Kevin M Warsh: Longer days, fewer weekends
Speech by Mr Kevin M Warsh, Member of the Board of Governors of the US Federal
Reserve System, at the 12th Annual International Banking Conference, Chicago, Illinois,
25 September 2009.
* * *
Recent media stories and more substantial works chronicle in great detail the events of the
past couple of years.1 A pair of conclusions might be fairly drawn from these early drafts of
history. One, the financial market turmoil of the past year proved to be of significant
consequence to the economy. And two, the Federal Reserve distinguished itself from
historical analogues by taking extraordinary actions to address risks to the economy. The
commentary, however, tends to part ways as to whether the extraordinary actions
undertaken were to the good or the detriment of the U.S. economy in the long-run.
As my fellow members of the Federal Open Market Committee (FOMC) and I stated earlier
this week, economic activity has picked up, conditions in financial markets have improved
further, and longer-term inflation expectations are stable.
Nonetheless, the second anniversary of the onset of the financial crisis - and about a year
from the darkest days of the Panic of 2008 - is no time to declare victory, scarcely the
moment to hand out medals.2 I cannot help but think of the strong but weary athlete who,
after a morning swim, embarks upon a grueling cycling contest to a rising din of cheers and a
smattering of boos...only to be reminded that he is participating in a triathlon, and that he has
a long run still before him.
In my view, it is unwise to prejudge the Fed's policy strategy - or to declare the victor or the
vanquished - by the split time, however notable it might be. We are at a critical transition
period, of still unknown duration, and we must prepare diligently for an uneven road race
ahead. If policy is not implemented with skill and force and some sense of proportionality, the
success of the overall endeavor could suffer.
Judgments made by policymakers in the current period are likely to be as consequential as
any made in the depths of the panic. That means policymakers should continue to
communicate as clearly as possible the guideposts, conditions and means by which
extraordinary monetary accommodation will be unwound, including the removal of excess
bank reserves.3
It also means that policymakers should acknowledge the heightened costs of policy error.
The stakes are high, in part, because the policy accommodation that requires timely removal
as the economy rebounds is substantial. And our policy judgments will ultimately prove
worthy of the accolades, and tender the ultimate rejoinder to their critics, if we rise to meet
this heightened responsibility. I am confident we will.
The final recounting of economic history, I submit, will judge that winning the battle against
the Panic of 2008 was a necessary but insufficient condition to win the peace and ensure a
strong foundation for economic prosperity. That outcome will require that policymakers have
equal parts capability, clairvoyance and courage, perhaps the most important of which is
courage.
For those of us at the Federal Reserve, the task ahead involves longer days, but in all
likelihood, fewer weekends. While the undertaking is as challenging as any we faced in the
preceding period, it is exceptionally well suited to the Federal Reserve's comparative
advantages of deliberation, dispassion, and a determination to make judgments based on the
long-term interests of the U.S. economy.
The task ahead
Economic histories in the United States and elsewhere are packed with examples in which
the monetary authorities, with the overwhelming benefit of hindsight, may have misjudged
the communication, timing or force of their exit strategies. In some cases, policymakers may
have waited too long to remove easy-money policies. In other cases, policymakers may have
acted too abruptly, normalizing policy before the economy was capable of self-sustaining
growth.
Errors of each sort are neither uncommon nor unexpected in the normal conduct of monetary
policy. During normal turns in the business cycle, the consequences of policy error to the
broad economy tend to be meaningful. Forgone output. Higher unemployment. Threats to
price stability. None of which are - or should be - acceptable to the Federal Reserve, or to
the broader body politic. And the current environment is anything but normal. There are
uncertainties regarding the trajectory of the economy recovering from a major financial crisis
and a deep recession. Equally, there are uncertainties about the performance of the
monetary transmission mechanism and the operation of the Federal Reserve's
unconventional policy tools. A nimble, even-handed approach toward our risk-management
challenges will prove necessary.
Monetary policy rules have for some time served as an alluring guide for policymakers,
particularly at transition points when guidance is especially useful. In particular, the Taylor
rule has proven to be informative in describing, if not prescribing, how a central bank might
adjust its interest rate policy instrument in response to developments in inflation and
macroeconomic activity.4
But, to make the outputs operational, we need reasonable
conviction in the reliability of our estimates of current resource utilization and inflation or, for
some alternative rules that have been proposed, forecasts of these model inputs.5 And it is
these kinds of estimates that appear especially uncertain during this period of economic
history, emblematic of the challenging task ahead. Policy rules and models alike tend to
presume average historical responses, incorporating typical transmission effects and normal
market functioning, which may not fairly capture the current state of play.
