William C Dudley: The outlook, policy choices and our mandate
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the Society of American Business Editors and Writers Fall
Conference, New York City, 1 October 2010.
* * *
The deep recession that ended in June 2009 has been followed by a very tepid recovery.
Economic activity has grown - but only slowly from levels far below the productive capacity
of the economy. With demand growth barely keeping pace with firms' ability to increase
productivity, job creation has been too weak to significantly reduce unemployment, which
stands today at 9.6 percent. And, as is typical in such circumstances of considerable slack,
the rate of inflation has declined.
Viewed through the lens of the Federal Reserve's dual mandate - the pursuit of the highest
level of employment consistent with price stability, the current situation is wholly
unsatisfactory. Given the outlook that the upturn appears likely to strengthen only gradually,
it will likely be several years before employment and inflation return to levels consistent with
the Federal Reserve's dual mandate.
Today, I will discuss why the recovery has been disappointing and highlight some of the
issues facing the Federal Reserve and monetary policy, echoing some of the themes laid out
by Chairman Bernanke in his Jackson Hole speech in late August. As always, what I am
going to say reflects my own views and does not necessarily reflect the views of the Federal
Open Market Committee and the Federal Reserve System.
In recent quarters the pace of growth has been disappointing even relative to our modest
expectations at the start of the year. After rising at about a 3.25 percent annual rate during
the second half of 2009, there has been a progressive slowing - to a 2.75 percent annual
rate during the first half of the year and, very likely, to an even slower rate in the third quarter.
The factors responsible for the failure of the recovery to pick up speed include: (1) the
gradual petering out of the contribution from the swing in inventories from rapid liquidation
during the first half of 2009 to a modest increase in the second quarter of 2010; 2) the
sluggish recovery in consumer spending; and 3) the continued weakness in housing.
Normally, at this stage of recovery, the handoff from growth led by inventory accumulation to
growth led by private final demand would have been more fully accomplished. This handoff
has been delayed because households have been paying down their debts - a process
known as deleveraging. In addition, many businesses have been reluctant to hire. This has
limited income growth. Slow income growth, and along with caution in the face of economic
uncertainty, has also restrained spending.
Although so-called "soft-patches" are quite common during the early stages of an economic
expansion, this soft patch is a bit different. First, it looks like it will last somewhat longer
because the deleveraging process is not yet complete. Second, the current weakness is
somewhat more concerning because it is occurring at a time that the central bank has
already cut interest rates to near zero.
In fact, this failure of the recovery to "catch fire" has occurred despite aggressive monetary
and fiscal policy steps to stimulate the economy. On the monetary policy side, short-term
interest rates have been nearly zero for a year and a half; the Fed purchased $1.7 trillion of
long-term assets, and the proceeds from maturing securities are being reinvested to keep the
balance sheet from shrinking unduly. On the fiscal side, a series of measures has provided
support to a broad range of activities.
The sluggish nature of the recovery in the face of very substantial stimulus reflects the
dynamics at work during the expansion that preceded it. Beginning around 2003,
underwriting standards for residential mortgages were significantly relaxed, leading to a
sharp rise in household borrowing and in home prices. The two trends were inextricably
linked. The rise in home prices helped to support additional demand for credit as households
used the collateral represented by their homes to borrow large sums of money via home
equity lines of credit and second mortgages. Chart 1 illustrates how the growing proportion of
nonprime first mortgage loans helped fuel the sharp rise in home prices.
As home prices rose and the stock market performed strongly, household net worth rose
sharply. Households responded by borrowing more and saving less. After all, why save when
the rise in home prices was adding to your wealth and the housing equity created by the rise
in home prices could be easily tapped for funds as needed? The use of home equity as a
source for funds to support consumption is evident in the fact that the homeowners' equity as
a share of home values was essentially flat over this period (Chart 2). This indicates that
homeowners were borrowing against their accumulated gains. The surge in home prices
pushed up the ratio of household net worth to disposable income to nearly 640 percent and
the personal saving fell below 2 percent (Chart 3).
