William C Dudley: The importance of financial conditions in the
conduct of monetary policy
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve
Bank of New York, at the University of South Florida Sarasota-Manatee, Sarasota, Florida, 30
March 2017.
* * *
It is a pleasure to be here today. I would like to thank the University of South Florida for
sponsoring this conference. As always, what I have to say today reflects my own views and not
necessarily those of the Federal Open Market Committee (FOMC) or the Federal Reserve
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System.
One aspect of today's event is the dedication of a financial laboratory to help students learn about
financial markets, which I think has great value. Knowledge of how financial markets operate is
an important aspect of financial and economic literacy, and it leads to greater financial security
over time. For example, one important lesson is that when the promised returns on an
investment offering are extraordinarily high, it is because the investment is either very risky or
fraudulent. When investing, it is important to remember that if it seems to be too good to be true,
it likely is!
Today, I want to take the opportunity to talk about the importance of financial markets in
influencing the economic outlook and, in turn, U.S. monetary policy. This is a subject near and
dear to my heart. Nearly 20 years ago-when I was working in the private sector-my
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colleagues and I introduced an index of financial conditions. I believe that my long-standing
focus on financial conditions has, over time, helped me become a better economic forecaster.
And, I am pleased that economists and analysts increasingly incorporate financial conditions into
their assessments of the economic outlook.
As I will argue, financial conditions in the United States play an important role in influencing
economic conditions. Because movements in financial markets are a major factor influencing
broader financial conditions, it is necessary to understand how financial market developments
can affect the economic outlook and, therefore, the appropriate setting of monetary policy. But,
this story gets more complicated, as the setting of monetary policy, in turn, affects market
developments and financial conditions. This two-way feedback is an important feature of the
interaction between financial conditions and monetary policy.
To begin, let me be clear about what we mean by "financial conditions." Focusing on the United
States, financial conditions can be broadly summarized by five key measures: short- and
longterm Treasury rates, credit spreads, the foreign exchange value of the dollar, and equity prices.
Although many other measures and prices can also be included in one's assessment, I think
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these five are the most essential.
In the conduct of monetary policy, the FOMC does not have targets for either specific
components of financial conditions or for financial conditions more broadly. We care about
financial conditions not for themselves, but instead for how they can affect economic activity and
ultimately our ability to achieve the statutory objectives of the Federal Reserve-maximum
employment and price stability. Let me provide a few examples. A decline in mortgage rates
can lift the demand for owner-occupied housing and support construction activity. A rise in equity
prices can boost household wealth, which is one factor that underpins consumer spending. The
foreign exchange value of the dollar can affect the relative competitiveness of importers and
exporters, which, in turn, influences the country's trade performance. Narrower credit spreads
can reduce the cost of capital for business and help support greater business investment.
In sum, financial conditions affect households' and firms' saving and investment plans, and,
therefore, play a key role in influencing economic activity and the economic outlook. This is why
the evaluation of financial conditions is so crucial in the conduct of monetary policy.
The FOMC traditionally implements monetary policy by adjusting the federal funds rate-the
short-term interest rate paid by banks that borrow reserves from other financial institutions.
However, few economic decisions directly depend on the federal funds rate. Rather, changes in
the federal funds rate affect the economy through their impact on other interest rates, which,
consequently, influence broader financial conditions. If financial conditions moved predictably
with the policy rate, then there would be no need for the FOMC to focus on financial conditions.
In such a world, by adjusting the level of the federal funds rate, the FOMC could be fully confident
that it could generate the appropriate financial conditions necessary to support achievement of
full employment and price stability.
In fact, the response of financial conditions to changes in short-term interest rates is not rigid and
predictable. Instead, as we shall see shortly, the linkage between the federal funds rate and
financial conditions changes over time, as it is influenced by a whole host of other factors.
Recent evidence suggests that even the relation between short-term and long-term rates has
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shifted substantially over the past 15 years. Moreover, at times, we have observed cases in
which financial conditions did not move in the same direction as the monetary policy stance. Let
me highlight two recent divergences which indicate that we need to keep a separate eye on the
evolution of financial conditions.
The first occurred in the mid-2000s. In June 2004, the FOMC decided to begin raising the federal
funds rate target in order to remove policy accommodation. It raised the target in 25-basis-point
increments at 17 consecutive meetings, pushing the rate up from a starting point of 1.0 percent
to a peak of 5.25 percent. Despite this tightening of monetary policy over two years, financial
conditions failed to tighten in a similar manner. This can be seen by looking at the behavior of
well-known measures of financial conditions during this period (Exhibit 1). The rise in short-term
rates was offset by a decline in long-term yields, a rise in equity prices and narrower credit
spreads.