Nonetheless, policymakers strive to answer the following questions: How is the economy
currently performing relative to its long-run potential, and is this likely to change in the next
few months? Where is inflation now relative to its desired level, and what are the prospects
for an acceleration or deceleration in prices in the near-term? Will changes in the federal
funds rate interact with financial conditions and affect future real activity and inflation
consistent with past practice? Or have these interactions changed, with implications for both
the outlook and the conduct of policy?
It may be, for example, that potential output has fallen by virtue of the panic and its
aftermath. If the resulting economy proves less adaptive, for example, the natural rate of
unemployment may well threaten to move upward, implying tighter labor markets at higher
unemployment rates, and lower potential output. These estimates are especially difficult to
ascertain given the uncertain contour of the financial architecture and the greater-than-usual
reallocation (and risk of misallocation) of labor and capital across sectors.
Of course, countervailing risks could cause a mark-up in economic potential that cannot be
dismissed: Productivity gains may turn out to be larger and more enduring than we expect,
and the remarkable resiliency of the U.S. economy could defy skeptics as it has done
repeatedly in the post-World War II era.
Data in the past couple of months show continued improvement in real economic
performance. In combination with the repair in financial markets, the outlook for gross
domestic product (GDP) in the next few quarters appears better, improving the odds of a
more enduring positive feedback loop arising from market developments and real activity.
Nonetheless, the medium-term risks to the outlook are still disquieting. Policies, broadly
defined, that purport to bring stability to the macroeconomy could risk lowering output
potential over the horizon.6 The uncertainty of the capital and labor reallocation process, a
global trade environment in transition, and a shifting regulatory environment represent
downside risks. The possibility that we fail to accurately gauge the resulting changes in
economic and inflation prospects - by virtue of the remarkable, iterative changes in private
sector practices and public policy prescriptions - is a foremost risk for policymakers. In this
environment, we should maintain considerable humility about optimal policy.
Preliminary, provisional, subject to revision, condition-dependent forecast
I just sought to describe the challenges in conducting monetary policy in this environment.
That should caution us to steer clear of ironclad policy prescriptions. Nonetheless, I would
hazard the view that prudent risk management suggests that policy will likely need to begin
normalization before it is obvious that it is necessary, possibly with greater force than is
customary, and taking proper account of the policies being instituted by other authorities.
Allow me to elaborate on each of these three items.
First, when will the Fed's extraordinary policy accommodation demand removal?
The central banker's standard reply, to which I would associate myself here, fits the bill:
When conditions warrant. The FOMC stated on Wednesday that "economic conditions are
likely to warrant exceptionally low levels of the federal funds rate for an extended period."
Although it just might be a central banker's rationalized excuse for not knowing, I genuinely
believe that more precise timing is unknowable.
In my view, if policymakers insist on waiting until the level of real activity has plainly and
substantially returned to normal - and the economy has returned to self-sustaining trend
growth - they will almost certainly have waited too long. A complication is the large volume of
banking system reserves created by the nontraditional policy responses. There is a risk, of
much debated magnitude, that the unusually high level of reserves, along with substantial
liquid assets of the banking system, could fuel an unanticipated, excessive surge in lending.
Predicting the conversion of excess reserves into credit is more difficult to judge due to the
changes in the credit channel.7
Financial market developments bear especially careful watching. They may impart a more
forward-looking sign of growth and inflation prospects than arithmetic readings of
stimulusinduced GDP or lagged composite readings of inflation.
The rapid, global revaluation of asset prices - in both directions - has served as a hallmark
of the past two years. Monitoring this trend, and gauging its durability, will demand keen
judgment. If asset prices find a new and enduring equilibrium, market participants and
policymakers alike may well gain additional comfort that the real economy is poised for
sustainable recovery. However, if asset prices retrace their recent gains, the real economy
would be adversely affected.
Understanding risk premiums embedded in asset prices will be critical to this task. In general,
risk premiums across asset classes fell significantly in the past six months, but remain
elevated, roughly consistent with prior recession periods. Some portion of the decline in
premiums and the concomitant run-up in equity prices, for example, can be fairly ascribed to
the abatement of tail risk that became apparent during the panic. Option prices across broad
equity market indexes show a substantial markdown in the likelihood of a substantial market
correction.