The surge in home prices was fueled by products and practices in the financial sector that
led to a rapid and unsustainable buildup of leverage and an underpricing of risk during this
period. These dynamics in turn provided the fuel that caused house prices and consumer
spending to rise much faster than income. As shown in Chart 4, the share of GDP accounted
for by consumption and residential investment climbed to a peak of 76 percent in 2005 from
71 percent in the mid-1990s.
The boom, of course, was unsustainable. The progressive easing of underwriting standards
that was needed to support housing demand could only persist as long as housing prices
were rising rapidly. But for home prices to rise rapidly, underwriting standards had to be
progressively relaxed in order to generate more buyers. When home prices began to slip
beginning in 2006, the dynamic swung into reverse. The collateral values supporting
borrowing and spending began to fall.
As banks' and other financial intermediaries' credit losses began to mount, credit availability
became impaired and this exacerbated the downward pressure on home prices and on
borrowing and spending. Not only did households that had overextended themselves have to
cut back; others also retrenched because they were also affected by declines in wealth and
heightened uncertainty about the economic outlook and their job prospects.
It is not surprising that the workout from the excesses of this type of boom would take a long
time. Just as it took several years for the boom to begin and run its course, so it would take
years, not months, for households and financial intermediaries to adjust their balance sheets
and behavior to the new environment. Households had to raise their saving rates in order to
rebuild their balance sheets. Financial intermediaries had to replenish their capital to replace
losses via loan charge-offs and other credit impairments. Both adjustments would need to
occur before the economy could grow rapidly.
With this in mind, the key questions are: 1) Where are we in the adjustment process, and
2) what, if anything, can monetary policy do to facilitate a smoother adjustment and more
rapid progress toward our dual mandate objectives?
In terms of the adjustment process, starting on the household side, most signs point to
significant progress. For example, the revisions to the national income and product accounts
announced in July revealed substantial upward revisions to the personal saving rate
(Chart 5). The current saving rate is broadly consistent with the historical relationship
between personal saving and the household net worth-to-income ratio. Of course, part of this
story depends on the stabilization of household net worth, which had earlier fallen sharply
due to declines in both home and equity prices. Although household net worth dropped
significantly again in the second quarter according to the Flow of Funds accounts, the
subsequent rise in the U.S. equity market is likely to have reversed that decline. Meanwhile,
housing price declines have moderated substantially, helped, in part, by the fact that the low
level of mortgage rates combined with the sharp drop in house prices has resulted in a
substantial improvement in affordability (Chart 6).
Households have retrenched in terms of their borrowing and this has helped push down the
household debt-to-income ratio sharply from its peak in 2007. Another factor behind the fall
in the debt-to-income ratio has been credit losses and debt forgiveness. Since 2007,
chargeoffs have reduced household debt outstanding by over $880 billion.
Some argue that the decline in the household debt-to-income ratio must go much further
before the deleveraging process can be complete. After all, the household debt-to-income
ratio is still far above the level reached as late as 2002, before the surge in household
borrowing began. Some even argue that household debt-to-income ratios must fall back to
the level of the 1980s. I think that this is an overly pessimistic view for a simple reason - both
household debt and household financial assets have been rising faster than income growth
on a secular basis since the 1950s. Focusing just on debt misses what is happening on the
other side of the balance sheet (Chart 7). One reason why both household assets and debt
have been rising faster than income is due to greater financial intermediation. For instance,
tax incentives encourage people to fund their 401(K) pension plans rather than pay down
mortgage debt as they get older.
The notion that the household adjustment process is well advanced is also supported by
other data, as well. For example, the share of after-tax income devoted to servicing debts, as
well as paying property taxes and homeowners insurance or rent, has declined sharply over
the past two years and is now back to levels that prevailed in the late 1990s (Chart 8). In
addition to the declining stock of debt, households have been able to refinance outstanding
debt at lower interest rates.
