in order to achieve its desired effect.

My own view is that we should consider hard-wiring more sprinkler systems into financial markets and insitutions. One obvious area to look is whether we can improve the risk-based capital approach embodied in Basel II. If capital is to function effectively, it needs to rise as risks increase and be depleted as losses materialize. I think we need to look especially at the procyclical behavior of leverage that we have observed in some large financial institutions, In addition, I believe there may be merit in considering formal liquidity requirements, and perhaps loan-to-value ratios for banks and other financial institutions, especially the large institutions that provide liquidity and risk-management products to other financial institutions and financial markets. I also think that it is time we extinguish some of the off-balance sheet fictions that have developed to excess in recent years.

I think it is naive to think that creditors will view their investments in the largest financial institutions as truly at risk. Consequently, I do not think that increased market discipline is likely to be the panacea that some believe.

[T]here is a risk that an extended period of low interest rates may distort long-run investment decisions; lead to a search for yield that results in excessive risk-taking; and contribute to the development of asset price bubbles.

In my view, these limitations are significant, and they lead me to believe that we should look to fiscal policy to play a more important role in responding to the spillover from a financial crisis. In contrast to monetary policy, fiscal policy can work effectively even when the financial system is impaired, and its effects are felt more broadly across the economy. My own view is that monetary policy may be a good first line of defense, but should not be relied upon too heavily for too long. Of course, we would have to rely less on monetary policy to respond to financial crises if we could, instead, take measures that would reduce the likelihood or severity of financial crises.

[H]istorically, I believe it has been more difficult to remove policy accommodation in a timely fashion, which may have consequences for a central bank's long-term inflation objective.

There is a real difficult issue here, because the incentives are out of line. I'm a rating agency, you're going to pay me to rate you. So how do you deal with that? Should we open the market? ... Either get those incentives aligned or you're going to have to oversee them.

From Q&A as reported by Market News International

What steps should market participants take to restore their disciplinary role in the financial system and prevent the depth of problems we have recently experienced? In the near term, investors can be expected to show a preference for simpler and more readily understood financial instruments, while showing a reluctance to put their money in the types of markets and investment vehicles that have caused much of the recent turmoil. They can also be expected to exert more “due diligence” and to favor the originators, rating agencies and fund managers that demonstrate a reputation for providing sound credit analysis and accurate disclosures. These are certainly some of the most apparent “lessons to be learned,” and it will take some time for our financial markets to regain the confidence of investors and meet this revised set of expectations.

Experience tells us, however, that as time passes and memories fade, market participants will always be tempted to relax their ongoing disciplinary role, particularly as any corrective steps begin to appear outmoded in a more prosperous time and as new and seemingly more profitable opportunities and investment vehicles are developed.

Energy has systematically begun to increase at a faster rate, food is systematically increasing, therefore the rationale for taking it out of the total (consumer price index) and looking at the core is less compelling. And so I am looking, and I think others are, at the total CPI, or (personal consumption expenditures) number as much as, if not more, now, than the core.

From Q&A as reported by Reuters

Because many of our current financial problems can be tied to asset-backed securities, beginning with the subprime market, we should ask ourselves what can be done to strengthen the regulatory framework surrounding securitization and to address the asymmetric information problems in this market. This is a particularly important question given the benefits that securitization can bring to our credit markets in terms of attracting new funding sources and distributing risk across a broader marketplace.

Among the ideas now being suggested are: (1) tighter registration requirements for loan originators; (2) improved disclosures by originators and securitizers on the underlying loans; (3) new limits on the types of asset-backed securities regulated institutions can hold; (4) greater liability, risk exposure or equity positions for originators and securitizers; and (5) new regulations for the agencies rating these securities.

Other regulatory steps may be necessary.

Thus, as we take on these new challenges, I'll leave you with this quote from 1930 to illustrate my point. It is from Paul Warburg, who was appointed a member of the first Federal Reserve Board by President Woodrow Wilson.

"In a country whose idol is prosperity, any attempt to tamper with conditions in which easy profits are made and people are happy, is strongly resented. It is a desperately unpopular undertaking to dare to sound a discordant note of warning in an atmosphere of cheer, even though one might be able to forecast with certainty that the ice, on which the mad dance was going on, was bound to break. Even if one succeeded in driving the frolicking crowd ashore before the ice cracked, there would have been protests that the cover was strong enough and that no disaster would have occurred if only the situation had been left alone."1

There are many challenges ahead, many choices to make. Some I suspect will be desperately unpopular.

There are no easy answers in dealing with this “too-big-to-fail” issue, but we need to take some strong steps if we are to restore the proper balance between financial risk and return and make market discipline effective. But we must be certain that whenever a bailout cannot be avoided, it should follow also that public authorities assume senior positions with respect to stockholders and other creditors at these “too-big-to-fail” institutions.

As you know, the past eight months have been a very difficult period for the U.S. economy. A sharp slowdown in growth has put the economy at the brink of a recession while, at the same time, rising commodity prices have caused inflation pressures to rise considerably. And, to make matters worse, these events have occurred against the backdrop of a collapse in housing markets that has shaken financial markets around the world.

The Federal Reserve has responded to these developments aggressively. It has taken unprecedented actions to provide increased liquidity to banks and other financial market participants to maintain the functioning of financial markets. And, it has eased monetary policy considerably to try to ensure that the disruptions in financial markets do not spread to the broader economy.

Despite current difficulties, in my view there is room for optimism about the near-term outlook for the U.S. economy. Financial markets appear to have stabilized somewhat, and the economy should pick up in the second half of the year as fiscal and monetary stimulus take hold. The damage to financial markets is severe, however, and it is likely to be some time before they are able to function normally. Indeed, I believe that major changes in industry practices and a significant rethinking of financial regulation will be required if we are to avoid similar problems in the future.

One other important regulatory concern is that many of the steps public authorities have taken over the last year to stabilize the financial system seem likely to weaken market discipline and extend moral hazard problems to a much wider financial marketplace. A key example of this, the recent sale of Bear Stearns, seems to indicate that in a crisis situation, public authorities will not be in a position to let market discipline play out when larger financial institutions encounter problems. Bear Stearns’ collapse indicates that such phrases as “systemically important” and “too-big-to-fail” can even be applied to investment banks below the top tier.

