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Tuesday, October 28, 2008

Financial Stability and the Fed

Stephen Roach says the Fed needs to broaden its mandate:

Add ‘financial stability’ to the Fed’s mandate, by Stephen Roach, Commentary, NY Times: A regulatory backlash is under way as the US body politic comes to grips with the financial crisis. ... As Washington creates a new system, it must also redefine the role of the Federal Reserve.

Specifically, the US Congress needs to alter the Fed’s policy mandate to include an explicit reference to financial stability. The addition of those two words would force the Fed not only to aim at tempering the damage from asset bubbles but also to use its regulatory authority to promote sounder risk management practices. Such reforms are critical...

By focusing on financial stability, the Fed will need to adjust its tactics in two ways. Firstly, monetary policy will need to shift from the Greenspan-Bernanke reactive, post-bubble clean-up approach towards pre-emptive bubble avoidance. Second, the bank will need to be tougher in its neglected regulatory oversight capacity. ...

I am not suggesting the Fed develops numerical targets for asset markets. It should have discretion as to how it interprets the new mandate. Yes, it is tricky to judge when an asset class is in danger of forming a bubble. But hindsight offers little doubt of the bubbles that developed over the past decade – equities, residential property, credit and other risky assets. The Fed wrongly dismissed these developments, harbouring the illusion it could clean up any mess later. Today’s problems are a repudiation of that approach.

There is no room in a new financial stability mandate for bubble denialists such as Alan Greenspan.. He argued that equities were surging because of a new economy; that housing forms local not national bubbles and that the credit explosion was a by-product of the American genius of financial innovation. ... Under a financial stability mandate, the Fed will need to replace its ideological convictions with common sense. When investors buy assets in anticipation of future price increases the Fed will need to err on the side of caution and presume that a bubble is forming that could threaten financial stability.

The new mandate would also encourage the Fed to ... deploy... other tools. In times of asset-market froth, I favour the “leaning against the wind” approach with regard to interest rates – pushing the Federal funds rate higher than a narrow inflation target might suggest. But there are other Fed tools that can be directed at financial excesses – margin requirements for equity lending as well as controls on the issuance of exotic mortgage instruments... In addition, the Fed should not be bashful in using the bully pulpit of moral persuasion to warn against the impending dangers of asset bubbles.

Of equal importance is the need for the Fed to develop a clearer understanding of the linkage between financial stability and the open-ended explosion of derivatives and structured products. Over the past decade, an ideologically-driven Fed failed to make the distinction between financial engineering and innovation. It understood neither the products nor their scale, even as the notional value of global derivatives hit $516,000bn in mid-2007, the eve of the subprime crisis – up 2.3 times over the preceding three years to a level that was 10 times the size of world gross domestic product. The view in US central banking circles was that an innovations-based explosion of new financial instruments was a huge plus for market efficiency.

Driven by its ideological convictions, the Fed flew blind on the derivatives front. ... Like all crises, this one is a wake-up call. The Fed made policy blunders of historic proportions that must be avoided in the future. Adding financial stability to its mandate is vital to preventing such errors again.

To the extent that instability in the financial sector impacts employment and price stability, it's already part of the mandate. To the extent that it doesn't, why should the Fed care?

In any case, it's already implicitly part of the mandate, e.g. Mishkins says:

[T]he Federal Reserve's mandate is "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Because long-term interest rates can remain low only in a stable macroeconomic environment, these goals are often referred to as the dual mandate; that is, the Federal Reserve seeks to promote the two coequal objectives of maximum employment and price stability. ... (By the way, I wish that I could also discuss the Federal Reserve's role in promoting the stability of the financial system, another key objective of central banks, but unfortunately that would violate my own personal mandate of finishing this speech in the allotted time.)

Or, for a more explicit statement, see here.

The issue isn't whether preemption of bubbles falls under the Fed's mandate, it's whether a bubble-popping policy can help the Fed to achieve it's goals of maximum employment and stable prices. Greenspan advocated a clean up after the mess philosophy because he thought that preemption did more harm than good (the harm comes from popping misidentified bubbles due to very noisy information), but recent experience has led the Fed to reconsider this approach.

I think there's a broader issue here that's important. Popping the next bubble will take courage, the ability to hold steady in the face of severe criticism. It won't be as simple as raising interest rates, though that could help, it will require forceful action by the Fed on other fronts including communication with the public about why it's necessary to reduce the opportunities for people to make money during the boom. The Fed will need to explain why the action isn't choking off productive, innovative activity and that's not a message people will want to hear. If Greenspan had started announcing that he thought housing was overvalued and that people should think twice before purchasing a home, and then think again, the protests would have been heard far and wide. It wouldn't have been easy to do, and I can imagine congress objecting and asking the Fed to explain itself as an implicit threat to its independence. I think Roach is asking for more instutitonal support and guidance in taking such action so that it can be defended more easily as a group decision based upon pre-existing policy, it shouldn't be viewed as an ad hoc move by the Fed or the policy of a single individual. That's why the Fed's announcement that it will reconsider it's approach to bubbles is a good sign, it's a first step toward providing the institutional cover and guidance that will be needed to pursue such strategies.

    Posted by on Tuesday, October 28, 2008 at 02:43 AM in Economics, Financial System, Monetary Policy | Permalink  TrackBack (0)  Comments (52)


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