Moreover, mortgage delinquency rates, even in the most serious category, have started to
fall, and data that tracks changes in the proportion of borrowers who are delinquent and then
become current versus becoming even more delinquent is encouraging (Charts 9 and 10).
Finally, the less serious delinquencies for credit card, auto and student loans have been
trending lower, though not the more serious delinquencies (Chart 11). Of course, these
recent improvements have come in the context of the stabilization in unemployment and
house prices. To ensure that the more favorable trends in household balance sheets
continue, the economic environment needs to become more supportive.
We should recognize that there is still considerable uncertainty about the level of the saving
rate and configuration of household balance sheets that will prevail in the coming years. It is
possible that households now perceive the world to be a riskier place than they did before
and will want to have more "rainy day" funds. More saving may also be needed to meet
higher downpayment requirements for home purchases. Thus, while we may be far along in
the adjustment process, it is difficult to judge just how much further we have to go.
Turning now to the issue of credit availability, there is no question that credit conditions are
still tight. There are a number of impediments: 1) Financial institutions - many of which still
face balance sheet problems of their own - have tightened underwriting standards and, 2) a
decline in property prices has cut collateral values and made the refinancing of many
residential and commercial mortgages difficult.
On the banking side, there is considerable differentiation across the industry in terms of
health. The largest banks in the United States are generally in much improved health
following the Supervisory Capital Assessment Process (SCAP) in 2008, which led to
substantial additional equity raising. For smaller banks, the situation is more mixed.
According to the FDIC, as of June 30, 2010, 829 of the nation's 7,830 commercial banks and
savings institutions remain on the FDIC's problem institution list.
But overall, the situation is one in which credit availability is slowly improving. According to
the Federal Reserve's Senior Loan Officers Survey, the percentage of banks reporting that
they were tightening credit standards across a wide range of lending categories peaked in
late 2008. The most recent data indicate that virtually no banks are tightening standards, and
a number of banks have begun to relax credit terms (Chart 12).
In addition to households, the small-business sector is another area that has seen a
contraction in credit. Focus groups and surveys conducted by the Federal Reserve System
suggest this contraction is the result of three distinct factors - a decline in demand for credit,
a tightening of lending standards, and a weakening of credit quality due to lower collateral
values and cash flows.1 Which is the most important is difficult to discern.
However, surveys of small-business owners indicate that much of the weakness in lending to
this sector reflects lack of demand. The National Federation of Independent Business (NFIB)
Small Business Optimism Index, for instance, asks respondents to indicate their single most
important problem from a standard list. For some time now, the response "poor sales" has
been the most frequently cited problem. In contrast, relatively few respondents cite "financial
and interest rates" as the most important problem (Chart 13). A caveat to this is that credit
constraints could be inhibiting the formation of new small businesses - something that
surveys of existing firms would not capture.
Although credit availability has begun to improve, the decline in collateral values remains a
significant impediment. For example, housing prices have declined so far that nearly one
quarter of homes are now worth less than the value of the mortgages that finance them.
Lacking sufficient collateral value, such homeowners cannot take advantage of the fact that
conforming mortgage rates are at their lowest level in history and refinance their mortgages.
Overall, the desire to rebuild wealth through savings and the limits on credit availability to
households has acted to restrain consumer spending, keeping the recovery tepid.
To some degree, this adjustment is unavoidable, as the economy had reached unsustainable
levels of consumption and housing demand. However, the fact that many of these
adjustments are inevitable does not rule out a role for monetary policy to support economic
activity. Very low interest rates can help smooth the adjustment process by supporting asset
valuations, including making housing more affordable and by allowing some borrowers to
reduce debt interest payments.
Beyond this direct role in smoothing the deleveraging process - to the extent that monetary
policy can "cut off the tail" of the distribution of potential adverse economic outcomes, making
a truly disastrous outcome less likely - it can help encourage those households and
businesses with money to spend to do so.
