Donald L Kohn: Financial markets and central banking
Speech by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal
Reserve System, at the C Peter McColough Series on International Economics, Council on
Foreign Relations, New York, 28 November 2007.
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I thought it might be useful to start this session with a few thoughts on some of the issues
facing central banks as they deal with the consequences of the recent turbulence in financial
markets.1 This list is not comprehensive: I have concentrated on the issues associated with
our roles as monetary policy makers and providers of liquidity - and even in that category I
cannot address all the issues in the short time allotted.
Like every other period of financial turbulence, this one has been marked by considerable
uncertainty. Central banks, other authorities, and private-market participants must make
decisions based on analyses made with incomplete information and understanding. The
repricing of assets is centered on relatively new instruments with limited histories - especially
under conditions of stress; many of them are complex and have reacted to changing
circumstances in unanticipated ways; and those newer instruments have been held by a
variety of investors and intermediaries and traded in increasingly integrated global markets,
thereby complicating the difficulty of seeing where risk is coming to rest.
Operating under this degree of uncertainty has many consequences. One is that the rules
and criteria for taking particular actions seem a lot clearer in textbooks or to many
commentators than they are to decisionmakers. For example, the extent to which institutions
are facing liquidity constraints as opposed to capital constraints, or the moral hazard
consequences of policy actions, are inherently ambiguous in real time. Another consequence
of operating under a high degree of uncertainty is that, more than usually, the potential
actions the Federal Reserve discusses have the character of "buying insurance" or managing
risk - that is, weighing the possibility of especially adverse outcomes. The nature of financial
market upsets is that they substantially increase the risk of such especially adverse
outcomes while possibly having limited effects on the most likely path for the economy.
Moral hazard
Central banks seek to promote financial stability while avoiding the creation of moral hazard.
People should bear the consequences of their decisions about lending, borrowing, and
managing their portfolios, both when those decisions turn out to be wise and when they turn
out to be ill advised. At the same time, however, in my view, when the decisions do go
poorly, innocent bystanders should not have to bear the cost.
In general, I think those dual objectives - promoting financial stability and avoiding the
creation of moral hazard - are best reconciled by central banks' focusing on the
macroeconomic objectives of price stability and maximum employment. Asset prices will
eventually find levels consistent with the economy producing at its potential, consumer prices
remaining stable, and interest rates reflecting productivity and thrift. Such a strategy would
not forestall the correction of asset prices that are out of line with fundamentals or prevent
investors from sustaining significant losses. Losses were evident early in this decade in the
case of many high-tech stocks, and they are in store for houses purchased at unsustainable
prices and for mortgages made on the assumption that house prices would rise indefinitely.
To be sure, lowering interest rates to keep the economy on an even keel when adverse
financial market developments occur will reduce the penalty incurred by some people who
exercised poor judgment. But these people are still bearing the costs of their decisions and
we should not hold the economy hostage to teach a small segment of the population a
lesson.
The design of policies to achieve medium-term macroeconomic stability can affect the
incentives for future risk-taking. To minimize moral hazard, central banks should operate as
much as possible through general instruments not aimed at individual institutions. Open
market operations fit this description, but so, too, can the discount window when it is
structured to make credit available only to clearly solvent institutions in support of market
functioning. The Federal Reserve's reduction of the discount rate penalty by 50 basis points
in August followed this model. It was intended not to help particular institutions but rather to
open up a source of liquidity to the financial system to complement open market operations,
which deal with a more limited set of counterparties and collateral.
The effects of financial markets on the real economy
Related developments in housing and mortgage markets are a root cause of the financial
market turbulence. Expectations of ever-rising house prices along with increasingly lax
lending standards, especially on subprime mortgages, created an unsustainable dynamic,
which is now reversing. In that reversal, loss and fear of loss on mortgage credit have
impaired the availability of new mortgage loans, which in turn has reduced the demand for
housing and put downward pressures on house prices, which have further damped desires to
lend. We are following this trajectory closely, but key questions for central banks, including
the Federal Reserve, are, What is happening to credit for other uses, and how much restraint
are financial market developments likely to exert on demands outside the housing sector?
Some broader repricing of risk is not surprising or unwelcome in the wake of unusually thin
rewards for risk taking in several types of credit over recent years. And such a repricing in
the form of wider spreads and tighter credit standards at banks and other lenders would
make some types of credit more expensive and discourage some spending, developments
that would require offsetting policy actions, other things being equal. Some restraint on
demand from this process was a factor I took into account when I considered the economic
outlook and the appropriate policy responses over the past few months.
