Daniel K Tarullo: Monetary policy and financial stability
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the 30th Annual National Association for Business Economics Economic Policy
Conference, Arlington, Virginia, 25 February 2014.
* * *
The financial crisis and its aftermath prompted an almost immediate call for change in
financial regulation. Beyond the basic reaction that prudential regulation needed to be
stronger and less subject to arbitrage, considerable support grew for the formerly minority
view that regulation also needed to be firmly grounded in a macroprudential perspective
explicitly directed at the stability of the financial system as a whole, not just at each regulated
firm individually. The crisis also prompted increased attention to the relationship between
monetary policy and financial stability. Here the lines of debate seem more sharply drawn
than in the area of financial regulation. While few today would take the pre-crisis view
common among central bankers that financial stability should not be an explicit concern of
monetary policy, there is considerable disagreement over - among other things - the weight
that financial stability concerns should carry compared with traditional monetary policy goals
of price stability and maximum employment.
This morning I will offer some comments on this ongoing debate. In part, these remarks will
give my perspective on some of the familiar points of contention, such as the relative priority
and role of nonmonetary, compared with monetary, policy instruments in responding to risks
to financial stability. I also want to suggest that the cumulative effect over the past few
decades of changes in financial technology, financial regulation, monetary policy itself, and
perhaps the real economy have significantly altered the ways in which monetary instruments
transmit through to the real economy. These changes may argue for refinement of monetary
policy tools. They may also indicate the need for regulatory measures that are neither time
varying nor limited to prudentially regulated firms, so as to provide a more stable financial
foundation within which monetary policy will operate.
The role of monetary policy in restoring financial stability
The Federal Reserve, as we have been reminded by many accounts on the occasion of its
centennial, was created largely in response to what we would now call financial stability
concerns, as specifically revealed by the Panic of 1907. When confronted with an even
deeper financial panic a hundred years later, the Federal Reserve deployed its full range of
policy tools - monetary policy, lender of last resort, and supervision - in an effort to stabilize
the U.S. financial system. The Federal Reserve cut the federal funds rate to nearly zero by
the end of 2008. It developed an innovative set of programs to provide liquidity to financial
institutions and to restore confidence in the markets. These tools provided liquidity not only to
commercial banks, but also to other financial institutions such as investment banks and
money market funds, as well as to key financial markets such as those for commercial paper
and asset-backed securities.1 This provision of liquidity was instrumental in helping restore
market confidence. Similarly, the development of the first supervisory stress test in 2009
helped to stabilize and restore confidence in the financial system as a whole by helping to
ensure that the 19 largest bank holding companies were sufficiently capitalized so that they
could continue serving as viable financial intermediaries.
The combination of these tools was effective in restoring financial stability. The Great
Recession that followed the crisis posed a new set of challenges. Given the constraint
imposed by the effective lower bound on the federal funds rate, the Federal Reserve took
unconventional measures to provide additional monetary accommodation during the
recession and the subsequent protracted recovery. These alternative policy tools included
large-scale purchases of longer-term Treasury and mortgage-backed securities for the
Federal Reserve's portfolio and enhanced communication about its anticipated future policy,
or "forward guidance," regarding the likely path of the federal funds rate.
Large-scale asset purchases provided additional monetary accommodation by putting
downward pressure on longer-term interest rates through a portfolio-balance channel. First
used in November 2008, the Federal Open Market Committee (FOMC) subsequently initiated
a series of purchase programs during the next several years and, in September 2012,
implemented an open-ended program that would continue until there was a substantial
improvement in the outlook for the labor market. With evidence accumulating that the labor
market is improving materially, the Committee has begun to scale back the rate of these
purchases.
The Committee's forward guidance is also intended to put downward pressure on
longerterm interest rates by influencing market expectations about the future path of short-term
rates. Initially, the Committee relied on date-based descriptions of the likely path of interest
rate policy. But in December 2012 the Committee shifted to quantitative, state-contingent
guidance to provide greater clarity about the likely course of the federal funds rate under
different paths for the economy. At that time, the Committee indicated that no increase in the
federal funds rate target should be anticipated so long as unemployment remained above
6-1/2 percent and inflation was projected to be no more than 2-1/2 percent one-to-two years
ahead.