Today's low and falling rate of inflation - at a time when interest rates are near zero - is a
problem that is slowing the adjustment process. Currently, by most measures, inflation is
below the level that members of the Federal Open Market Committee (FOMC) view as
consistent with price stability. Although the Federal Reserve has no formal numerical inflation
target, it is noteworthy that the long-run inflation forecasts of the FOMC members cluster
around 1.75 percent to 2 percent for the personal consumption expenditures (PCE) deflator.
This compares with a 1.5 percent year-over-year rate for the PCE deflator and 1.4 percent
rate for the core PCE deflator, which excludes food and energy prices.
Low and falling inflation is a problem for several reasons. First, low and declining inflation
makes it harder to accomplish needed balance sheet adjustments. That is because, all other
things being equal, lower inflation means slower nominal income growth. Slower nominal
income growth, in turn, means that less of the needed adjustment in household
debt-toincome ratios will come from rising incomes. This puts more of the adjustment burden on
paying down debt.
Second, and even more importantly, low and falling inflation can cause inflation expectations
to decline. This is important because inflation expectations are an important factor that
influences actual future inflation. Moreover, when inflation expectations decline, the expected
real cost of credit increases - a subject I will return to in a moment.
So what could the Federal Reserve do? As I see it, there are two potentially complementary
avenues. First, we could take steps to make our current highly accommodative stance of
monetary policy more effective in stimulating economic activity by providing additional
guidance about what we are trying to achieve today and in the future. Second, we could find
ways to increase the amount of stimulus we currently provide via our balance sheet.
Turning to the first issue, clear communication about objectives and intent is an important
element of effective monetary policy. For example, communicating clearly our intention to
return inflation to more normal levels can help keep inflation expectations well anchored
around levels consistent with our inflation goals. As the central bank, we and we alone can
control inflation - if not precisely in the short run, then over the medium term. By clarifying
our intentions, we can reduce the risk of further disinflation - or even an outright
debtdeflation spiral that would make it still more difficult to accomplish the necessary
balancesheet adjustments.
Clear communication on the part of a central bank is important at all times, but it is even
more critical when the federal funds rate is at or near its effective lower bound. In this
environment, a decline in inflation expectations that drives up the real interest rate and
thereby increases the real cost of credit cannot be offset by simply lowering the federal funds
rate. Thus, in a very direct sense, a fall in inflation expectations when the target interest rate
is at the zero bound represents a de facto tightening of monetary policy and of financial
conditions. Such a tightening would clearly be highly undesirable at a moment when
unemployment is too high, inflation is too low and the economy has only moderate forward
momentum.
In this situation, the FOMC must be clear and resolute in its commitment to its price stability
objective. This is why the most recent FOMC statement clearly stated that underlying
inflation was running somewhat below levels consistent with the dual mandate.
There are a range of options we could pursue if we judged it worthwhile to go even further in
communicating our objectives and intent. We could be even more explicit with regard to the
inflation rate that the Committee views as compatible with price stability, for instance, by
stating an explicit inflation objective as is common practice in other advanced economies.
This could help anchor inflation expectations at the desired rate. It would also clarify the
extent to which the current level of inflation falls short of that rate.
If we were to go down this path, it would be important to note that any provision of more
information on our inflation objective would not be a signal that the inflation element of the
dual mandate had become more important than the full employment objective. Instead, it
would principally reflect the fact that inflation being "too low" (just like inflation being "too
high") is an impediment to achieving the full employment objective of the dual mandate.
If we judged it desirable, we could go still further and provide more guidance on how
monetary policy would react to deviations from any stated inflation objective. One possibility
would be to keep track of inflation shortfalls when the federal funds rate is constrained by the
zero bound, as is the case today. For example, if inflation in 2011 were a 0.5 percentage
point below the Fed's inflation objective, the Fed might aim to offset this miss by an
additional 0.5 percentage point rise in the price level in future years.
In the current environment, such an approach would have some advantages as well as some
disadvantages. When there is a large amount of slack in the economy, the Federal Reserve
might not easily be able to hit an inflation objective soon. But, the central bank could
plausibly promise to make up the difference later on. Indeed, the further the Fed fell behind
its inflation objective in the near term, the more inflation would need to increase in order to
push the actual path of prices up to the path consistent with price stability over the long run.
