Roger W Ferguson, Jr: Central banks and markets
Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the Federal
Reserve System, at the Bond Market Association 2002 Awards Dinner, New York, 9 October 2002.
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I thank the members of the Bond Market Association for selecting me to receive the 2002
Distinguished Public Service Award. I am particularly honored to join the company of previous
recipients, who have included my colleagues Alan Greenspan and Bill McDonough, former Treasury
Secretary Rubin, and Senators Christopher Dodd and Kay Bailey Hutchinson.
I understand that the proceeds from this dinner will be used to support the work of the Bond Market
Foundation, whose mission includes advancing the financial literacy of disadvantaged Americans.
That this is a high purpose is beyond doubt. I know that I could speak for much longer than you care to
listen about why the understanding of economics and finance is crucial for individuals in a market
economy. Knowledgeable and astute consumers can avoid making those investment errors that come
from misunderstanding or being misled. They also promote competition among providers, which
benefits us all. Personal financial security enhances individual well-being. And, at a more fundamental
level, our social fabric and national image are intimately connected to our material aspirations. The
United States cannot be the land of opportunity unless all of our citizens have both the tools and the
ability to use those tools to improve their livelihoods and lives. Fortunately, the increasing supply of
services provided by our financial system - and the increasing complexity and diversity of product
offerings - have increased consumer demand for improved financial education. The Bond Market
Foundation, like the Federal Reserve, has been looking for new ways to meet that demand.
There are numerous other ways in which the Federal Reserve and the Bond Market Association, and
the fixed-income markets more generally, work together to improve the well-being of our fellow
citizens. Obviously, the impulse of monetary policy is transmitted, in part, through interest rates set by
the market. We target only the overnight rate, and traders and investors, such as those represented
and serviced by those here this evening, determine longer-term interest rates on Treasury and private
securities. The resulting structure of rates and spreads in the fixed-income markets can in turn be a
valuable tool that we can use when analyzing the current state of macroeconomic conditions and
forecasting the future.
Clearly, however, the roles of the fixed-income markets and the Federal Reserve are complementary,
not identical. Your role is to allocate scarce savings among competing demands. Ours is to set overall
conditions, particularly by maintaining price stability, that allow market prices to accurately reflect
supply and demand dynamics. A price system that is accurate in that way supports the market
allocation of all resources, including capital, to their most productive uses. At times, markets and
Federal Reserve policy are complementary in an additional way. As we saw last September 11, when
conditions in markets become so stressed that they no longer function efficiently for pricing and
allocating risk, the Federal Reserve may be called upon to provide temporary infusions of liquidity.
However, it is also important to understand the limits of what the Federal Reserve, or monetary policy
more generally, can do. First, monetary policy action cannot appropriately be targeted to benefit one
industry, region, or economic group. We key our policy on the average macroeconomic condition that
prevails, knowing that conditions may vary greatly among industries, regions, and groups. Of course,
that means that those individuals and businesses whose conditions are significantly different from the
average might feel aggrieved. A closely related logic applies to relative prices. With one major
exception, the Federal Reserve does not attempt to adjust the relative price of any class of goods,
services, or assets. That major exception is the overnight funds rate. In that market, in which we have
a monopoly on supply, we set the price and let the market determine the quantity demanded. We do
this because we find that adjusting the price of overnight credit is currently the most efficient way to
achieve our mandate of low and stable inflation and maximum sustainable growth. But that is where
our monopoly ends. Short-term interest rates are such a powerful tool for central banks because so
many other financial assets are priced based, in part, on the price of short-term credit and market
expectations about the future adjustment of that price. In all other markets, the forces of supply and
demand determine prices.