These unconventional tools appear to have been effective in helping promote the economic
recovery. In particular, research largely supports the conclusion that changes in guidance
influenced interest rate expectations, that asset purchases pushed down longer-term interest
rates and boosted asset prices, and that these improvements in financial conditions
contributed to the economic recovery in recent years.2 The unemployment rate has fallen
from 10 percent at its 2009 peak to 6.6 percent today, although debate continues over
whether significantly lower labor force participation rates and other labor market indicators
should be read to indicate somewhat less progress than the unemployment rate alone would
suggest. But, while the recovery has been frustratingly slow and remains incomplete, there
has been real progress, despite the fact that in the past couple of years a restrictive fiscal
policy has been working at cross-purposes to monetary policy, and that balance sheet repair
and financial strains in Europe have made it more difficult for the economy to muster much
self-sustaining momentum.
Monetary policy and risks to financial stability
I hardly need remind this audience that the monetary policy pursued by the Federal Reserve
in the past five years has occasioned considerable debate and controversy. Much of the
debate revolves around the degree of efficacy of the unconventional instruments, particularly
large-scale asset purchases, and particularly whether there might be diminishing returns to
these purchases in some circumstances. I am certain that analysis of these issues will
continue not only in the near term, but also in academic circles for years to come.
A good bit of criticism has focused on the large expansion of the balance sheet and the
sizable amount of excess reserves in the banking system. One oft-stated worry is that when
it is time to normalize policy, we will be unable to withdraw reserves as quickly as needed to
prevent an unwanted rise in inflation. Under the operating procedures used prior to the crisis,
the presence of large quantities of excess reserves could well have impeded the FOMC's
ability to raise short-term interest rates. But we have a variety of tools to neutralize the
effects of our balance sheet without selling assets. For example, we now pay interest on
reserves; raising that rate would put upward pressure on short-term rates. In addition, we can
drain reserves by employing fixed-rate overnight reverse repurchase agreements, term
deposits, and term repurchase agreements. We will continue to develop and, as appropriate,
test these tools to allow normalization of the balance sheet without unwanted inflationary
consequences.
The area of concern about recent monetary policy that I want to address at greater length
relates to financial stability. The worry is that the actual extended period of low interest rates,
along with expectations fostered by forward guidance of continued low rates, may be
incentivizing financial market actors to take on additional risks to boost margins, thereby
contributing to unsustainable increases in asset prices and a consequent buildup of systemic
vulnerabilities. Indeed, in the years preceding the crisis, a few prescient observers swam
against the tide of conventional wisdom to argue that a sustained period of low rates was
inducing investors to "reach for yield" and thereby endangering the financial system.3
The incentive to reach for yield can be a real and significant concern in some circumstances.
A low rate environment tends to squeeze the profitability of financial intermediaries of many
types as they reinvest in assets with lower yields.4 Because these institutions can be driven
by a variety of agency and accounting concerns to target high returns or place undue weight
on the short-term performance of their portfolios, the pressure to maintain current yield can
create incentives for these firms to take on excessive risk.5 This risk can manifest itself as
excessive leverage, or greater credit or duration risk in portfolio choices, with the potential for
large losses under adverse conditions. In addition, to the extent that investors crowd into
similar asset classes, low rates can potentially inflate a speculative bubble, the ultimate
unwinding of which could have negative consequences for economic activity.
Here, then, is the potential quandary: The very accommodative monetary policy that
contributed to the restoration of financial stability could, if maintained long enough in the face
3
One of the most notable such expositions was provided in 2005 at the Jackson Hole symposium by Raghuram
Rajan, a distinguished academic economist who has since become Governor of the Reserve Bank of India
(see Raghuram G. Rajan (2005), "Has Financial Development Made the World Riskier? (PDF)" paper
presented at "The Greenspan Era: Lessons for the Future," a symposium sponsored by the Federal Reserve
Bank of Kansas City, held in Jackson Hole, Wyo., August 25-27).