To the extent this policy was more credible, it might do a better job keeping inflation
expectations from falling. This might make monetary policy more stimulative and, thus, might
help the FOMC achieve its objectives more quickly.
However, such an approach would only work well if people understood how it would operate
and formed their expectations of future inflation accordingly. And there could also be
significant costs. For example, if people mistakenly concluded that the Fed was tinkering with
its long-run inflation objective, this could lead to greater uncertainty about future inflation.
This might lead to higher risk premia and higher nominal interest rates that would undermine
the effectiveness of such a policy to stimulate the economy.
In addition to communication strategies, the Federal Reserve has a second set of tools,
namely the ability to expand its balance sheet to stimulate activity and move inflation toward
desired levels - either by purchasing medium and long-term Treasuries or agency
mortgagebacked securities. Such purchases of long-duration assets pull down the level of long-term
interest rates by removing duration from private-sector hands, who respond by purchasing
other long-dated assets.
Two interesting questions pertain to balance sheet expansion: (1) How much would the Fed
have to purchase to have a given impact on the level of long-term interest rates and
economic activity, and, (2) what constraints exist in terms of limits to balance- sheet
expansion, and what are the costs involved that could impede efforts to meet the dual
mandate now or in the future? The questions demand serious consideration prior to any
decision to expand the balance sheet further.
With respect to the first question, some simple calculations based on recent experience
suggest that $500 billion of purchases would provide about as much stimulus as a reduction
in the federal funds rate of between half a point and three quarters of a point. But this
estimate is sensitive to how long market participants expected the Fed to hold on to these
assets.
More broadly, the clearer and more credible the framework governing purchases, the greater
the likelihood that market participants would act in a manner that helped the Fed achieve its
objectives. In particular, the more confident market participants are in the Fed's ability to exit
when the time is right, the more effective its purchases will be in stimulating the economy.
Suppose the Fed was indeed successful in reducing long-term interest rates further - what
then? Some claim that lower rates would have no effect on economic activity - that the Fed
would be "pushing on a string." This is too dark a view. Although the responsiveness of
demand to reductions in interest rates is probably lower in a world in which balance sheet
constraints are important, the responsiveness is not zero. I believe that it remains significant.
Even in today's challenging circumstances, lower long-term rates would support the
economy through a number of channels. Lower long-term rates would support the value of
assets, including houses and equities and household net worth. Lower long-term rates would
make housing more affordable and support consumption by enabling households to
refinance their mortgages at lower rates. This would increase the amount of income left over
for other spending. Of course, this channel can be made more powerful to the extent that
further progress can be made in efficient mortgage debt restructurings that allow households
with negative equity in their homes to take advantage of the drop in mortgage rates. In
addition, lower long-term rates would reduce the cost of capital for businesses, thereby
fostering higher levels of capital spending for any given economic outlook.
In considering the limits to balance sheet expansion, there are two constraints - one major
and one more minor. The first constraint is the risk that the balance sheet expansion might
cause inflation expectations to become unanchored, leading to higher risk premia. This risk is
presumably greater in a period in which budget deficits are high, as they are today.
If exit concerns were to rise as purchases increased, then a rise in inflation risk premia would
offset at least some of the expected fall in interest rates. In contrast, the more credible the
ultimate exit strategy, the less likely it is that inflation risk premia would go up and the more
effective purchases would be in lowering long-term rates. Also, the more credible the ultimate
exit plan, the more confident investors would be about the Fed's willingness to do what is
needed to accomplish its objectives. This is important because it would help stabilize
longerrun inflation expectations at levels consistent with the dual mandate.
The FOMC should be able to assure investors that it has both the means and the will to exit
when - but not before - the time is right. That is because the Federal Reserve has the tools
to control financial conditions and credit creation even with an expanded balance sheet.