The danger from a public policy perspective is that a much broader group of managers and creditors may now believe and act as if they have an added layer of protection from the risks they pursue. Beyond “too-big-to-fail” concerns, other market discipline and moral hazard problems may be inherent in some of the recent and more expansive proposals to support housing markets and in the actions the Federal Reserve had to take to provide liquidity to the market and expand discount window access.

From the standpoint of private market discipline, this crisis has provided the first major test of securitization, complex financial instruments, risk modeling, and our new and broader market structure. Recent events indicate dismal test results: Many financial institutions and investors did not adequately judge, price or control the risks they assumed and did not prepare well for changing financial conditions.

[T]here are reasons that suggest the economic slowdown will be short-lived. Part of the pickup in growth will likely come from the tax cuts that are going into effect currently, part from the monetary policy stimulus provided by low interest rates and part from a boost to exports from the lower dollar. Forecasters also see moderation in energy and food costs later this year, which would provide a boost to growth but also lead to lower inflation pressures.

As I indicated earlier, we are also seeing signs of stabilization in financial markets, with improved liquidity and more transactions. Still, many markets are not functioning normally, and it will take additional time for the damage to be assessed and repaired.

As to monetary policy, the current accommodative stance should be sufficient to cushion the economy from a deeper slowdown and the risks that financial disruptions could spill over to the broader economy. As the economy recovers and credit conditions improve, however, it will be necessary for the Federal Reserve to remove the policy accommodation in a timely manner. How fast this occurs will depend on whether inflation pressures moderate or intensify in the period ahead.

Earlier, I mentioned the potential impact of the recent financial market disruptions on growth. Indeed, concern with the effects of these disruptions and, in particular, the possibility they could lead to a severe credit contraction was the principal motivation for the aggressive easing of monetary policy by the Federal Reserve over the past several months. ... Although credit conditions have tightened considerably in recent months and some markets for asset-backed securities have shut down, we have not seen as large a credit crunch as some anticipated. Indeed, outside of some mortgage markets, consumers and businesses with strong credit histories have continued to have access to credit on reasonable terms. Consequently, in my opinion, financial markets disruptions, while noteworthy, are not the major story behind the recent weakness in economic activity. Energy price increases and housing dominate this slowdown.

 [R]ising energy prices have sapped consumer and business spending. Because so much of our oil is imported, an increase in oil prices effectively acts as a tax on consumer and business spending.

Some would dismiss these rising inflationary pressures as temporary.  I believe they are more serious.  Energy prices have been trending up for the past five years, and there are good reasons for thinking that higher food and commodity prices are not being entirely driven by temporary supply and demand imbalances.  However, the bigger concern is that these increases are beginning to generate an inflation psychology to an extent that I have not seen since the 1970s and early 1980s.  Measures of inflation expectations in surveys and financial markets are moving higher, and businesses are increasingly passing on higher input and commodity prices to consumers and business customers.  In this environment, in my opinion, there is a significant risk that higher inflation will become embedded in the economy and require significant monetary policy tightening to reduce it.

It is a simple fact of history that, over a business cycle, markets tend toward excess optimism in which risk is seriously underestimated. In some cases, public policy is required to “bail out” undeserving parties so as to minimize the broader impact on the economy. It is also a fact that no matter the source of the financial problem, no matter the size of the institution or the region in which the problem emerges, the Federal Reserve will be part of any solution that is developed. This was the case in the ’70s, ’80s and ’90s during the foreign debt, farm, real estate and energy crises and is the case today. As a necessary principal party in prudential supervision and as the lender of last resort, the Federal Reserve is best positioned for this task.

``The economy is growing far less than its potential,'' Hoenig [said]. The U.S. can expand at 2.5 percent without creating inflation, versus the 0.6 percent annual rates of the last two quarters, he said. ``When you're that much below potential, people are losing their jobs and the economy isn't creating as much wealth as it should.''

As reported by Bloomberg News.

We estimate ... that every $10 increase in the cost of a barrel of oil reduces the real GDP somewhere between two-tenths and perhaps as much as a half a percentage point.

At a conservative level, that means that we have taken at least another percentage point off on a national scale in terms of real gross domestic product.

As reported by Reuters

[Inflation is increasing] to what I call unacceptable levels.

As reported by Bloomberg News

I think there is a real danger and the psychology around inflation is beginning to change. Expectations about inflation are beginning to change and that is a major concern to me.

Once people start passing this on, start thinking about inflation as a way of life, behaviors change

As reported by Market News International and Reuters

We have had this financial crisis; I think on balance as we at the Federal Reserve have provided liquidity to the marketplace, it's my thought that we have stabilized things.

This allows the other policy choices, the tax cut ... monetary policy that's in place, to strengthen the economy as it goes through the course of the year. And in that context then, our big challenge will be to make sure that we bring inflation in check and make sure that we do not repeat some of the experiences we had in the late 70s and early 80s when inflation became far too high.

As reported by Reuters.

To the extent that the economy as we watch it ... avoids recession, and to the extent that you watch commodities, you do want as quickly as possible to get back to neutral.  If you can do that, the implications for the long run are much more favorable in terms of inflation expectations and how it gets embedded into the economy.
...
The goal is to get to neutral without tanking the economy. I think that it is important that we do that as reasonably soon as we can.

I expect only modest improvement in the second half of this year, with GDP growth in a range of 1 to 1.5 percent.  Growth will be supported over this period by the fiscal stimulus from the tax rebates, from further strength in exports and government spending, and from the current accommodative stance of monetary policy.  Indeed, growth is likely to be relatively strong in the third quarter because of the rebates and then may soften noticeably in the fourth quarter.
...
I am disappointedly, even less optimistic about the inflation outlook over second half of the year.  Indeed, I expect both overall and core inflation measures to rise further over the next several months.

There are some very tentative signs of improvement in existing home sales, and my expectation is that housing will be less of a drag on growth as we move through 2009.

It will be important for the Federal Reserve to monitor inflation developments and inflation expectations closely, and to move to a less accommodative stance in a timely fashion.  When to begin this process, and how fast to move, will be difficult decisions for the Federal Open Market Committee in the period ahead.  I can assure you, however, that the Federal Reserve takes both parts of its "dual mandate" seriously and will walk that fine line to maintain stable economic activity and low inflation.

For Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, chocolate isn't as sweet as it used to be: The cost of almost every ingredient has gone up. ``Commodities across the board have pressured us,'' said Bryan Merryman, the chief financial officer of Rocky Mountain Chocolate Factory Inc., as he led Hoenig on a two-hour tour of the company's Durango, Colorado, factory this week. ``There are a lot of pressures in our system that we haven't seen before.''...``When you see a business like this one, where everything it uses has been accelerating in price, you see what it does to a business person,'' Hoenig, 61, said. The July 15 visit ``reinforced the way I think, because I'm on record as being concerned about inflation,'' he said.
...
Anecdotes like the ones gathered at the Rocky Mountain factory make their way into the Fed's so-called Beige Book report and are a part of a give-and-take process of gathering and sharing information, Hoenig said. ``The Fed is not just a Washington-centric institution,'' he said. ``It's an institution that has 12 regional banks reaching out for information and sharing information with citizens.''...``What the reserve banks hear from their contacts can provide the Fed with an early warning of changes that may not show up in the published statistics for several weeks or even months,'' said Al Broaddus, former president of the Richmond Fed.

As reported by Bloomberg News.

When we consider these consequences it becomes more apparent, to me at least, that we must strive to limit public safety nets and minimize their associated moral hazard problems… To return to my analogy, this means doubling back across the river to a more historical central banking role, and making clear a future crossing would be rare…

If we choose to double back, then we must also direct more supervisory focus to the market interdependencies among commercial banks, and we must institute better mechanisms to unwind failing nonbank financial institutions and their counterparty exposures.  

For the Federal Reserve, adding a more explicity financial stability mandate to its existing dual mandate for price stability and economic growth raises important and difficult questions about the compatibility of these responsibilities and the problems that might arise in attempting to achieve them all simultaneously.

...

I would like to focus on the following four questions as particularly important to our understanding of how financial stability fits into a central bank’s portfolio of responsibilities.

First, can we define a set of principles to guide a central bank’s mandate for financial stability?... 

Second, does a central bank have the ability to effectively pursue a tripartite mandate?...

Third, how does a central bank trade off potentially conflicting objectives under a tripartite mandate?...

 Finally, how can a central bank implement a financial stability mandate while maintaining the independence needed to actively pursue its other mandates?...

 …While there is little doubt that central banks will continue to have responsibility for financial stability going forward, recent events raise important questions about how this mandate should be implemented.

[F]or a market economy to work best, it must to the maximum extent possible find a balance between financial stability and a stable price environment and in doing so must be able to allow individual institutions to fail.  The "Too Big to Fail" issue will only grow in importance as the consolidation of the financial industry grows in both size and scope in future decades.

One of the most obvious observations from the current turmoil is that a crisis can stem from parts of the financial market not covered by traditional safety nets.  In past crises, we have typically been able to direct our efforts toward banks and other depository institutions where we have safety nets and a supervisory and regulatory framework to address institutional problems and restore market confidence.  However, many of the institutions and markets now under stress are not subject to prudential oversight.

(W)hile inflation is receding for the moment, I must remind you that monetary policy is extremely accommodative, and if it remains so too long, as history suggests it may, inflation pressures could re-emerge as the economy recovers.
...
Inflation will remain moderate over 2009 and much of 2010.  Lower energy and commodity prices along with moderate improvement in demand for goods and services will keep price pressures temporarily contained.  How prices behave beyond the immediate horizon depends most critically on how the Federal Reserve conducts policy and manages its expanding balance sheet in a strengthening economy.  This is no doubt the central bank's most difficult long-run challenge.

Although the early attempts to staunch the recession were well-intentioned, it will be a subject of debate for some time on whether the rush to action might have contributed to the worsening of conditions.

My outlook calls for the economy to contract further through much of 2009 until later in the year when the effects of policy actions begin to stimulate GDP growth.
...
Putting all of the pieces of the outlook together, the picture for the last quarter of 2008 and at least the first half of this year is grim.  The magnitude of the downturn is likely to surpass that of the 1990 and 2001 recessions.
...
If we pursue systematic policies with the right balance of monetary and fiscal stimulus, the early signs of economic recovery could show themselves as early as the third quarter of 2009.

The Federal Reserve is not only providing liquidity to the financial industry, it is also taking on the financial industry's role as intermediary to business firms.  This is a dramatic expansion of the central bank's role in the economy.  It is reflected most vividly in the combined balance sheet of the 12 Reserve Banks, which has increased from $900 billion in mostly Treasury securities in the fall of 2007 to $2.3 trillion in other assets today, and this will increase still further in the months ahead.

The Federal Reserve must now manage its balance sheet in a manner that not only places liquidity into the economy but also in a manner that does not undermine the long-term functioning of markets.  It must design an exit strategy that at the appropriate time both removes excess liquidity from the economy and allows it to withdraw as a significant intermediary.  Failure to have such a strategy risks undermining an efficient financial market system.

A critical element affecting the recovery in 2009 will be the introduction of additional fiscal stimulus into the economy.
...
For the moment, putting our economy back on its feet is the priority, and with the monetary and fiscal actions that are underway, we should see improvement as we enter the second half of 2009.

"The first thing I tell people on deflation is obviously there is always a possibility, but I don't consider it to be a large possibility," Kansas City Federal Reserve President Thomas Hoenig said in response to a question.

As reported by Reuters.

Without going into great detail about the {Resolution Finance Company}, I will note the four principles that Jesse Jones, the head of the RFC, employed in restructuring banks. The first step was to write down a bank’s gad assets to realistic economic values. Next, the RFC would judge the character and capacity of bank management and make any needed an appropriate changes. The third step was to inject equity in the form of preferred stock, but this step did not occur until realistic asset values and capable management were in place. The final step was receiving the dividends and eventually recovering the par value of the stock as a bank returned to profitability and full private ownership.

I would be the first to acknowledge that some things have changed in our financial markets, but financial crises continue to occur for the same reasons as always – over-optimism, excessive debt and leverage ratios, and misguided incentives and perspectives – and our solutions must continue to address these basic problems.

How should we structure this resolution process? While a number of details would need to be worked out, let me provide a broad outline of how it might be done.  First, public authorities would be directed to declare any financial institution insolvent whenever its capital level falls too low to support its ongoing operations…

Next, public authorities should use receivership, conservatorship or “bridge bank” powers to take over the failing institutions and continue its operations under new management…

Shareholders would be forced to bear the full risk of the positions they have taken and suffer the resulting losses…

All existing obligations would e addressed and dealt with according to whatever priority is set up for handling claims…

There is legitimate concern for addressing these issues when institutions have significant foreign operations. However, if all liabilities are guaranteed, for example, and the institution is in receivership, such international complexities could be addressed satisfactorily.