4
Low interest rates depress net interest margins for banks as the value of their deposit franchise falls, and they
boost the present value of liabilities for insurers and pension funds while reducing their prospective returns
from fixed-income investments.
5
For instance, inflows into mutual funds, a key determinant of an investment manager's compensation, are
strongly positively correlated with recent fund performance. For example, see Judith Chevalier and Glenn
Ellison (1997), "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy,
vol. 105 (6), pp. 1167-200.
of slow recovery in the real economy, eventually sow the seeds of renewed financial
instability. Yet removal of accommodation could choke off the recovery just as it seems
poised to gain at least a bit more momentum. Such a situation requires assessment of the
extent of this risk and, of particular importance to my topic today, the appropriate role of
monetary policy in containing it.
Protecting financial stability
In presenting the mix of salient considerations in reacting to possible financial stability risks
arising from extended periods of accommodative monetary policy, I should state at the outset
something that will not likely come as a surprise to any of you. My observation has been that
people's views on these risks tend to be at least generally correlated with their views on the
effectiveness of monetary policy over the past few years and on the size of the output gap
that remains today. Having said that, I have also observed that most people engaging in
these discussions - whether in policy circles, commentary, or academic work - would agree
on the basic policy instruments available for systemic risk containment, even as they would
disagree on the extent of the threat and the relative utility of those instruments. So let me
now present some of my own thoughts on both the specifics of the present situation and on
some of the ongoing policy issues raised by these discussions.
As a preliminary matter, it is important to note that incorporating financial stability
considerations into monetary policy decisions need not imply the creation of an additional
mandate for monetary policy. The potentially huge effect on price stability and employment
associated with bouts of serious financial instability gives ample justification. Of course, this
preliminary observation underscores the fact that the identification of systemic risks,
especially those based on the putative emergence of asset bubbles, is not a straightforward
exercise. The eventual impact of the bursting of the pre-crisis housing bubble on financial
stability went famously underdiagnosed by policymakers and many private analysts. But
there would be considerable economic downside in reacting with policy measures each time
a case could be made that a bubble was developing. That is, there is ample opportunity for
both Type 1 and Type 2 errors. As the metrics for assessing systemic risks continue to
improve, this problem may be alleviated, but I suspect it will never be eliminated.
We are paying close attention to the macroprudential risks posed by the low interest rate
environment, particularly given the possibility that interest rates may remain historically low
for some time even after the FOMC begins to increase its target for the federal funds rate.
The Federal Reserve has, as a result of a number of organizational changes made since the
crisis, a more focused structure for monitoring potential risks to financial stability and using
the information we glean from this monitoring to shape our supervisory and regulatory
actions. One prominent change has been the reorientation of our supervision of large bank
holding companies through the creation of the Large Institution Supervision Coordinating
Committee, or LISCC, to specifically incorporate systemic risk considerations. Another has
been the creation of the Office of Financial Stability Policy and Research, which is charged
with monitoring financial risks, analyzing the implications for financial stability, and identifying
macroprudential policies for mitigating detected risks.
At present, our monitoring does find some evidence of increased duration and credit risk, but
the increases appear relatively moderate to date - particularly at the largest banks and life
insurers. Moreover, valuations for broad categories of assets such as real estate and
corporate equities remain within historical norms, suggesting that valuation pressures, if
present, are confined to narrower segments of assets. For example, valuations do appear
stretched for farmland, although recent data are suggesting some slowing, and for the equity
prices of some small technology firms.
Still, there are areas where investors appear to have been very sanguine regarding certain
types of exposure and modest in their demands for compensation to assume such risk.
Highyield corporate bond and leveraged loan funds, for instance, have seen strong inflows,
reflecting greater investor appetite for risky corporate credits, while underwriting standards
have deteriorated, raising the possibility of large losses going forward.