Payment of interest on reserves allows us to control short-term rates with even a large
amount of excess reserves outstanding. In addition, we can drain excess reserves in several
ways. We have developed term deposit accounts and the ability to conduct reverse
repurchase operations with a large number of counterparties that would allow us to drain a
large volume of reserves. Also, when the time is right, the Fed can always sell assets. Such
asset sales would lead to a rise in longer-term rates and this would have a contractionary
effect on the demand for credit.
I am very mindful of concerns here and abroad that balance sheet expansion could be
interpreted as a policy of monetizing the federal debt. However, I regard this view to be
fundamentally mistaken. It misses the point of what would be motivating the Federal
Reserve. The FOMC would only engage in large-scale asset purchases in order to push the
economy more rapidly toward the dual mandate goals of full employment and price stability.
Once these goals were accomplished, there would be no basis for further purchases
regardless of the government's fiscal position because additional purchases would not be
consistent with this mandate.
The second constraint is that further balance sheet expansion would increase the Federal
Reserve's interest rate risk by raising the maturity mismatch between its assets and
liabilities. Recall that the bulk of the Fed's liabilities are overnight reserves and the bulk of its
assets are longer-term Treasuries, agency and agency MBS securities. The bigger the
balance sheet becomes, the more a future rise in interest rates will squeeze the Federal
Reserve's net interest margin.
Some worry that this exposure to higher short-term rates could conceivably affect the
Federal Reserve's monetary policy credibility in the future. Some market participants might
worry that the Federal Reserve could become reluctant to raise short-term rates in a timely
way because this would constrain the amount of revenue that it would earn and remit to the
Treasury. I am confident there is nothing to worry about on this score.
Even if the Federal Reserve was not obliged to act in keeping with its dual mandate - which
it is - with its assets skewed toward longer-duration securities, the Federal Reserve would
have every incentive to ensure price stability over the long term.
It is true that the larger the size of the balance sheet, the more likely it is that the Fed would
ultimately sell assets back into the market, potentially at prices that could result in losses.
Although some fear that such losses could compromise the Federal Reserve's
independence, there is no reason why this should be the case, providing we stick closely to
our mandate at all times.
To date, the Fed's actions in responding to the crisis have resulted in abnormally large profits
that might reasonably be set against any subsequent losses. But much more importantly, our
dual mandate does not state that we should do what is necessary to promote full
employment and price stability only at times when we are virtually certain that in doing so we
will make a profit. It directs us to promote full employment and price stability at all times.
Profits and losses in any given year are much less important than getting the U.S. economy
back to the highest level of employment consistent with price stability.
In making our assessments about next steps, we need to be a bit humble about our capacity
to forecast how market participants would respond to our actions. We do not control their
behavior nor have much historical experience that we can draw on to easily assess how they
are likely to behave. Even viewpoints that turned out to be incorrect could persist for a long
time and generate adverse consequences. It is not enough for us to be right in theory. We
also have to be convincing in practice and in explaining why concerns we think are
misplaced are indeed unwarranted.
As Chairman Bernanke indicated at Jackson Hole, the FOMC's decision with respect to
providing additional accommodation will be made by weighing the costs against the benefits.
This is a dynamic process, which depends on the evolution of the economic outlook and our
own ability to learn how to become more effective in improving the cost/benefit trade-offs.
And, at its last meeting in September, the FOMC said it is "prepared to provide additional
accommodation if needed to support the economic recovery and to return inflation, over time,
to levels consistent with its mandate."
Currently, my assessment is that both the current levels of unemployment and inflation and
the timeframe over which they are likely to return to levels consistent with our mandate are
unacceptable. In addition, the longer this situation prevails and the U.S. economy is stuck
with the current level of slack and disinflationary pressure, the greater the likelihood that a
further shock could push us still further from our dual mandate objectives and closer to
outright deflation.
We have tools that can provide additional stimulus at costs that do not appear to be
prohibitive. Thus, I conclude that further action is likely to be warranted unless the economic
outlook evolves in a way that makes me more confident that we will see better outcomes for
both employment and inflation before too long.
Thank you for your kind attention. I would be happy to take a few questions.
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