In contrast, there have been times when financial conditions tightened even as the FOMC
reduced short-term interest rates. For example, consider what happened during the heart of the
financial crisis. Even as the FOMC lowered the federal funds rate in the fall of 2008-eventually
hitting its effective lower bound that December-credit spreads widened sharply, household and
business loan underwriting standards tightened sharply, liquidity in many financial markets dried
up, and the U.S. stock market plummeted. Financial conditions tightened despite the aggressive
easing of monetary policy during this period.
There are many explanations for why the relationship between the federal funds rate and financial
conditions is so variable. Without being exhaustive, let me highlight three. First, animal spirits in
financial markets wax and wane, pushing asset values up or down in a manner that can more
than offset the effects of movements in short-term interest rates. The movements in many
financial markets following last year's presidential election are a notable example of this
phenomenon. Second, domestic financial conditions are influenced by what happens abroad. If
the monetary policy of major U.S. trading partners becomes easier relative to policy in the United
States, then it could lead to a dollar appreciation that would weigh on U.S. trade performance, all
else equal. Third, financial instability and stress can cause risk-averse investors to increase
their demand for safe assets. This can push up risk premia and credit spreads, and push down
stock prices-which can more than offset the impact of an easier monetary policy.
Divergences between short-term interest rates and financial conditions often appear to be larger
and more persistent in the United States than in most other advanced economies. There are
several reasons for this. First, the U.S. financial system depends less on its banking system to
intermediate financial flows than in other countries. The share of credit supplied by the banking
sector fluctuates around 50 percent in the United States, which is much lower than in the euro
area, Japan and the United Kingdom (Exhibit 2). Second, in contrast to most other countries,
U.S. residential housing is financed mainly by 30-year fixed-rate mortgages, rather than-as is
the case in most other countries-adjustable-rate mortgages with rates that much more closely
track their central banks' short-term interest rate targets. Third, the equity market plays a much
more important role in the United States than elsewhere. The total market capitalization of the
U.S. equity market is considerably higher than in the euro area and Japan (Exhibit 3).
Because the evolution of financial conditions can diverge from the path of the federal funds rate,
financial conditions need to be carefully considered in the conduct of monetary policy. However, I
want to reiterate that what we care about is not financial conditions themselves, but rather their
influence on economic activity. Accordingly, we should care much more about longer-term
movements in financial conditions than about higher-frequency, transitory movements. That is
because behavior in firms and households will be influenced much more by how financial
conditions evolve over time, rather than by where they happen to be at a particular moment.
To emphasize this point, let me give two contrasting examples-one where financial conditions
moved sharply but not persistently, and another where financial conditions moved systematically
over a longer time period. We will see that it is the long-lived movements that have the largest
influence on the economic outlook.
For the first example, consider the U.S. equity market in 1987. The S&P 500 index began the
year at 242, shot up to a peak of 337 in August (an increase of almost 40 percent) and
plummeted to a trough of 225 in October (a fall of 33 percent). When the stock market fell more
than 20 percent on October 19th-which came to be known as "Black Monday"-many feared
that the decline would lead to a recession. After all, that crash was the largest-ever one-day
percentage decline of the U.S. stock market. But, no recession occurred. Importantly,
households sustained their spending despite the sharp decline in household wealth. This
happened, in part, because household spending had not yet responded much to the sharp run-up
in stock prices earlier in the year, so consumer spending turned out to be relatively insensitive to
the market's sharp reversal. In addition, the damage from the sharp stock market decline was
mitigated by the Federal Reserve's commitment "to serve as a source of liquidity to support the
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economic and financial system."
A contrasting example is the sharp appreciation of the dollar that began in 1978 and reached a
peak in March 1985. The persistent strength of the dollar had a significant negative consequence
for U.S. trade performance. Our trade deficit widened sharply in 1985 and 1986, which
contributed to the sharp slowdown in U.S. manufacturing production growth-and a milder
slowdown in GDP growth-over this period.
This leads to an important question: When should the FOMC take changes in financial
conditions into consideration in its conduct of monetary policy? I don't think there is a simple
answer. Financial conditions matter in influencing the economic outlook, but so do many other
factors. It is true that monitoring financial conditions can help improve the effectiveness of the
policy decision-making process. However, as I hope is clear from my previous examples, there
is no mechanical link between policy rates and financial conditions that monetary policymakers
can systematically rely upon to set policy.
Another key question is what one should focus on in assessing financial conditions. Again, I
don't think there is a simple answer, as the significance of any particular aspect of changes in
financial conditions depends on the economic circumstances and environment. In the early- to
mid-2000s, the combination of looser mortgage underwriting practices and home equity
withdrawal were major financial factors contributing to that economic expansion. The
subsequent housing crash was exacerbated by the sharp reversals of mortgage lending
standards and home equity withdrawal, which together contributed to the severity of the Great
Recession. Today, these factors seem less important because lending practices in the housing
market have been much more stable in recent years.