In these circumstances, it has to date seemed appropriate to rely on supervisory responses.
For example, in the face of substantial growth in the volume of leveraged lending and the
deterioration in underwriting standards, the Federal Reserve, the Office of the Comptroller of
the Currency, and the Federal Deposit Insurance Corporation issued updated guidance on
leverage lending in March 2013.6 This guidance outlined principles related to safe and sound
leveraged lending activities, including the expectation that banks and thrifts originate
leveraged loans using prudent underwriting standards regardless of their intent to hold or
distribute them.
In addition, the Federal Reserve, alongside other regulators, has been working with the firms
we supervise to increase their resilience to possible interest rate shocks. For instance, in
both the 2013 and 2014 stress test and capital planning exercises, we incorporated various
combinations of interest rate shocks in the adverse scenarios. Supervisors have also been
working to estimate the implications of a wider variety of interest rate shocks. Our analysis to
this point (undertaken outside of our annual stress test program) suggests that banking firms
are capitalized to withstand the losses in asset valuations that would arise from large spikes
in rates, which, moreover, would see an offset from the increase in the value of bank deposit
franchises. This finding is consistent with the lack of widespread stress during the period of
May through June 2013 when interest rates increased considerably.7 The next set of
stresstest results, which we will release next month, will provide further insight on this point, both to
regulators and to markets.
While ad hoc supervisory action aimed at specific lending or risks is surely a useful tool, it
has its limitations. First, it is a bit too soon to judge precisely how effective these supervisory
actions - such as last year's leveraged lending guidance - have been. Second, even if they
prove effective in containing discrete excesses, it is not clear that the somewhat deliberate
supervisory process would be adequate to deal with a more pervasive reach for yield
affecting many areas of credit extension. Third, and perhaps most important, the extent to
which supervisory practice can either lean against the wind or increase the overall resiliency
of the financial system is limited by the fact that it applies only to prudentially regulated firms.
This circumstance creates an incentive for intermediation activities to migrate outside of the
regulated sector.
Should this shift occur in significant ways, the financial system could ultimately be exposed
again to the very risks against which much post-crisis regulatory reform has been directed.
To be sure, it is not a trivial task for unregulated financial-sector participants to move into
activities in which regulated institutions have traditionally operated. But if the potential gains
were high enough, unregulated actors could have sufficient incentive to do so. Indeed, it
must be recognized that regular recourse to supervisory measures in response to nascent
financial stability concerns would likely be perceived as increasing the payoff from this form
of regulatory arbitrage.
The limitations of supervision as a tool for managing the risks to financial stability that could
arise from protracted periods of low interest rates have intensified interest in time-varying
macroprudential policies - that is, measures that can be calibrated to changing economic or
financial conditions. The appeal of such requirements is that they could, at least in principle,
be adopted reasonably quickly as risks increased, implemented in a straightforward way, and
applied to all market actors engaged in the covered activities, not just prudentially regulated
firms. A frequently cited example is increased loan-to-value requirements for certain types of
lending such as residential or commercial mortgages.
Having just recently addressed at some length the promise and limitations of such
timevarying macroprudential tools, I will not repeat those views at length today.8 I can summarize
by saying that, in practice, such policies face a number of challenges, including questions
about the reliability of measures to guide policy actions, which officials should make
macroprudential decisions, the speed with which policies might realistically be implemented
and take effect, and the appropriate calibration of policies that will be effective in damping
excesses while not unnecessarily reducing well-underwritten credit flows.9 And, as with
supervisory policies, there is reason to doubt how effective they would be in circumstances
where credit growth had been excessive across wide parts of the economy.
