Vice Chairman Donald L. Kohn
At the Kellogg Distinguished Lecture Series, Kellogg School of Management, Northwestern University, Evanston, Illinois
November 16, 2009
I titled my talk “Policy Challenges for the Federal Reserve.” I did that before I knew what I was going to discuss, because just about any topic involving the Federal Reserve would entail policy challenges. So let me begin by narrowing the topic just a bit: I would like to talk about the challenges that lie at the intersection of monetary policy and financial stability.
Our economy is just beginning to recover from a horrendous episode in which mispricing of risk–especially in home mortgage lending, but more broadly as well–led to financial instability that in turn led to a severe recession. Much attention is, appropriately, being focused on the implications of this episode for the reform of financial regulation. The Congress, financial regulators, and analysts are debating those critical issues.
I will focus on some possible implications of the recent episode for monetary policy. The questions I want to address are, first, how should we take account of financial stability in the conduct of monetary policy–for example, should financial stability be another specific responsibility of monetary policy, in addition to its responsibilities for promoting maximum employment and stable prices? And second, what do the crisis and our response imply for the monetary policy tools of the Federal Reserve? I don’t have the answers to these questions, but I thought it would be useful to discuss them.1 Importantly, I speak only for myself, not for my colleagues on the Federal Open Market Committee.2
Monetary Policy and Financial Stability
Traditionally, most analysts thought that when monetary policy successfully promoted economic stability, it would also promote financial stability. When business cycle swings are moderate and inflation rates are low and predictable, households and firms can make and follow through on long-term plans for spending, saving, and investment. Lending institutions can better evaluate the likely profitability of capital projects, thus reducing their risk of credit loss. And the moderate swings in long-term interest rates and other asset prices that were thought to be fostered by such an environment should tend to limit the exposure of balance sheets.
However, although monetary policy over the past several decades did help foster economic stability, some have questioned whether it also contributed substantially to the lax practices that led to the buildup of financial vulnerabilities and the resulting severe recession. Two aspects of the Federal Reserve’s conduct of monetary policy are cited by these critics. One, some assert that we responded asymmetrically to movements in asset prices, easing aggressively in response to declines and not tightening correspondingly when asset prices rose. This perceived asymmetry is alleged to have given market participants the sense that they could engage in a one-way bet–that the Federal Reserve would cushion asset-price declines with cheap money but would not increase interest rates to make it more expensive for them to finance bets that asset prices would rise. Second, some believe that the Federal Reserve kept policy too loose around 2003 and then tightened too slowly and predictably in 2004 and 2005, in effect encouraging if not underwriting the bubble in house prices that lay behind so many of our troubles over the past two years.
My perspective is that policymakers have kept their eyes firmly on medium-term macroeconomic stability–that is, on the legislated objectives of maximum employment and stable prices. We responded to developments in asset and credit markets to the extent that they affected the macroeconomic outlook, but we did not assign them extra weight in our deliberations. In particular we did not react asymmetrically to asset-price developments; it only looks that way on the surface because asset prices tend to rise slowly and fall rapidly. Had we been more ready to ease than to tighten monetary policy, the economy would have tended to run above its productive potential on average and inflation would have risen. In fact, inflation fell over the 1980s and 1990s.
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