Some have suggested that under some circumstances central banks should adjust the overnight funds
rate to affect intentionally the relative price of another asset class, namely equities. But if a central
bank elevates another set of relative prices to being targets of policy, I believe that it should have
strong conviction in two areas. First, that its tool, the provision of reserves to the banking system, will
predictably influence that relative price, and with minimal unintended consequences. Second, that
adjusting that relative price will, in turn, have a predictable and significant role in achieving our
mandate. In the case of equities, I believe that we cannot hold a strong conviction in either regard. The
link between overnight reserves and prices of equities is too remote and indirect, and the impact of
equity prices on the balance of aggregate supply and demand is too uncertain, for those prices to be a
target of policy. To be clear, this is not an argument for never considering prices in asset markets
when determining how well we are likely to do in achieving our goals. Monetary policymakers follow
developments in the equity and other asset markets as part of the process of evaluating and
forecasting economic conditions. That is, the values of equity claims affect spending decisions and
help forecast economic activity. But, in that regard, a similar role is played by many other important
determinants of spending, including long-term interest rates, the foreign exchange value of the
currency, the government's fiscal position, and economic activity abroad. We can employ our one
instrument to temper or augment the net effect of changes in these factors on spending and
production, but we do not have the tools to respond to each individually. Our tool is most efficiently
deployed to adjust overnight interest rates.
There is a more general principle at work here. No doubt, the balance sheet of the Federal Reserve is
large and the attention paid to our pronouncements intense. Nobody would deny that central banks
can be quite powerful and that monetary policy works, over time. But in the scheme of things, a central
bank's ability to smooth asset prices (if it wanted to) or to buffer shocks to spending or production is
somewhat limited. The textbooks teach that monetary policymakers can vary interest rates to offset
fluctuations in aggregate demand. The reality is that when the shortfall in desired spending is large or
arises quite quickly, as was the case last year when businesses slashed their investment plans in light
of a perceived overhang of capital, the initial monetary policy offset can be only partial and not
necessarily synchronous. Eventually, of course, monetary policy does work; but the lags continue to
be unpredictable and both the level of rates and the time required for policy to have the desired
equilibrating impact depend greatly on the force of the macroeconomic instability that must be
confronted and are not knowable at the start of a cyclical event.
Similarly, the central bank can meet elevated demands for liquidity during times of crisis, but the
private sector cannot look to the central bank to eliminate all risk, just as it cannot look to us to support
specific subsets of the economy or alter relative prices. Real decisions result in uncertain outcomes,
and sometimes the result is adverse. What we can do, of course, is strive to minimize macroeconomic
risks - such as the risk that the general price level will fluctuate erratically and unpredictably, as is the
case when inflation is high, or that the adjustment of economic activity will be made more difficult
because the overall price level is declining.
We can also make your job in pricing and trading risk easier by reducing uncertainty about the goals
and tactics of monetary policy in dealing with macroeconomic forces. There have been many changes
over the years in how the Federal Reserve communicates with the public. Currently, the Federal Open
Market Committee issues a statement to the public shortly after every meeting. The statement
provides information about and a rationale for the policy stance adopted at the meeting, the
Committee's view about the balance of risks to the outlook, and a tally that identifies how each
member voted. The balance-of-risks statement does not itself predict the future course of monetary
policy but rather provides the Committee's assessment of the risks to good economic performance
going forward. Although this judgment may have obvious implications for policy if those risks are
realized, it is up to investors to draw out the expected path of short-term interest rates, looking
primarily to incoming data and changed forecasts of the real economy.
The Committee recently chose to identify the votes of members, including the policy preferences of
any dissenters, in order to give market participants a more accurate view of its opinions. On too many
prior occasions, market participants formed inferences about the Committee's vote, from indirect and
frequently misleading sources of information, before the vote was released as part of the minutes after
the next meeting. Therefore, we decided to eliminate that potential source of misunderstanding, and,
for a central bank, we made that decision relatively quickly. I am pleased with the Committee's quick
response, since I believe that part of the trust that the Federal Reserve now enjoys is built on the belief
that we will attempt to minimize sources of misunderstanding.
Let me close by thanking you again for bestowing this honor on me. Public service has many benefits.
Working directly and indirectly with members of the Bond Market Association was an expected benefit,
but receiving this award was certainly an unexpected and much appreciated honor for me.