But, the broad and continued ascent in equities appears increasingly to reflect a new
judgment about the modal outcome for economic growth and corporate earnings. If it turns
out that equity risk premiums continue their recent trajectory, real economic performance
would be bolstered further by sturdier household, business and financial firm balance sheets.
It is not just the trend or level of asset prices that should inform policymakers. Correlations of
asset prices across markets also provide important insights. In times of panic, historic
correlations break down and commonality predominates. Those firms and individuals with
purportedly "well-diversified portfolios" going into the panic bore painful witness to this truth.
During extreme conditions, sharp swings in investor sentiment often dominate changes in
relative valuations and, for a time, limit the degree to which financial markets effectively
allocate credit.
This breakdown in historic correlations is not unique to the onset of panics. It may
predominate when panic conditions are in retreat. For instance, in the past couple of months,
U.S. stock market indexes and corporate bond prices both moved meaningfully higher, while
Treasury yields and the foreign exchange value of the dollar fell. These movements are
difficult to reconcile with historical experience or by ascribing them to changes in the modal
growth path for the economy. Rather, this odd constellation of movements in asset prices
may indicate changes in investor preferences and in the distributions of outlooks for inflation
and growth. It would be more reassuring to growth and inflation prospects in the coming
months if asset prices were to signal a clearer, more reliable message.
Second, how might the policy response evolve?
Many of the programs created during the panic were designed to atrophy - due to their
changing relative attractiveness in price and other terms - as market conditions improved.
This natural unwinding has proven largely successful. As a result, the Federal Reserve's
balance sheet composition has changed in recent months, even while the overall balance
sheet size has remained relatively constant.
Several of the Fed's non-traditional programs to provide monetary stimulus were established
under section 13(3) of the Federal Reserve Act, the Fed's governing statute. The Congress
authorized the Federal Reserve to lend to non-depository institutions, as the programs do,
only under "unusual and exigent circumstances." The judgment that the 13(3) standard is no
longer satisfied would cause an unwinding of nontraditional policy tools by the Fed, and
presage a normalization of policy.8
Ultimately, when the decision is made to remove policy accommodation further, prudent risk
management may prescribe that it be accomplished with greater swiftness than is modern
central bank custom. The Federal Reserve acted preemptively in providing monetary
stimulus, especially in early 2008 when the economy appeared on an uneven, uncertain
trajectory. If the economy were to turn up smartly and durably, policy might need to be
unwound with the resolve equal to that in the accommodation phase. That is, the speed and
force of the action ahead may bear some corresponding symmetry to the path that preceded
it. Of course, if the economy remains mired in weak economic conditions, and inflation and
inflation expectation measures are firmly anchored, then policy could remain highly
accommodative.
"Whatever it takes" is said by some to be the maxim that marked the battle of the last year.
But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and
financial distress, and discarded when the cycle turns. If "whatever it takes" was appropriate
to arrest the panic, the refrain might turn out to be equally necessary at a stage during the
recovery to ensure the Fed's institutional credibility. The asymmetric application of policy
ultimately could cause the innovative policy approaches introduced in the past couple of
years to lose their standing as valuable additions in the arsenal of central bankers.
Third, how might U.S. monetary policy be affected by other macroeconomic policies?
Monetary policy is not conducted in a vacuum. The Federal Reserve, and other monetary
policymakers, will be keen observers to the judgments made by the fiscal authorities around
the world. Central bankers will necessarily take account of these judgments.
Financial markets' affection for decoupling - that is the disassociation of U.S. economic
prospects from the rest of the world - tends to wax and wane. My own views on the subject
are less ephemeral. Our prospects for economic growth are highly correlated with the
prospects of our large trading partners. And if fiscal, regulatory and trade policies diverge or
deteriorate, economic prospects globally could suffer. But if the better path prevails - that
born of the past couple of generations of economic dynamism, positive-sum trade flows,
fiscal sustainability and regulatory best practices - we will emerge from this crisis with a
stronger, more integrated global economy and more resilient financial markets.
Monetary policy convergence has proven remarkable, and remarkably constructive,
throughout the crisis. When the removal of accommodation begins in earnest, we should be
alert to see if this trend continues.