WASHINGTON (MNI) – The following is the second of four sections of
the text of Federal Reserve Vice Chairman Donald Kohn’s remarks late
Wednesday prepared for Davidson College in Davidson, North Carolina:

Now that the financial markets are functioning much better, we have
closed the emergency facilities that we created to lend to nonbanks. The
homework assignment is to think about the design of liquidity facilities
going forward. Ive tentatively concluded that the recent crisis has
demonstrated that in a financial system so dependent on securities
markets and not just banks, we need to retain the ability to lend
against good collateral to certain groups of sound, regulated, nonbank
financial firms. I’m not suggesting that we establish permanent
contingency liquidity facilities, just that the Federal Reserve retain
the authority to create the tools necessary to meet liquidity needs of
groups of nonbank institutions should a panic impair the ability of
securities markets, as well as banks, to function and the Board of
Governors find that the absence of such functioning would threaten the
economy. The collateral would have to be of good quality and the
institutions sound to minimize any credit risk to the Federal Reserve.
Holding open this possibility is not without cost. With credit
potentially available from the Federal Reserve, institutions would have
insufficient incentives to manage their liquidity to protect against
unusual market events. Hence, the emergency credit would generally be
provided only to groups of institutions that were regulated and
supervised to limit such moral hazard. If the Federal Reserve did not
directly supervise the institutions that would potentially receive
emergency discount window credit, we would need an ongoing and
collaborative relationship with the supervisor. The supervisor should
ensure that any institution with implicit access to emergency discount
window credit nevertheless maintained conservative liquidity policies.
The supervisor would also provide critical insight into the financial
condition of the borrower and the quality of the available collateral
and more generally whether lending was necessary and appropriate.

Large-Scale Asset Purchases and the Buildup of the Reserve Base

The Federal Reserve and other central banks reacted to the
deepening crisis in the fall of 2008 not only by opening new liquidity
facilities, but also by reducing policy interest rates to close to zero.
Such rapid and aggressive responses were expected to cushion the effects
of the shock on the economy by reducing the cost of borrowing for
households and businesses, thereby encouraging them to keep spending. In
addition, the Federal Reserve and a number of other central banks have
provided more guidance than usual about the likely future path of
interest rates to help financial markets form more accurate expectations
about policy in a highly uncertain economic and financial environment.
In particular, we were concerned that market participants would not
fully appreciate for how long we anticipated keeping interest rates low.
If they hadnt, intermediate- and longer-term rates would have declined
by less, reducing the stimulative effect of the very low policy rates.

Given the severity of the downturn, it became clear that lowering
short-term policy rates alone would not be sufficient. We needed to go
further to ease financial conditions and encourage spending. Thus, to
reduce longer-term interest rates, like those on mortgages, we purchased
large quantities of longer-term securities, specifically Treasury
securities, agency mortgage-backed securities, and agency debt.

Central banks have lots of experience guiding the economy by
adjusting short-term policy rates and influencing expectations about
future policy rates, and the underlying theory and practice behind those
actions are well understood. However, the economic effects of purchasing
large volumes of longer-term assets, and the accompanying expansion of
the reserve base in the banking system, are much less well understood.
So my second homework assignment for monetary policymakers and other
interested economists is to study the effects of such balance sheet
expansion; better understanding will help our successors if,
unfortunately, they should find themselves in a similar position, and it
will help us as we unwind the unusual actions we took. One question
involves the direct effects of the large-scale asset purchases
themselves. The theory behind the Federal Reserve’s actions was fairly
clear: Arbitrage between short- and long-term markets is not perfect
even when markets are functioning smoothly; and arbitrage is especially
impaired during panics when investors are putting an unusually large
premium on the liquidity and safety of short-term instruments. In these
circumstances, reducing the supply of long-term debt pushes up the
prices of the securities, lowering their yields.

But by how much? Uncertainty about the likely effect complicated
our calibration of the purchases, and the symmetrical uncertainty about
the effects of unwinding the actions — of reducing our portfolio —
will be a factor in our decisions about the timing and sequencing of
steps to return the portfolio to a more normal level and composition.
Good studies of these sorts of actions are sparse. Currently, we are
relying in large part on studies that examine how much interest rates
dropped when purchases were announced in the United States or abroad.
But such event studies may not be an ideal means to predict the
consequences of reducing our portfolio, in part because the economic and
financial environment will be very different, and also because event
studies do not measure effects that develop or reverse over time. We are
also uncertain about how, exactly, the purchases put downward pressure
on interest rates. My presumption has been that the effect comes mainly
from the total amount we purchase relative to the total stock of debt
outstanding. However, others have argued that the market effect derives
importantly from the flow of our purchases relative to the amount of new
issuance in the market. Some evidence for the primacy of the stock
channel has accumulated recently, as the prices of mortgage-backed
securities appear to have changed little as the flow of our purchases
has trended down.

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** Market News International Washington Bureau: 202-371-2121 **

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