For a free market system to be succesful, firms must be allowed to fail based upon a predefined set of rules and principles that market participants can rely on when determining their strategies and making decisions.  This is particularly important for financial institutions.  The key principles should apply if we are talking about a small bank in Tulsa or a large financial conglomerate in New York CIty.

Nationalization is the process of the government taking over a going concern with the intent of operating it.  Though a bridge institution is the most likely outcome when a large financial firm fails, the goal is for the firm to be reprivatized as quickly as possible.  In addition, subject to regulatory agency oversight, the bridge firm would be managed by private sector managers selected for their experience in operating well-run, large, complex organizations.

There has been much talk lately about a new resolution process for systemically important firms that Congress could enact, and I would encourage this be implemented as quickly as possible, but we do not have to wait for new authority.  We can act immediately, using essentially the same steps we used for Continental.
Stock could be issued and control assumed by a government entity.  A bridge institution could be created within the institution so essential services and operations would continue as normal.  Where necessary, the government would provide capital in exchange for preferred shares convertible to common stock upon sale.  Existing shareholders would provide the government warrants to purchase all outstanding shares with the amount exercised determined by the government's resolution cost.  Senior management and directors would be replaced.

It is well-known that the 12 Reserve Banks, along with their branches, play an important role in giving the Federal Reserve a truly national perspective on issues related to monetary policy and banking.  But they also conduct important research to help the Federal Reserve and others understand the underlying issues for those with low incomes and those who are underserved in the area of financial services.

[T]he structure of the Federal Reserve System also is not the problem, as has been recently suggested.  It would be a sad irony if the outcome of a crisis initiated on Wall Street was to result in Wall Street gaining power at the expense of the other parts of the country.  The 12 Regional Federal Reserve Banks that make up the Federal Reserve System were established by Congress specifically to address the populist outcry against concentrated power on Wall Street.  Its structure reflects the system of checks and balances that serves us well at all levels of government, and it is the reason I am here today able to express an alternative view.

It is critical that we correctly diagnose the cause of this crisis.  The structure of our regulatory system is neither the cause nor the solution.  These "too big to fail" institutions are not only too big, they are too complex and too politically influential to supervise on a sustained basis without a clear set of rules constraining their actions.

[A]ctions that strive to protect our largest institutions from failure risk prolonging the crisis and increasing its cost.  Of particular concern to me is the fact that the financial support provided to firms considered "too big to fail" provides them with a competitive advantage over other firms and subsidies their growth and profit with taxpayer funds.

"I think it will take us most of the rest of the year," to move out of recession, Hoenig said.

As reported by Reuters.

The Federal Reserve's response to this crisis in providing liquidity and support to institutions and markets outside of its traditional purview has been significant, creative and timely.
However, in stepping outside its normal sphere of operations and making decisions about which markets and institutions to support, the Federal Reserve has also moved into credit-allocation decisions which are more properly performed by the marketplace itself and by fiscal authorities when necessary.  These decisions have also caused the Federal Reserve to greatly expand its balance sheet and have almost certainly set expectation for similar responses in any future crises.  All of this will make it more difficult for the Federal Reserve to quickly remove its policy accommodation in the future and, thereby, will subject it to new tests of its independence as a monetary authority.

I have outlined a resolution framework for how we deal with the large, systemically important institutions at the center of this crisis in the United States.  Boiled down to its simplest elements, the plan would require those firms seeking government assistance to put the taxpayer senior to all shareholders with the impact on managers and directors depending on the viability of the firm.  Nonviable institutions would be allowed to fail and be placed into a negotiated conservatorship or a bridge institution, with the bad assets liquidated while the remainder of the firm is operated under new management and reprivatized as soon as feasible.

In my view, the rush to respond has had negative consequences...Without a systematic plan for addressing the crisis, policy actions have been ad hoc, resulting in inequitable outcomes among firms, creditors and investors that have increased uncertainty and undermined confidence.  Nowhere is this more apparent than in the treatment of large, complex financial institutions that have been labeled as "systemically important" and "too big to fail."

[C]ritics suggest the failure of one of these institutions could be very disruptive and worsen the crisis, citing Lehman as an example. I am not at all advocating the approach taken with Lehman. Rather, I am arguing for a timely, managed and orderly resolution of large, insolvent institutions, with their basic functions continuing under new management.

[A]s the payments system continues to evolve, the Federal Reserve's role will need to change.  In my view, it would not be desirable for the Federal Reserve to scale back its presence in retail payments or even exit retail payments as some might advocate.

While the Federal Reserve could focus more on regulation and oversight to achieve its mandate as many other central banks are doing, I suggest that it should leverage its experience and position as an operator to achieve its objectives {regarding electronic retail payments}.
Historically, the Federal Reserve's role in both checks and ACH reflects a preference to operate within the market rather than as a pure regulator.  We are well aware that industries can - and do - quickly develop methods to exploit any regulatory loopholes and avoid the intended outcome.  By competing with the private sector on a level playing field, the Federal Reserve can encourage efficiency and integrity from an "on the ground" position.
Looking forward, I also suggest that it could do so in the realm of electronic payments more broadly.

Starting from where we are today, it is clear that interest rates must rise.  As the economy recovers, even at a modest pace, resource demands will begin to increase.  At this point, the current level of monetary accommodation will need to be withdrawn to avoid introducing inflationary impulses. Also, with the almost certain adjustments that need to occur in consumption, savings and the rebalancing of imports and exports, I expect there would be additional pressure for interest rates to rise steadily over time.

The markets won’t be fooled by artificially low rates for long.  Market participants realize that a period of high deficits and accommodative monetary policy are an invitation to increased inflationary pressure.  I suspect we are experiencing the first signs of the markets’ concerns in the rising rates and increased volatility in longer-term Treasury markets.

My view of the more immediate outlook for the U.S. economy is that we will emerge from this recession - perhaps as soon as the second half of the year, but most likely in early 2010, as many economists project.

Over the past two decades, the U.S. has created for itself a set of economic imbalances that, in my judgment, have significantly increased uncertainty and placed economic growth at risk for future generations of Americans.
...
Because the U.S. economy is so large and, by historical standards, so successful, it has the capacity to carry such imbalances far longer than most economies would be permitted in today's global markets.  However, such an advantage will eventually end and comes with its own costs.