An important issue now is whether concerns about losses on mortgages and some other
instruments are inducing much greater restraint and thus constricting the flow of credit to a
broad range of borrowers by more than seemed in train a month or two ago. In general,
nonfinancial businesses have been in very good financial condition; outside of variable-rate
mortgages, households are meeting their obligations with, to date, only a little increase in
delinquency rates, which generally remain at low levels. Consequently, we might expect a
moderate adjustment in the availability of credit to these key spending sectors. However, the
increased turbulence of recent weeks partly reversed some of the improvement in market
functioning over the late part of September and in October. Should the elevated turbulence
persist, it would increase the possibility of further tightening in financial conditions for
households and businesses. Heightened concerns about larger losses at financial institutions
now reflected in various markets have depressed equity prices and could induce more
intermediaries to adopt a more defensive posture in granting credit, not only for house
purchases, but for other uses a well.
Liquidity provision and bank funding markets
Central banks have been confronting several issues in the provision of liquidity and bank
funding. When the turbulence deepened in early August, demands for liquidity and reserves
pushed overnight rates in interbank markets above monetary policy targets. The aggressive
provision of reserves by a number of central banks met those demands, and rates returned
to targeted levels. In the United States, strong bids by foreign banks in the dollar-funding
markets early in the day have complicated our management of this rate. And demands for
reserves have been more variable and less flexible in an environment of heightened
uncertainty, thereby adding to volatility. In addition, the Federal Reserve is limited in its ability
to restrict the actual federal funds rate within a narrow band because we cannot, by law, pay
interest on reserves for another four years.
At the same time, the term interbank funding markets have remained unsettled. This is
evident in the much wider spread between term funding rates - like libor - and the expected
path of the federal funds rate. This is not solely a dollar-funding phenomenon - it is being
experienced in euro and sterling markets to different degrees. Many loans are priced off of
these term funding rates, and the wider spreads are one development we have factored into
our easing actions. Moreover, the behavior of these rates is symptomatic of caution among
key marketmakers about taking and funding positions, and this is probably impeding the
reestablishment of broader market trading liquidity. Conditions in term markets have
deteriorated some in recent weeks. The deterioration partly reflects portfolio adjustments for
the publication of year-end balance sheets. Our announcement on Monday of term open
market operations was designed to alleviate some of the concerns about year-end
pressures.
The underlying causes of the persistence of relatively wide-term funding spreads are not yet
clear. Several factors probably have been contributing. One may be potential counterparty
risk while the ultimate size and location of credit losses on subprime mortgages and other
lending are yet to be determined. Another probably is balance sheet risk or capital risk - that
is, caution about retaining greater control over the size of balance sheets and capital ratios
given uncertainty about the ultimate demands for bank credit to meet liquidity backstop and
other obligations. Favoring overnight or very short-term loans to other depositories and
limiting term loans give banks the flexibility to reduce one type of asset if others grow or to
reduce the entire size of the balance sheet to maintain capital leverage ratios if losses
unexpectedly subtract from capital. Finally, banks may be worried about access to liquidity in
turbulent markets. Such a concern would lead to increased demands and reduced supplies
of term funding, which would put upward pressure on rates.
This last concern is one that central banks should be able to address. The Federal Reserve
attempted to deal with it when, as I already noted, we reduced the penalty for discount
window borrowing 50 basis points in August and made term loans available. The success of
such a program lies not in loans extended but rather in the extent to which the existence of
this facility helps reassure market participants. In that regard, I think we had some success,
at least for a time. But the usefulness of the discount window as a source of liquidity has
been limited in part by banks' fears that their borrowing might be mistaken for accessing
emergency loans for troubled institutions. This "stigma" problem is not peculiar to the United
States, and central banks, including the Federal Reserve, need to give some thought to how
all their liquidity facilities can remain effective when financial markets are under stress.
Conclusion
In response to developments in financial markets, the Federal Reserve has adjusted the
stance of monetary policy and the parameters of how we supply liquidity to banks and the
financial markets. These adjustments have been designed to foster price stability and
maximum sustainable growth and to restore better functioning of financial markets in support
of these economic objectives. My discussion today was intended to highlight some of the
issues we will be looking at in financial markets as we weigh the necessity of future actions.
We will need to assess the implications of these developments, along with the vast array of
incoming information on economic activity and prices, for the future path of the U.S.
economy. As the Federal Open Market Committee noted at its last meeting, uncertainties
about the economic outlook are unusually high right now. In my view, these uncertainties
require flexible and pragmatic policymaking - nimble is the adjective I used a few weeks ago.
In the conduct of monetary policy, as Chairman Bernanke has emphasized, we will act as
needed to foster both price stability and full employment.