As I have said previously, however, given that procyclicality is an important contributor to
systemic risk, there is good reason to continue work on developing time-varying policies. I
would devote particular attention to policies that can act as the rough equivalent of an
increase in interest rates for particular sources of funding. Such policies would be more
responsive to problems that were building quickly because of certain kinds of credit, without
regard to whether they were being deployed in one or many sectors of the economy. In that
respect, such policies should be more effective (and perhaps less controversial) in slowing
the buildup of excess credit than a measure directed squarely at one sector, which might be
quickly met by the redirection of a reach for yield to other asset classes.
One example is the countercyclical capital buffer in Basel III, which provides for an increase
in the risk-weighted capital requirements of prudentially regulated banking organizations of
up to 2-1/2 percentage points when "credit growth is excessive and is leading to the buildup
of system-wide risk."10 Because stricter capital requirements lead to higher levels of bank
equity - which is typically more expensive than debt - they would likely result in higher
funding costs for the bank-intermediated credit utilized by other market participants. In this
regard, time-varying macroprudential policies can be thought of as addressing cyclical
systemic risks via interest rates in a manner somewhat akin to a tightening of monetary
policy, which by raising benchmark interest rates affects a similar increase in funding costs.
Clearly, time-varying macroprudential policies could not be viewed as a substitute for
monetary policy. Like ad hoc supervisory policies, they would influence a narrower set of
transactions and, as such, would not "get in all the cracks" of the financial system, to use a
phrase coined by my colleague Jeremy Stein. But, to shift metaphors, they could potentially
provide something of a speed bump, while not producing the much broader effect on the
economy that a federal funds rate increase would. Moreover, time-varying macroprudential
policies may also give monetary policymakers more of an opportunity to assess whether the
asset inflation is generalized and sustained enough to warrant a change in monetary policy.11
8
See Daniel K. Tarullo (2013), "Macroprudential Regulation," speech delivered at the Conference on
Challenges in Global Financial Services, Yale Law School, New Haven, Conn., September 20.
9
Note that this issue of shared or complementary authorities, grounded in constitutional considerations such as
democratic accountability and avoiding too much concentration of power in any one part of government, is
already a factor. While the Financial Stability Oversight Council was created in part to allow for coordination of
the authorities of its constituent agencies, it cannot assure coordination among independent entities, most of
which have a number of independent members. Even within the Federal Reserve, there is not a unity of
relevant authority, in that regulatory and supervisory powers are lodged only in the Board of Governors,
whereas monetary policymaking rests with the entire FOMC.
10
Basel Committee on Banking Supervision (2011), "Basel III: A Global Regulatory Framework for More
Resilient Banks and Banking Systems," (Basel, Switzerland: Bank for International Settlements, June), p. 57.
11
It is worth noting that time-varying macroprudential policies like the countercyclical capital buffer also bolster
resilience in the financial sector by increasing bank and dealer loss absorbency. Countercyclical or even
Although the three federal banking agencies included a countercyclical capital provision in
the capital regulation to implement Basel III adopted last summer, the provision will not take
effect in the United States until 2016. However, when the countercyclical capital buffer
provision of Basel III does come into effect in the United States, we will have the benefit of
experience for this tool from other countries. Over the past year, the Norges Bank, the
Reserve Bank of New Zealand, and the Financial Policy Committee at the Bank of England
have all finalized general statements on how this policy lever will operate in their jurisdictions,
with implementation in each case proceeding in advance of when the policy will come into
effect under Basel III.12 Moreover, in December, the Norwegian Ministry of Finance accepted
the advice of the Norges Bank to activate a countercyclical capital buffer in the face of rising
financial imbalances. The level of the buffer will be set at 1 percent of risk-weighted assets,
starting July 1, 2015.13
The foregoing discussion has considered the ways in which existing supervisory authority
and new forms of macroprudential authority may allow monetary policymakers to avoid, or at
least defer, raising interest rates to contain growing systemic risks under circumstances in
which policy is falling well short of achieving one or both elements of the dual mandate.