This recession is often described as the worst in post-World War II history, and that may very well be correct.  From it will flow a host of policy issues that will require careful review and hard choices if we are to assure our national economy's long-term strength and vitality.

In thinking about the long run while contemplating the current economic situation, I would humbly amend the famous observation of economist John Maynard Keynes.  in the long run, we are all dead but our children will be left to pick up the tab.

Just as there is slack, there is also an enormous amount of stimulus in the economy and coming into the economy...Being too slow to remove our expansionary actions would very likely be inflationary.

The 12-bank system, as I've said many times, is absolutely essential to having an effective central bank. … The banking activities in the Midwest, in our region, are in many ways different than what you're going to find in Manhattan or in California. And having a reserve bank that understands not just its banking but the businesses that are unique to this region -- we're an agricultural region, we have a lot of energy in this region -- I think, is absolutely essential to the policymaking process as I go back to Washington and participate in that and communicate about it, and as I deal with commercial banks here, community banks or regional banks and businesses.  So -- and I've told people, in 1913, when this institution was organized, there was not an operational need for 12 banks.  That was a very important part of bringing consensus of support around the central bank and improving the communications of that central bank. It hasn't changed one iota. I would say, if you look at these times, it's probably more important than ever.

Although we have a legal framework for dealing with failing institutions, we have learned that, in a crisis, the “systemic spillover” that can emerge from failures of our largest institutions and the threat to the broad economy require additional consideration. The most recent examples of this have led to the suspension of normal bankruptcy and bank resolution processes, thus institutionalizing the concept of too big to fail in our economic system.

Some have well illustrated the responses associated with the recent crises to an emergency crew acting to save a burning home before it destroys the entire neighborhood. I agree that acting to save the neighborhood was important. However, to extend the metaphor, if the fire was started by a homeowner who ignored fire codes and smoked in bed, should the neighbors be required to rebuild the home at twice its original size at their expense?

www.wrightson.com/federal_reserve/fedspeak/item/4587

There needs to be a set of basic rules of performance that apply to systemically important institutions. I would emphasize that these rules need to be easily understood and enforceable. For example, I strongly support simple leverage standards for setting capital requirements at financial institutions…Risk-based capital standards, in contrast, are complex, procyclical, and easier to avoid.

…

While no system is perfect, clear and firm rules are easier to understand and enforce. Principles-based oversight is an exercise in philosophy, not a supervisory framework.

I judge the economy at or near the bottom of the cycle.

I am not suggesting a V-shaped cycle.  I think ... it will be a very slow recovery, given the seriousness of the problems in the financial industry and the slowness with which the capital in those institutions will be rebuilt.

As reported by Reuters.

We know we cannot have this highly accommodative policy without risking some pretty difficult inflationary consequences. So let's deal with that.

Once we get the policy rate in a range ... around neutral -- I cannot identify what neutral is, but I know that it is not a quarter of a percentage point over a long period of time -- you stay within that range.

What we need to do is get to some level of policy that is more constrained, around a neutral level, and then let the economy work its way through.

As reported by Reuters.

As we become more confident that we are at the bottom of the recession and are moving into recovery, we must become more resolute in systematically reducing our balance sheet and raising interest rates to levels we might all agree are more in line with the economy’s long-run growth path.

Many times in the last year I have expressed my astonishment that Congress was able to approve $700 billion in TARP funds in approximately one week and yet 18 months have passed since Bear Stearns was acquired by JPMorgan and there is still no resolution authority for the largest financial firms.

We all know that the neutral rate is not zero.  Equally obvious to me is that a rate of 1 or 2 percent is not tight monetary policy -- it is still very accommodative.  As we consider our choices, I would not support a tight monetary policy in the current environment, but my experience tells me that we will need to remove our very accomodative policy sooner rather than later.  Even if we were to start immediately, much time would pass before incremental increases could be considered tight or even neutral policy.

"Right now, monetary policy is extremely accommodative as I have said, and it is going to remain so as we struggle through this early stage" of recovery.

As reported by Bloomberg News.  This remark followed his more hawkish, headline-making comments from two days earlier. 

[Regulators should] designate banks in advance that are systemically important... Preparation is really important. We have to define 'systemic' to get things started to deal with this issue [of too big to fail].

We have to go back and think of some of the reasons why [excessive risk-taking] came about at these very large institutions -- without changing the structure that eliminated Glass-Steagall -- and the consequences of that... [Breaking apart very large firms] is a fair thing to consider.

Those of you who have heard me speak previously, both here and elsewhere, know that I frequently point out that consumer debt levels are too high and that individuals must save more.  So, how does that position align with my statements about the importance of consumer spending in the recovery and our broad economy?  If the U.S. is to reduce its dependence on other countries for credit and support that its private and public investment demands, savings and consumption must return to more historical norm.  But like the decline itself, the adjustment process must proceed gradually or we risk disrupting consumption to such an extent tha twe undremine the economy itself.  The challenge is to establish the appropriate pace of change.

Low rates also interfere with the economy’s ability to allocate resources and distort longer-term saving and investment decisions. Artificially low rates discourage saving and subsidize borrowers at the expense of savers. Over the past decade, we channeled too many resources into residential construction and financial activities. During this period, real interest rates—nominal rates adjusted for inflation—remained at negative levels for approximately 40 percent of the time. The last time this occurred was during the 1970s, preceding a time of turbulence. Low interest rates contributed to excesses. It would be a serious mistake to attempt to grow our way out of the current crisis by sowing the seeds for the next crisis.

Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, said the central bank should end its purchases of mortgage debt as planned in March because the private market for the securities is “healing.”

My view was that we should change the language. I didn't object on the fact that interest rates were low at this time, but I think policymakers need to have the broadest options possible and the language that we use, that is very low for an extended period, was appropriate during the height of the crisis to assure that we were not going to make any changes, but now the economy is beginning to recover. It has been in recovery now for two quarters. We have to be thinking a little bit longer ahead and that's really what my admonition was.

In response to a question about his dissenting vote against the "extended period" clause in the January FOMC statement.