The importance and complexity of financial conditions also underscore the need for caution in
following any mechanical monetary policy rule. For example, the most well-known rule-the
Taylor Rule-does not explicitly take financial conditions into account in terms of its monetary
policy prescription. In that rule, the federal funds rate depends only on the deviations of output
from its potential and inflation from the Federal Reserve's 2 percent objective, and on the level of
the real short-term interest rate consistent with a neutral stance of monetary policy. Because the
interactions can shift between financial conditions and the economic outlook-as well as
between financial conditions and the federal funds rate-the absence of financial conditions in
this rule can cause it to perform poorly as a guide for monetary policy.
As a case in point, consider what the 1999 variant of the Taylor Rule indicated as the appropriate
monetary policy setting in September 2008, just prior to the failure of Lehman Brothers. In the
Bluebook document that the Federal Reserve Board staff prepared for the September 2008
FOMC meeting, the 1999 Taylor Rule called for a federal funds rate setting of 3.5 percent for the
fourth quarter of 2008, well above the 2 percent setting at the time of the meeting. The standard
1993 Taylor Rule-which puts a greater weight on inflation-called for an even higher federal
funds rate target of 4.1 percent. Given the rapid deterioration in financial conditions, instead of
following the prescription from these rules, the FOMC cut the federal funds rate rapidly over the
next three months, pushing the federal funds rate down to a range of 0 to a quarter of 1 percent
by year-end.
Consistent with this episode, such rules often perform poorly at times when the economic
environment and outlook are rapidly changing. This is one important reason why I do not support
proposals that would require the Federal Reserve to explain to Congress whenever its federal
funds rate target deviates from a particular prescriptive monetary policy rule. As Federal
Reserve Chair Yellen explained in a recent speech, not only are there a plethora of rules to
choose from, but following any monetary policy rule in a perfunctory manner would likely lead to
inappropriate monetary policy at times-especially during economic turning points when the
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outlook is changing rapidly.
Also, requiring the Federal Reserve Chair to explain frequently why the FOMC had deviated from
a particular rule would unduly impinge on the ability of the FOMC to conduct monetary policy in a
manner insulated from short-term political considerations. Of course, Congress has the right to
hear from the Federal Reserve about its conduct of U.S. monetary policy. There are already
several opportunities, including regular testimony and semiannual monetary policy reports. If
Congress desires, such communications could become more frequent or enhanced. But, my
point is that these exchanges should not be triggered by deviations from a mechanical rule. And,
of course, I feel that this is especially true for a rule that does not account for financial
conditions.
Now that I have expounded upon the importance of financial conditions, I would like to discuss
their implications for the current stance of U.S. monetary policy. As I see it, there were a number
of factors behind the FOMC's decision in March to take another step in gradually removing
accommodation by raising the federal funds rate target by 25 basis points to a range of three
quarters of a percent to 1 percent.
Most importantly, the economy has continued to grow modestly above its sustainable long-term
pace. This has led to continued, sturdy monthly job gains and a gradual diminution of the amount
of slack in the U.S. labor market. Forward-looking indicators foreshadow a continuation of this
trend. For example, household and business confidence has increased markedly over the past
few months.
The economic outlook abroad also appears to have brightened. Growth has picked up in Europe.
Commodity prices have risen, reducing the pressure on emerging market economies that are
major commodity exporters. There are still significant uncertainties and risks abroad, but overall,
these risks seem significantly lower than they were a year ago.
Inflation has moved closer to our 2 percent longer-run objective. Headline inflation on a
yearover-year basis has moved up in the past few months as the sharp declines in energy prices in
late 2015 and early 2016 have fallen out of the calculation. Core inflation-which ignores the
more volatile movements in energy and food prices-also has moved slightly higher. Over the
12 months through January 2017, the core personal consumption expenditure deflator has risen
at about 1.75 percent, up from 1.6 percent a year earlier. Thus, I have become more confident
that inflation will stabilize around the FOMC's objective over the medium term.
While there is still considerable uncertainty about fiscal policy and its potential contribution to
economic activity, it seems likely that it will shift over time to a more stimulative setting.
Consequently, it appears that the risks for both economic growth and inflation over the medium
to longer term may be shifting gradually to the upside.
