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. First, 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 its 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 its 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.

Comments

[Jolly_Rancher:]

The key to the game is anticipating investor expectations and reactions. In other words, outguessing investors. Once investors understand what the Fed's strategy is, the game is over. The reason is that investors by nature want to make as much money as possible, and the investors' "favorite" way to make money is in a speculative bubble. Humans as a group are bipolar. Therefore, once they understand the rules of the game, they then proceed to work around the rules to create that bubble. The Fed can try to grab as much smoke as it can, but eventually the whole room fills up with smoke and there's nothing left to do but turn on the attic fan and kick everybody out.

2008 Oct 28 12:22 PM

[Socialism c...:]

The government needs to get the hell outta economics!! Greenspan was part to blame for this mess...the Fed needs to be abolished...total scam, used to manipulate for the benefit of the few at the top. The other major blame goes to socialist Dems who perpetrated the whole subprime lending farce on us at taxpayer expense!!

Let private money remain private!! Abolish the income tax and let us do as WE WANT with what is OURS to begin with!! The way to restore the economy is to let the private citizen have control over their own property once again. By strange coincidence, an abolishment of the income tax and a return to funding government by sales & other consumptive taxes, would also restore control over the government (as opposed to vice versa!!) to the people!!

P.S. -- hope you all are following the latest Democrat proposals to nationalize our 401Ks into government bonds yielding 3%!! They better damn well not touch that! There will be an all-out revolution if they go there.

2008 Oct 28 12:32 PM

[Smarty_Pants:]

"Financial Stability and the Fed"

HaHaHa! Very funny considering that the chief enabler of financial instability was the FED to begin with.

Kinda like proposing that we let the fox guard the henhouse.

2008 Oct 28 02:07 PM

[moonbat1775:]

How about this for stability: a stable money supply? No inflation, no deflation and a 100% reserve requirement for banks.

Wait, I have a better idea. Go to the Bureau of Standards and have them adjust weights and measures every year so we can have permanent economic growth without the need for real growth. We can make the pound weigh less, the gallon hold less, the ruler shorter so we can all be over 6'. Oh, we would need a masculine and feminine pound so the ladies could weigh less. The possibilities are endless.

2008 Oct 28 02:25 PM

[Smarty_Pants:]

I like moonbat's idea. Can we make a new standard for mirrors so I'm handsomer?

2008 Oct 28 02:56 PM

[moonbat1775:]

Smarty,
You'll do fine. I learned too late that women are mostly interested in character and money making potential. C'est la vie, EXCEPT, some like poetry and you'll do very well there too.

About those mirrors, adaptive optics should do the trick.

2008 Oct 28 03:06 PM

[Smarty_Pants:]

As long as they do something. Paper bags are getting pretty expensive and they only last until it rains.

2008 Oct 28 03:16 PM

[moonbat1775:]

ah, the "Unknown Economist".

"Chucky, baby! Chucky baby! I have a joke that will make you look stupid ..."

2008 Oct 28 03:23 PM

[Smarty_Pants:]

Q: How do you tell which engineer is the extrovert?

A: He's the one looking at other peoples' feet.

2008 Oct 28 05:02 PM

[moonbat1775:]

There once was an engineer shy
whose gaze would not reach to the thighs.
But it turned out quite well
a fine lass thought him swell,
for him, what a pleasant surprise.

2008 Oct 28 05:16 PM

[flow5:]

The Federal Reserve should be given powers commensurate with its responsibilities:

I am inclined to the opinion that regulatory and supervisory decision-making processes should lie entirely with the Board of Governors, and that the Board should be reconstituted to include the Secretary of the Treasury, the Comptroller of the Currency, the Chairman of the Federal Home Loan Bank Board, the Director of the Federal Deposit Insurance Corporation, the Director of the Office of Thrift Supervision, and the Chairman of the Securities and Exchange Commission.

2008 Oct 29 12:25 PM

[Old Wizard:]

I believe that there will always be those who game the system. Thatis why any policy change or regulation should force any participant in the construct or marketing of any asset class to have sufficient skin in the game. Packaging of mortgages with little asset backing by third parties in order to sell derivative securities to a fourth party had at least two parties with no skin in the game. The ability to buy commodities with a nickel on the dollar had the purchaser with very little skin in the game, etc. Fixing these problems is not that difficult so that the game players have to risk more of the wealth to play. This may not eliminate all bubbles, but it ought to reduce their size. As a result of 1929, margin limits were raised from the10 cents on the dollar to the 50 and then higher on stocks traded on the stock exchange. Why should any marketable security or commodity be any different?[oil e.g.] Making lending agencies hold the mortgages they write and permitting only the sale of the original mortgage to a third party would fix that game. Forbidding naked short selling and monitoring of large hedge funds on the short and long side for manipulation of the market would also be helpful. These seem to me to be logical and simple steps to stabilize ou financial system and make the Feds and Treasury's job manageable

2008 Nov 01 11:50 AM

[Jan VanDenBerg:]

These bubbles are best prevented using regulation of the banking/broker/insuran... system, not with changes in monetary policy, such as interest rates.

Isn't that what the Fed is supposed to do -- regulation of the financial system?

We need a more centralized bureaucracy for financial market regulation gathering together all the regulating agencies and it needs to be charged with promoting financial stability, exactly as Mark Thoma suggests.

If leverage throughout the financial system had been adequately regulated, much of the explosion in the broad money supply -- totally ignored by the Fed, who focusses quite incorrectly on narrow money aggregates -- could have been avoided.

Global leverage should be held to reasonable levels.

All financial institutions making loans (so, including brokerages offering sales on margin and not including hedge funds, which receive loans) should be required to maintain reserves of at least 5%. That implies leverage of no more than 20 throughout the entire system. That is quite unlike the 40s and 50s we have been dealing with.

Overleverage must be targetted.

Raising interest rates or tightening monetary policy is not the tool to use. Just regulate leverage.

We also need central registry of the ownership of all derivative products.

Jan VanDenBerg

2008 Nov 30 02:15 PM