The job numbers lag the economy. Don’t misunderstand me. I think having people back to work is extremely important, but you don’t want your short term – your impatience about monetary policy -- to cause you to create new problems two years from now or two and a half years from now that cause people to lose their jobs again. So it’s that balance that’s using the policy in a careful, measured way that I think matters. I don’t know if I am seeing anything different, but I think I am trying to maximize the ability to assure that the recovery continues and we’re sure that we don’t end up with a new bubble down the line or inflation two, or three, or four years from now. Remember, interest rates were very low in 2001, 2002 and the effects of that really came much later and that’s what we have to keep in mind for the future.

And the third thing we need is to really begin to listen to the Volcker Rule and to Paul Volcker and to begin to think about how you put detail around that and how you would implement over the future so that we don’t find ourselves dealing in an emergency overnight situation without clear guidance.

Well, in the long run of course, I’ve said in public speeches, we need to have the policy rate at least higher than 3%. But now remember that’s a long time ahead. I said 3 1/2% to 4 1/2% and a half in a very long period. So that’s quarters or maybe even years ahead depending on how the economy recovery goes.

The Canadian experience in the second half of the 1990s is suggestive of the third—and the only responsible—way to resolve our growing fiscal imbalance: By addressing its source in an environment of price stability. All seem to agree this is the way we would prefer to go, but of course the devil is in the details. At the outset, it requires an institutional framework committed to having an independent central bank. This discourages the fiscal authority from turning to its central bank and should it do so, strengthens the bank’s ability to say “no.”

"Depending on your assumptions about the economy, that federal debt will grow at an unsustainable level starting immediately, or in a very few years,” Hoenig said. “We do have significant private debt, so that’s in place, so what worries me about that [is] that puts pressure on the Fed to keep interest rates artificially low as you try to deal with that debt.”

In a C-SPAN interview, as reported by the Wall Street Journal

Confining the Federal Reserve's supervisory role to only the largest firms will, I fear, inadvertently make the Federal Reserve the central bank to the largest firms while disenfranchising the other 6,800 banks.

[I]t is the largest financial firms that have an implicit, recently made explicit, guarantee that taxpayer dollars will be used to protect them from failure, regardless of what risks they assume.  It is only now that we are discussing legislation to address the issue of a special class of the largest firms that we have deemed too-big-to-fail.  This is the one item that must be addressed if we are to have any real competitive equity among all financial institutions.  What is proposed may need to be strengthened, but it is a start.

While calling for action myself, I have been uneasy with what I have seen so far... We must reinvigorate fair competition within our system in a culture of business ethics that operates under the rule of law.  When we do this, we will not eliminate the small businesses' need for capital, but we will make access to capital once again earned, as it should be.

I don't think we have any business guaranteeing Wall Street spreads. We need to recognize that and address it by removing these guaranteed extremely low rates. I think it's extremely important that we do that, and not create the conditions for speculative activity and a new crisis down the road.

By itself,the current state of the economy warrants an accomodative monetary policy. However, as the economy continues to improve, risks emerge around the act of holidng rates low for an extended period.

I have dissented at the last two FOMC meetings specifically because I believe the "extended period" language is no longer warranted and I am concerned about the buildup of financial imbalances creating long-run risks.

An alternative policy option is to be more proactive, but cautious. This would require initiating a reversal of policy earlier in the recovery while the data are still mixed but generally positive.

Under this policy course, the FOMC would initiate sometime soon the process of raising the federal funds rate target toward 1 percent. I would view a move to 1 percent as simply a continuation of our strategy to remove measured that were originally implemented in response to the intensification of the financial crisis that erupted in the fall of 2008. In addition, a federal funds rate of 1 percent would still represent highly accommodative policy.

[W]e should get our balance sheet back down to less than a trillion dollars to allow us to engage in short-term securities transactions.

You see, New Mexico’s financial institutions were not too big to fail. They were never invited to meetings and told to accept financing from the Troubled Asset Relief Program. As a result, banks and residents of Santa Fe, like those in towns all over Middle America, have struggled mightily through this recession. It was clear that, like politics, the effects of financial crises are mostly local.

[T]he proposed financial reform legislation would significantly narrow the supervisory role of the Federal Reserve, so that it would oversee only the very largest institutions, most of which are headquartered in New York City. Congress established the Federal Reserve System in 1913 with 12 banks in a federated structure, like our political system, so that it would include regional perspectives to counterbalance the influence of Wall Street and Washington. To now narrow the Fed’s supervision to just the largest banks would be to devalue those broader perspectives. The Federal Reserve would no longer be the central bank of the United States, but only the central bank of Wall Street.

[T]he proposed financial reform legislation would significantly narrow the supervisory role of the Federal Reserve, so that it would oversee only the very largest institutions, most of which are headquartered in New York City. Congress established the Federal Reserve System in 1913 with 12 banks in a federated structure, like our political system, so that it would include regional perspectives to counterbalance the influence of Wall Street and Washington. To now narrow the Fed’s supervision to just the largest banks would be to devalue those broader perspectives. The Federal Reserve would no longer be the central bank of the United States, but only the central bank of Wall Street.

I strongly support establishing hard leverage rules that are simple, understandable and enforceable and that apply equally to all banking organizations that operate in the United States.

[With the extended period pledge having been removed,] the FOMC would be prepared to raise the funds rate target to 1% by the end of summer.

Between August 2002 and January 2005- two-and-a-half years- the federal funds rate was below the rate of core inflation.  Such low interest rates encourage borrowing and a buildup of debt, sometimes in ways we do not fully appreciate until much later with the benefit of hindsight.  In addition, low interest rates- especially with a commitment to keep them low- led banks and investpors to feel "safe" in the search for yield, which involves investing in less-liquid and more risky assets.  In addition, financial institutions often search for yield by increasing the amount of assets supported by each dollar of net worth- leverage.  For example, leverage at securities broker dealers rose dramatically.  After averaging just 13 1/4 between 1970 and 2000, leverage climbed to a high of 40 in the third quarter of 2007- the start of the financial crisis.

It was after a period of too-low interest rates, too much credit, too much leverage that the collapse of the housing bubble, the rapid deleveraging and the ensuing financial crisis occurred.  And it was after these events that unemployment rose to more than 10 percent and the United States lost 8.4 million jobs.  In 2010, we have only gained back 573,000 jobs.

