Comments to the U.S. Monetary Policy Forum
U.S. Monetary Policy Forum
University Club of New York
New York, New York
I would like to compliment the organizers for posing a very challenging set of questions for the panel to address. Although you will quickly notice that I am not going to respond to each question explicitly, I will address what I think are the key issues. And in doing so, I think you will see how I have approached monetary policy decision-making during the challenging environment that has inspired these questions. As always, these are my own views and not those of the FOMC or my other colleagues in the Federal Reserve System.
The four questions for the panel can be boiled down to two broad issues:
- When and how does excessive risk-taking lead to a degree of financial instability that substantially complicates the conduct of monetary policy?
- Are current policy tools adequate to deal with this instability?
Let me start by summarizing my views. First, because periods of financial stress are relatively rare in economies with strong commitments to price stability and low variability in economic activity, the normal approaches to monetary policy—as summarized by the Taylor Rule—generally serve us quite well. Second, during periods of nascent or even actual financial stress, it is appropriate for policy to maintain its focus on obtaining its macroeconomic goals over the medium term. Third, timely access to substantive information about financial market participants' activities is a critical aid to policymakers when assessing disruptions to the credit intermediation process that could adversely affect the real economy. In the United States, the Fed's supervisory responsibilities have been a helpful tool in obtaining such information.
Before I go on, allow me to quibble with the term "excessive risk-taking." As we all know, it is difficult to define what "excessive" is.
We need to bear in mind that risk-taking is an important ingredient in economic growth and the efficient allocation of resources. Developing new technologies and their applications requires creativity and a willingness to take risks. Some innovators will succeed and invent great things, and some will fail. Resources will flow to the successful innovators, which boosts productivity and economic growth. Workers also take risks, choosing new careers and job opportunities to improve their standard of living. Clearly risk-taking is an important ingredient in well-functioning competitive economies, and living standards are enhanced by such activities.
But when is this risk-taking "excessive" and when could it have large downside economic effects? This is difficult to know simply by observing the decisions and investments as they are made. For example, a large investment project may appear to be relatively safe when the probability of its success is judged to be high. In addition, the investment might be part of a larger diversified strategy designed to reduce the overall risk profile of the firm. Of course, in the end the investment strategy may turn out to be more risky than understood ex ante. The greater risk could be due to overly optimistic assessments of the likelihood of the investment payoffs or the lack of diversification achieved by the portfolio as the returns to the various investments turn out to be more correlated than had been anticipated.
The financial developments that spawned some of last summer's turmoil in subprime mortgage markets have some of these properties. The extent to which risk-taking was excessive at the outset remains unclear. But the important question for today is whether our policy responses to these events in themselves will lead to further excesses at some point in the future. There is no way to answer this question for sure. But I think that we can minimize the potential for problems if monetary policy focuses clearly on our legislative mandate to facilitate financial conditions that promote effectively the goals of maximum employment and price stability.
Now, let me discuss how I see financial markets and financial stability fitting into our policy objectives. There is no analogy in financial markets to macroeconomic price stability. The prices of financial products may change quite substantially when new information arrives. Indeed, one of the most important activities of financial markets is price discovery—the efficient assimilation of all available information into asset values. This promotes the appropriate allocation of capital among competing demands and supports maximum sustainable growth. And it is this efficient functioning of markets that is our concern with regard to financial stability.
Most of the time, monetary policy intersects financial markets directly at our primary policy tool—the federal funds rate. To alter the trajectory of inflation and economic growth towards their goals, changes in the federal funds rate directly alter short-term risk-free rates of interest. Perceptions of our willingness and ability to adjust future policy then may also alter risk premiums in fixed-income markets and result in a change in the cost of financial credit to numerous other borrowers.
When the economy is weak and we lower rates to stimulate activity, we encourage risk-taking. This is a natural consequence of lowering rates. At the margin, projects which previously had too much risk relative to their expected return become more attractive for two reasons: The future returns may look better and the financing costs are lower. And this may be a good thing, for example, if it can help stimulate an economy that is mired in a situation where overcautious businesses or households are holding back on investment and spending. These actions would further reduce macroeconomic risk.