However, as has doubtless been apparent, I believe these alternative policy instruments
have real limitations. As I noted earlier, I do not think that at present we are confronted with a
situation that would warrant a change in the monetary policy we have been pursuing. But for
that very reason, now is a good time to consider these issues more actively. One useful step
would be development of a framework that would allow us to make a more analytic, less
instinctual judgment on the potential tradeoffs between enhanced financial stability and
reduced economic activity. This will be an intellectually challenging exercise, but in itself
does not entail any changes in policy.
Monetary policy and financial system
I have to this point described the possible need to balance longer-term financial stability and
shorter-term economic growth considerations in the implicit context of a specific point in time,
with the decision on use of supervisory, macroprudential, or monetary policy tools dependent
on the level and nature of the potential systemic risk, the likely efficacy of each tool in
containing that risk, and the expected side effects of each tool on growth. But in thinking
about the relationship between monetary policy and financial stability, it is also worth taking a
view less focused on decisions at a specific point in time.
Changes in financial technology, regulation, and perhaps the real economy over the past few
decades have profoundly affected the channels by which credit is created in the economy,
and thus the potential for financial instability. The progressive integration of traditional
lending and capital markets activities has created a fundamentally different financial system
from that which existed from the mid-1930s through the mid-1970s, during which strict
activities restrictions, limitations on competition, and deposit interest rate caps had shaped a
banking system that was very stable and reasonably profitable, but not particularly innovative
in meetings the needs of either savers or borrowers. The extensive deregulation of banking
in the 30 years preceding the crisis, while understandable as a response to the threat posed
by capital markets and unregulated financial firms to the franchise of regulated firms, left the
financial system without a basic framework to contain the risks posed in the new
environment.
The explosive growth of short-term wholesale funding in the years preceding the crisis is the
exemplary case of how the regulatory system has not kept pace with the integration of
traditional lending and capital market activities. The amount of credit created through those
channels meant that aggregate credit growth in the economy relative to GDP was much
higher than just a few decades earlier, a development that may itself be connected to a
greater likelihood of financial crises.14 Moreover, this funding was peculiarly susceptible to
runs that can prompt fire sales and the sudden withdrawal of credit from counterparties.
These direct financial stability concerns have been my principal motivation in devoting so
much attention to measures such as minimum margins on securities financing transactions, a
version of which are currently under development internationally under the auspices of the
Financial Stability Board.15 But these kinds of changes might also make the trade-off between
systemic risk and near-term growth aims a bit easier, since a financial system with more
ballast will be less prone to listing in response to accommodative monetary policies directed
at the dual mandate goals of price stability and maximum employment. Were such a regime
of minimum margins in place, one could also see the potential for enhancing the
effectiveness of monetary policy by adding a time-varying, countercyclical component.
Finally, it may also be worth considering some refinements to our monetary policy tools.
Central banks must always be cognizant of important changes that may result in different
responses of households, firms, and financial markets to monetary policy actions. There is
little doubt that the conduct of monetary policy has become a good deal more complicated in
recent years. Some of these complications may diminish as economic and financial
conditions normalize, but others may be more persistent. Central banks, in turn, may want to
build on some recent experience, adapted for more normal times, in addressing the desire to
contain systemic risk without removing monetary policy accommodation to advance one or
both dual mandate goals.
One example would be altering the composition of a central bank's balance sheet so as to
add a second policy instrument to changes in the targeted interest rate. The central bank
might under some conditions want to use a combination of the two instruments to respond to
concurrent concerns about macroeconomic sluggishness and excessive maturity
transformation by lowering the target (short-term) interest rate and simultaneously flattening
the yield curve through swapping shorter duration assets for longer-term ones.
Conclusion
In reviewing the relationship between financial stability considerations and monetary policy, I
have suggested that monetary policy action cannot be taken off the table as a response to
the build-up of broad and sustained systemic risk. But I have also tried to suggest that the
development of existing supervisory tools, the judicious use of macroprudential measures,
the adoption of some structural measures affecting certain forms of financing, and perhaps
some refinements of monetary policy tools can together reduce the number of occasions on
which a difficult tradeoff between financial stability considerations and near-term growth or
price stability aims will need to be made.