Even after the latest increase, the federal funds rate target range at three quarters of a percent to
1 percent is still unusually low in both nominal and inflation-adjusted terms. While most FOMC
participants judge the equilibrium short-term real interest rate that is consistent with a neutral
monetary policy to be low-perhaps in a range of 0 to 1 percent-this is still above the current
inflation-adjusted federal funds rate. In such circumstances, it seems appropriate to scale back
monetary policy accommodation gradually in order to reduce the risk of the economy
overheating, and to avoid a significant inflation overshoot in the medium term.
Finally, prior to the March FOMC meeting, financial conditions were generally easing rather than
becoming tighter, even as the FOMC raised its policy rate in December and market participants
increasingly expected further policy tightening in the coming year. Between the December and
March FOMC meetings, U.S. equity prices rose by about 4 percent, and credit spreads, such as
those for high-yield bonds, narrowed. Long-term yields and the trade-weighted dollar were little
changed over this period.
William McChesney Martin, the ninth chair of the FOMC, once famously opined that the Federal
Reserve is "in the position of the chaperone who has ordered the punch bowl removed just when
the party was really warming up." I don't think we are removing the punch bowl, yet. We're just
adding a bit more fruit juice.
Before I conclude, let me make a few comments about the Federal Reserve's balance sheet. As
you are undoubtedly aware, the Federal Reserve dramatically expanded the size of its balance
sheet during and following the financial crisis to provide accommodation to support the economy
when short-term interest rates were constrained by their effective lower bound. Currently, we
are reinvesting maturing Treasury securities and agency mortgage-backed securities
repayments to keep the size of the balance sheet generally stable. We have said that we plan to
continue this policy of reinvestment until we are well along in the process of normalizing the level
of the federal funds rate. As the FOMC has raised the federal funds rate three times, this
process seems to have proceeded smoothly so far, prompting renewed interest in our balance
sheet and reinvestment policy.
The anticipation of and actual announcement by the FOMC of changes in reinvestment policy is
likely to push up longer-term interest rates and tighten financial conditions somewhat, just as the
earlier purchases pushed down long-term interest rates. To what extent is difficult to judge.
Presumably, financial conditions would tighten by more if we were to end reinvestments earlier
and more abruptly. This suggests a better course may be to taper reinvestments gradually and
predictably.
In addition, because changes in reinvestment policy will likely tighten financial conditions, we will
have to take this into account in our interest rate decisions. My view is that reducing the Federal
Reserve's balance sheet and raising short-term interest rates are two different, yet related, ways
of removing monetary policy accommodation. Therefore, I would expect that, when we begin to
end reinvestment, we will have to consider the implications for the appropriate short-term interest
rate trajectory.
In conclusion, financial conditions are important. They matter enormously to monetary policy
because their movements can often diverge from the trajectory of short-term rates, and because
they affect economic activity and the economic outlook. While it is essential to account for
financial conditions appropriately in conducting monetary policy, it is also important not to
overreact to every short-term wiggle in financial markets. In addition, it is important to remember
that the policy goal is not the level of financial conditions per se, but the achievement of the
Federal Reserve's dual mandate objectives. Sometimes, that will be consistent with easing
financial conditions, and at other times, it will be consistent with tighter financial conditions. At all
times, our focus will be on achieving our objectives of maximum sustainable employment and
price stability, thereby supporting the livelihoods of households and businesses throughout the
United States.
Thank you for your kind attention. I would be happy to take a few questions.
1
Ozge Akinci, Nicola Cetorelli, Richard Crump, David Lucca, Jonathan McCarthy, Paolo Pesenti and Joseph Tracy
assisted in preparing these remarks.
2
See William Dudley and Jan Hatzius, "The Goldman Sachs Financial Conditions Index: The Right Tool for a New
Monetary Policy Regime," Goldman Sachs Global Economic Paper Number 44, 2000.
3
For a discussion of various financial conditions indexes see Jan Hatzius, Peter Hooper, Frederic S. Mishkin,
Kermit L. Schoenholtz, and Mark W. Watson, "Financial Conditions Indexes: A Fresh Look after the Financial
Crisis," U.S. Monetary Policy Forum (Chicago: Chicago Booth Initiative on Global Markets, 2010) pp. 3-59.
4
Samuel G. Hanson, David O. Lucca and Jonathan H. Wright (2017), "Interest Rate Conundrums of the 21st
Century," Federal Reserve Bank of New York Staff Report No. 810, March.
5
Carlson, Mark, "A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve
Response," Finance and Economics Discussion Series No. 2007-13, Divisions of Research & Statistics and
Monetary Affairs, Federal Reserve Board, Washington, DC, November 2006.
6
Janet L. Yellen, "The Economic Outlook and the Conduct of Monetary Policy," speech at the Stanford Institute for
Economic Policy Research, Stanford University, Stanford, California, January 19, 2017.