WASHINGTON (MNI) – The following is the third 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:
A second issue involves the effect of the large volume of reserves
created as we buy assets. The Federal Reserve has funded its purchases
by crediting the accounts that banks hold with us. Those deposits are
called “reserve balances” and are part of bank reserves. In our
explanations of our actions, we have concentrated, as I have just done,
on the effects on the prices of the assets we have been purchasing and
the spillover to the prices of related assets. The huge quantity of bank
reserves that were created has been seen largely as a byproduct of the
purchases that would be unlikely to have a significant independent
effect on financial markets and the economy. This view is not consistent
with the simple models in many textbooks or the monetarist tradition in
monetary policy, which emphasizes a line of causation from reserves to
the money supply to economic activity and inflation. Other central banks
and some of my colleagues on the Federal Open Market Committee (FOMC)
have emphasized this channel in their discussions of the effect of
policy at the zero lower bound. According to these types of theories,
extra reserves should induce banks to diversify into additional lending
and purchases of securities, reducing the cost of borrowing for
households and businesses, and so should spark an increase in the money
supply and spending. To date, that channel does not seem to have been
effective; interest rates on bank loans relative to the usual benchmarks
have continued to rise, the quantity of bank loans is still falling
rapidly, and money supply growth has been subdued. Banks behavior
appears more consistent with the standard Keynesian model of the
liquidity trap, in which demand for reserves becomes perfectly elastic
when short-term interest rates approach zero. But portfolio behavior of
banks will shift as the economy and confidence recover, and we will need
to watch and study this channel carefully.
Another uncertainty deserving of additional examination involves
the effect of large-scale purchases of longer-term assets on
expectations about monetary policy. The more we buy, the more reserves
we will ultimately need to absorb and the more assets we will ultimately
need to dispose of before the conduct of monetary policy, the behavior
of interbank markets, and the Federal Reserve’s balance sheet can return
completely to normal. As a consequence, these types of purchases can
increase inflation expectations among some observers who may see a risk
that we will not reduce reserves and raise interest rates in a timely
fashion.
In fact, longer-term inflation expectations generally have been
quite well anchored over the past few years of unusual Federal Reserve
actions. And we are developing and testing the tools we need to remove
accommodative monetary policy when appropriate. I am confident the
Federal Reserve can and will tighten policy well in advance of any
threat to price stability, and successful execution of this exit will
demonstrate that these emergency steps need not lead to higher
inflation.
Monetary Policy and Financial Imbalances
The past few years have illustrated two lessons about the
relationship between macroeconomic stability and financial stability.
First, macroeconomic stability doesn’t guarantee financial stability;
indeed, in some circumstances, macroeconomic stability may foster
financial instability by lulling people into complacency about risks.
And second, some shocks to the financial system are so substantial,
especially when they weaken a large number of intermediaries, that
decreases in aggregate demand can be large, long lasting, and not
quickly or easily remedied by conventional monetary policy.
Given the heavy costs of the financial crisis, the question
naturally arises as to how it could have been avoided. My third
assignment is to reexamine whether conventional monetary policy should
be used to lean against financial imbalances as well as aim for the
traditional medium-term macroeconomic goals of maximum employment and
price stability. One key question is whether we are likely to know
enough about asset price misalignments and the effects of policy
adjustments on those misalignments to give us the confidence to
deliberately tack away for a time from exclusive pursuit of our
macroeconomic objectives. Obviously, reducing the odds of financial
crises would be very beneficial, but we need to balance that important
objective against the potential costs and uncertainties associated with
using monetary policy for that purpose.
One type of cost arises because monetary policy is a blunt
instrument. Increases in interest rates damp activity across a wide
variety of sectors, many of which may not be experiencing speculative
activity. Moreover, small policy adjustments may not be very effective
in reining in speculative excesses. Our experience in 1999 and 2005 was
that even substantial increases in interest rates did not seem to have
an effect on dot-com stock speculation in the first episode or on house
price increases in the second. And larger adjustments would incur
greater incremental costs. As a consequence, using monetary policy to
damp asset price movements could lead to more variability in output and
inflation around their objectives, at least in the medium term. Among
other things, greater variability in inflation could lead inflation
expectations to become less well anchored, diminishing the ability of
the central bank to counter economic fluctuations.
We simply do not have good theories or empirical evidence to guide
policymakers in using short-term interest rates to limit financial
speculation. Given our current state of knowledge, my preference at this
time would be to use regulation and supervision to strengthen the
financial system and lean against developing problems. Monetary policy
would be used only if imbalances were building and regulatory policies
either were unavailable or had proven ineffective. The homework
assignment is to improve our ability to identify incipient financial
imbalances and understand their interactions with changes in policy
interest rates. A related issue, which Ill assign for extra credit, is
critical for the conduct of policy in the future. Some observers have
attributed the bubbles observed in some asset prices in recent years to
a decades-long downward trend in real interest rates. In this view, the
decline in interest rates has caused investors to reach for yield by
purchasing riskier assets with higher returns, driving the prices on
riskier assets above fundamental values. Many critics of central banks
ascribe the drop in real rates to monetary policy decisions that kept
rates unusually low, on average, over the business cycle From my
perspective, the decisions the central banks were making about their
policy rates were shaped by the underlying determinants of the balance
of saving and investment, including, in the past decade or so, the high
saving propensities of the newly emerging Asian economies and the
sluggish rebound in investment globally after the recession early last
decade. Nonetheless, it is important that we understand the reasons for
the decline in average real rates and whether low rates are likely to
persist — and that very tough problem is the extra credit assignment.
For one thing, as the economic expansion gains traction and central
banks back off the current highly accommodative stance of policy,
policymakers will need to understand how the longer-term trend in real
rates has influenced the point at which the policy rate becomes
restrictive. For another, if rates are going to continue to be low by
historical standards, regulators will need to be especially alert to any
signs that a reach for yield by investors is contributing to excessive
risk-taking.
Inflation Objectives
The final homework assignment concerns the inflation objectives of
central banks. Central banks have widely chosen to target inflation
rates near 2 percent. The Federal Reserve is required by law to conduct
monetary policy to achieve maximum employment and stable prices. We
havent announced an explicit inflation rate target consistent with that
dual mandate, but the Federal Reserve governors and Reserve Bank
presidents publish our individual forecasts for inflation over the
longer run, conditional on our individual views of appropriate monetary
policy. Those forecasts indicate that most of the FOMC participants
believe that inflation should converge to 1-3/4 to 2 percent over time.
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** Market News International Washington Bureau: 202-371-2121 **
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