However, in principle, these effects could go too far and encourage too much risk–taking. How would we know? In my mind, we would begin to see imbalances emerge that would put our policy goals at risk over the medium term. For example, in the late 1990s, we felt that the increases in household wealth—much of it related to the booming stock market—were causing spending to outstrip the economy's productive capacity at that time and posing a threat to price stability.
When thinking about policy adjustments, a useful benchmark is the line of research on policy rules pioneered by John Taylor. This research indicates that most historical policy actions have been systematic responses to changes in the prospects for our goal variables of output growth, employment, and inflation. The main ideas are the systematic response component, and that particular rules are benchmarks for typical policy. Financial developments play a role in these systematic responses through the normal effects of changes in the funds rate on other credit conditions that affect the real economy. So policy responds to economic developments that affect the achievement of its goals. As long as the goals themselves are compatible with the structure of the economy, it is hard to see how the normal conduct of policy would generate excessive risk-taking.
Of course, even Taylor's research points out that periods of financial stress may require policy responses that differ from the usual prescriptions. It's not that we downgrade our focus on the policy goals. It is that during these times we often are highly uncertain about how unusual financial market conditions will influence inflation and economic activity. The baseline outlook may be only modestly affected by the conditions, but there may be risks of substantial spillovers that could lead to persistent declines in credit intermediation capacity or large declines in wealth. These in turn would reduce business and household spending. In such cases, policy may take out insurance against these adverse risks and move the policy rate more than the usual prescriptions of the Taylor Rule.
Now if we took out such insurance too liberally or too often, then private sector markets would change their views regarding policy and alter their base level of risk-taking. But in doing so, we likely would observe inflationary imbalances emerging or unusual volatility in output. So part of our job as a central bank is to properly price these insurance premiums against the achievement of maximum employment and price stability over the medium term. Importantly, when insurance proves to be no longer necessary, removing it promptly and recalibrating policy to appropriate levels will reiterate and reinforce our commitment to these fundamental policy goals. And if we are transparent so that markets understand that we will adhere to this strategy, such insurance-based monetary policy will not encourage excessive risk-taking.
We also must remember that we can't eliminate risk and uncertainty completely; nor would it be a good idea to do so. But by the same token, we don't want to add to uncertainty. The literature on asset bubble pricking is related to this discussion of excess risk-taking: Should a policymaker deflate a bubble before it becomes problematic? I am skeptical that we can identify bubbles with enough accuracy and know enough about how to act to say that we wouldn't have more failures than successes. Remember that in 1996, many commented that the stock market might be overvalued; however, the then unappreciated acceleration in productivity eventually justified even higher valuations. Furthermore, as former Chairman Greenspan  noted, in order to make sure you burst a bubble, you have to attack it aggressively, because if your attack fails, it just gets bigger. And there are big risks to the real economy of making such large moves.
I would now like to say a few words about the adequacy of our toolkit during periods of financial disruptions. We have several ways to add liquidity to the economy in addition to the normal open market operations: the discount window—extended to term borrowing and the new Term Auction Facility—and foreign exchange swaps to help enhance liquidity abroad. In these operations we accept as collateral assets that others see as less readily marketable. I do not think this adds undue risk since we only lend to qualified solvent institutions and the collateralization rates include appropriate haircuts on riskier assets. In addition, we sterilize the effects of the borrowings on aggregate reserves, so that the liquidity injections are done while maintaining the fed funds rate target. This keeps the funds rate at a level we see as consistent with achieving our announced policy goals.
Another tool we have is the ability to obtain timely information directly from financial market participants that can help us gauge the extent and potential fallouts of financial disruptions. One way we do so is through our role as a supervisor: Our experience here has given us a good base of understanding and timely access to a wide range of information regarding financial intermediaries' activities. This is important, since most financial crises involve developments in new or unusual products that affect the income flows and balance sheets of these institutions. There seem to be synergies from the knowledge we gain through supervision and the policy questions we are faced with during periods of unusual financial stress. In addition to information from banking entities, it is important to have information flows from other financial sector participants.
Thanks and I look forward to a lively discussion.
Note: Opinions expressed in this article are those of Charles L. Evans and do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.