If we are to achieve a steady rate environment, it is also important that the Federal Reserve's balance sheet be restored to its pre-crisis size and composition.  Obviously, this requires the careful process of selling the Federal Reserve's $1.3 trillion portfolio of mortgage-backed securities.  Various approaches to this can be identified but most agree that it should be done with the process or time horizon clearly set out for all to see.  I also would suggest it begin at least when the fed funds rate rises above 1 percent or sooner if conditions provide the opportunity

[U]ncertainty, even in good times, I think can be harder on you than certainty in bad times.

I believe the economy has the wherewithal to recover. However, if, in an attempt to add further fuel to the recovery, a zero interest rate is continued, it is as likely to be a negative as a positive in that it brings its own unintended consequences and uncertainty. A zero policy rate during a crisis is understandable, but a zero rate after a year of recovery gives legitimacy to questions about the sustainability of the recovery and adds to uncertainty.

It gives me pause, for example, that after the recent devastating experience of the global banking crisis, regulatory authorities are already backing off initial attempts to strengthen international capital requirements for these largest banks and financial firms. The Basel Committee just announced an agreement to establish for our largest global banks a Tier 1 capital-to-asset ratio of 3 percent. This is a 33-to-1 leverage ratio. Bear Stearns entered this crisis and failed with a 34-to-1 leverage ratio. It leaves a small cushion for error and is a level of risk that I judge unacceptable.

In the third quarter of 2003 … GDP expanded at what turned out to be nearly a 7 percent annual rate, yet rates were left at 1 percent for several months. With the low rates very low for a considerable period, credit began to expand significantly and set the stage for one of the worst economic crisis since the great depression. In my view, it was a very expensive insurance premium. Unemployment today is 9.5 percent. I fully acknowledge that I was on the FOMC at that time. That’s why I believe that zero rates during a period of modest growth are a dangerous gamble.

Before this week’s FOMC meeting, The Wall Street Journal wrote that the Fed would add more stimulus into the economy—including the purchase of long-term treasuries. It turns out that reporter was remarkably prescient.

Despite the provisions of the Dodd-Frank Act to end too- big-to-fail, community banks will continue to face higher costs of capital and deposits until investors are convinced it has ended.

We are trying to avoid the same group so that we get this group think that people can attribute if you only talk to the same people over and over... You don’t get good outcomes unless there is a broad diversity of views, discussion, debate.

{Hoenig} also rejected the idea of raising the Fed’s informal inflation target above 2 percent because of concern over the possibility of falling prices. 

“I have to tell you it horrifies me,” Hoenig said, responding to an audience question. “It assumes you can fine- tune things like interest rates.” \

“I have never agreed to” an informal inflation target, he said. “Two percent inflation over a generation is a big impact.”

As reported by Bloomberg News

 

In the period leading up to this most recent crisis, the regulatory authorities, like the industry, trusted that the market would self-regulate. It didn’t, it can’t and it won’t. The industry's structure and incentives are now inconsistent with the market being the disciplinarian.

The Volcker Rule does not reinstitute Glass-Steagall. It does improve the odds toward financial stability by instituting a partial return to the separation of commercial and investment banking activities. It strives to affirm the principle that those institutions that by their franchise have access to the safety net should be separated from those firms that are free to speculate with shareholder, not taxpayer, funds.

Paul has it right.

....

As a Swiss central banker once insisted to me many years ago, “ [I]t is the central bank's job to focus on the long run so that the short run can take care of itself.”  For me, one certain lesson from this most recent crisis is that both the industry and supervisory authorities lost sight of the long run.

In fact, right now the economy and banking system are awash in liquidity with trillions of dollars lying idle or searching for places to be deployed or, perhaps more recently, going into inflation hedges. Dumping another trillion dollars into the system now will most likely mean they will follow the same path into excess reserves, or government securities, or “safe” asset purchases. The effect on equity prices is likely to be minor as well. There simply is no strong evidence the additional liquidity would be particularly effective in spurring new investment, accelerating consumption, or cushioning or accelerating the deleveraging that is hopefully winding down.

The structural change that has taken place in the U.S. economy since the height of the financial crisis will take time to set in... stoking change with monetary policy is a "bargain with the devil."

- Thomas Hoenig, in response to audience questions following a speech at the University of Kansas

I believe that moving rates modestly off of zero, where they have been since December 2008, still represents highly accommodative monetary policy... More importantly, such action is necessary if we are to ensure a more stable economy.

Mr. Hoenig does not have a vote next year, and he must retire after he turns 65 in September. As for his future, Mr. Hoenig, a train enthusiast who reads biography and history in his spare time, is certain that he will not follow other Fed veterans who have gone to work on Wall Street. “I can tell you one thing,” he said. “I’ll never work for a too-big-to-fail bank.”

The crisis has only made the biggest banks even bigger. “They have enormous power,” Mr. Hoenig said. “Just look at their lobbying expenses. I use the word — and it’s a fairly flammable word — oligarchy. These things are huge and powerful, and that’s where the money is. This country through its history has abhorred concentration of financial power, and for good reason.”

In essence, the Federal Open Market Committee has maintained an emergency monetary policy stance in a recovering economy and has continued to ease into the recovery. I believe these actions risk creating a new set of imbalances, or bubbles. Importantly, such actions as they continue are demanding the saving public and those on fixed incomes subsidize the borrowing public.

There are those who believe we have made great strides with Dodd-Frank and if we implement it well, all will be fine. Some believe that that the industry is over-regulated, which may be true, but we should not confuse over-regulated with well-regulated. And some of us are certain that in spite of all that’s been done and debated, the soundness of the largest financial institutions and the systemic risks they continue to pose is no better. In my view, it is even worse than before the crisis. As well-intentioned as the Dodd-Frank Act may be, it will not improve outcomes.

Today, I am convinced that the existence of too big to fail financial institutions poses the greatest risk to the U.S. economy. The incentives for risk-taking have not changed post-crisis and the regulatory factors that helped create the crisis remain in place. We must make the largest institutions more manageable, more competitive, and more accountable. We must break up the largest banks, and could do so by expanding the Volcker Rule and significantly narrowing the scope of institutions that are now more powerful and more of a threat to our capitalistic system than prior to the crisis.

It is ironic that in the name of preserving free market capitalism in this country, we have undermined it so deeply.

Q: There is an undercurrent of anti-Fed sentiment among the freshman Republicans. Support for the gold standard, anti-fiat currency… How do you respond to it?

A: I say I understand. I say gold is a very legitimate monetary system. However it will not end crises. It will not end credit bubbles. And it can be just as disruptive as a fiat currency – as an example the Great Depression when gold was hoarded and we had a very serious deflationary experience. Yes, the Fed contributed to it, but also governments contributed to it with their hoarding issues.

Q: But end the Fed?

A: I don’t see that a modern economy would function better without a central bank. We might have stable prices, but that is on average. In the meantime, we would have very strong deflationary pressures and very high inflationary pressures. The average is zero. That is the problem with that. It is not going to solve the world’s problems.

Q: Is QE2 working?

A: I would say it is having effects but at what price later on? My view is it is not just about intended consequences, it is about unintended consequences.

Q: How about tapering off QE2?

A: I certainly would. I am for tapering them off. If you can do it in the right way without disrupting the markets, then yes, by June or sooner. But that precondition is a pretty tough precondition – doing it in the right way, not disrupting markets.

Q: Communication?

A: Communication, communication, communication.

"I know we need to start by, if we were to do that, communicating to the market that we are not guaranteeing them the yield curve, that we are going to remove this language of ‘extended period,’" Hoenig, president of the Kansas City Fed, said in an interview with CNBC today. He said he didn’t know when the central bank may make such a move, while expressing a preference the Fed act this year.

The economy "has been improving," said Hoenig, who added that he believes the Fed should begin to consider "renormalizing" policy and that he favors "non-zero" interest rates.

Rising oil prices are not a "permanent" or "defining" factor for the economy right now, he said.

I really want to take away the punch bowl before the room gets drunk, because this punch is, I think, a little bit spiked.  I’m not for tight monetary policy, I’m for non-zero monetary policy.

As the United States continues to ease policy into its recovery, once again there are signs that the world is building new economic imbalances and inflationary impulses. I would suggest also that the longer policy remains as it is, the greater the likelihood these pressures will build and ultimately undermine world growth.

Today, my view has not changed. The FOMC should gradually allow its $3 trillion balance sheet to shrink toward its pre-crisis level of $1 trillion. It should move the U.S. federal funds rate off of zero and toward 1 percent within a fairly short period of time. Then, after evaluating the effects of those actions, it should be prepared to move the funds rate further toward a level that could be reasonably judged as closer to normal and sustainable.

"My view is QE2 was unnecessary,” Hoenig said of the plan to purchase $600 billion in Treasuries in a second round of quantitative easing, during a Bloomberg Television interview in London. “My concern would be if there were any further easing into a recovery is that you do accelerate imbalances that then cost you dearly later."

"We really do need to think about redefining the scope of legitimate financial activities of the commercial banks,” Hoenig said, voicing a previously stated view. “That means to break them up, in essence."

"There are two things: the size of the adjustment will be a factor, and the duration before we introduce the adjustment will be a factor," Hoenig said. "I think the smaller, the sooner, then you get expectations generated and you get people thinking, 'I'd better match my assets and liabilities because if I don't I'm going to find myself in trouble.'"

“I can’t go anywhere in my district and have people not ask me about inflation” in items including gasoline, groceries and paper products, Hoenig said to reporters today in Washington. The Fed needs to “calm inflationary fears” by raising interest rates, and “if we don’t do that, then I think they will build over time,” he said.

Banking organizations that have access to the safety net should be restricted to the core activities of making loans and taking deposits and to other activities that do not significantly impede the market, bank management and bank supervisors in assessing, monitoring and controlling bank risk-taking. However, these actions alone would provide limited benefits if the newly restricted activities migrate to shadow banks without that sector also being reformed. Thus, we also will need to affect behavior within the shadow banking system through reforms of money market funds and the repo market.

Zero is not the right rate, that much I am pretty confident of.

Hoenig spoke after international regulators forged an agreement over the weekend that requires the world’s largest banks to hold extra capital. The requirement is aimed at strengthening the biggest banks’ financial cushions to prevent another financial crisis.

Responding to an audience question, Hoenig said the surcharge may not reduce risks to the broader financial system, compared with his recommendations.

“I don’t have any faith in it at all,” he said. Discussing the Dodd-Frank law’s authority for the government to wind down a failing big firm without a bailout, Hoenig said, “I just can’t imagine it working.”

If I judged—or if evidence suggested—that a zero rate would solve our country’s unemployment problem or speed up the recovery without causing other adverse consequences, I would support it. However, monetary policy is not a tool that can solve every problem.

Complicating the fragility around monetary policy, fiscal policy as a pro-growth policy instrument also appears to be approaching its limit. The government’s stimulus efforts to support the economy, along with lower tax revenues, have resulted in historically large fiscal deficits and a very large debt level. Without a dramatic change, the deficit and the debt will only become more daunting with the rising cost of entitlement programs and likely higher interest rates.

We must change our national savings rate. To rebalance the U.S. trade position from deficit to balance requires that the sum of private and public savings match domestic investment. In other words, a country must not produce less than it consumes if it wishes to balance its trade position with the rest of the world.

Hoenig repeated his call for raising the central bank’s target interest rate to 1 percent as part of a normalization of monetary policy reflecting that the recovery is more than two years old.

“ I am not for tight monetary policy,” he said. “I am for nonzero monetary policy” that isn’t “wracked with imbalances and new crises we have to deal with.”

Hoenig repeated his criticism of the central bank’s near- zero interest-rate policy. “I’ve lived through three crises now and I know the conditions that are right for bubbles and guess what? Zero interest rates create the conditions for bubbles,” he said today at an agriculture conference at the Kansas City Fed.

I suspect that as we’ve done in the past we will look to the central bank of the United States and the world’s central banks to inflate our way out of this because it’s so much easier.

He also told CNBC the federal funds rate has to slowly be raised "over a period of time" to 1 percent from the current 0 percent so it doesn't "shock the economy," and then it should move back "toward a more normal level as the economy allows."

"I don't think zero is the right policy," Hoenig said. "You can't have any type of a market, whether a commodities or a services market, that will run efficiently at a price of zero."

“I have real concerns about trying to fine-tune and micro-manage the economy when monetary policy is a blunt tool,” Hoenig said today in an interview with Bloomberg Radio’s “The Hays Advantage” with Kathleen Hays. Efforts to “redefine yield curves” may “introduce new complexities and risk new unintended consequences,” he said.

“We risk further imbalances,” said Hoenig, 65, who doesn’t vote on the FOMC this year. “We ought to be very, very humble in our expectations of what we can do with this instrument we call monetary policy.”