Lael Brainard: An update on the outlook, liquidity and resilience
Speech by Ms Lael Brainard, Member of the Board of Governors of the Federal Reserve
System, at the Institute of International Bankers Annual Washington Conference, Washington
DC, 7 March 2016.
* * *
These remarks represent my own views, which do not necessarily represent those of the Federal Reserve Board
or the Federal Open Market Committee.
This is a fitting moment to take stock of economic and financial developments, following a
volatile start to the year. I will begin by reviewing the outlook, then provide a brief recap of how
financial market liquidity has fared, and finish by commenting on the resilience and resolvability
of the large interconnected banks.
Outlook for the United States
I am heartened by the continued strong progress on employment and the resilience of
American consumers, which stand out against a considerably more challenging global
backdrop. I am pleased with the continued strength in the U.S. labor market, which is drawing
people back into the labor force. In February, the unemployment rate was 4.9 percent - a level
that is one-half its peak during the depths of the recession in 2009. Last Friday, we learned
that employment growth has averaged 223,000 per month over the past 12 months. And there
likely is some room to go: The prime-age employment-to-population ratio remains
1 3/4 percentage points below levels prevailing prior to the financial crisis, while a relatively
large share of employees who are working part time would prefer to work full time. In addition,
wage growth remains relatively slow.
Domestic activity continues to grow at a moderate pace. The pace of consumer spending, after
slowing some at the end of last year, looks to have picked up in January, and auto sales
remained strong in February. Over the past two years, consumption has increased at about a
3 percent pace, on average, and I expect to see growth to continue at close to this pace based
on solid job and income growth - together with elevated readings on consumer confidence and
the boost to household purchasing power from persistent declines in energy prices.
The housing sector has also contributed steadily to growth over the past year. With housing
activity well below pre-recession norms, it appears there is still scope for continued growth in
construction activity.
In contrast, sectors of the economy that are sensitive to energy prices or international demand
have been a drag. In response to the plunge in oil prices, investment in drilling and mining
structures fell 50 percent last year, and continued reductions in the number of drilling rigs this
year suggest that further declines are likely.1 At the same time, firms and workers in the energy
sector have experienced extreme financial difficulties and severe job losses.
Although the euro area and Japan are recovering, their demand growth remains very low,
despite extraordinary monetary accommodation. In emerging market economies growth last
year came in at only one-half the average rate from 2009 to 2013. Because China has
accounted for one-third of the growth in world Gross Domestic Product (GDP) and trade, the
recent slippage in Chinese economic growth is having an important effect globally. Even if
Chinese growth does not slide further, the changing composition of its growth toward
consumption and services and away from resource-intensive manufacturing and investment
will pose important challenges to commodity exporters and other emerging economies,
especially since China had previously accounted for upwards of one-half of global imports of
many base metals.
Weak foreign demand relative to the United States has pushed down net exports and
contributed to a nearly 20 percent strengthening of the real trade-weighted dollar since
mid2014. As a result, net exports subtracted a little more than 1/2 percentage point from GDP
growth in 2014 and 2015, and econometric models suggest that past appreciation will lead to
close to another 1 percentage point subtraction this year.2
These effects are especially prominent in the U.S. manufacturing sector, where output is
sluggish, and the agricultural sector has also been hit hard by the rise in the value of the dollar.
In addition, with profits at many firms adversely affected by the rise in the dollar and weak
demand abroad, business fixed investment increased only 1-1/2 percent last year after
contributing significantly to growth earlier in the recovery.
On balance, in recent months, financial conditions have tightened somewhat with equity prices
moving lower and corporate risk spreads widening, although conditions have improved in
recent weeks. In addition, progress on inflation has been slow. Prices for personal consumption
expenditures (PCE) have increased 1.3 percent over the 12 months through January, well
below the Federal Open Market Committee's (FOMC) 2 percent target. Reductions in energy
prices are, in part, responsible for this low rate, and if energy prices stabilize, top-line inflation
should move higher. Still, a stabilization in energy prices is not assured. Market participants
have been repeatedly surprised by the depth and persistence of oil price declines: Both spot
and far futures oil prices, for example, have fallen in five out of the past six quarters since
mid2014.
But even after discounting the influence of energy prices, core PCE inflation has been
stubbornly stuck in the vicinity of 1-1/4 to 1-1/2 percent since 2012.3 Most recently, the dollar
has played an important role in holding down non-oil import prices, which fell 3-1/2 percent last
year and subtracted an estimated 1/2 percentage point from core inflation.4 Should the dollar
stabilize, the downward influence on inflation should dissipate. But, as with oil prices, the
movement in the value of the dollar has been more persistent than markets and many
observers expected, with increases in every quarter since mid-2014.
If the labor market continues to improve, higher resource utilization should also put some
upward pressure on inflation going forward. However, the effect of resource utilization on
inflation is estimated to be much lower today than in past decades.5
An important concern about persistently low inflation is that it can lead to a fall in longer-term
inflation expectations, making it much more difficult to achieve our inflation target. For the most
part, longer-term inflation expectations appear to have remained reasonably stable, though
there are some concerning signs. Longer-term inflation expectations of professional
forecasters and primary dealers have held quite steady in recent years at levels consistent
with the FOMC's target. However, households' inflation expectations appear to have moved
down somewhat recently. Five-to-10-year inflation expectations in the University of Michigan
Surveys of Consumers have edged lower over the past year or two with the level in February
nearly 1/2 percentage point below the 10-year average. Three-year inflation expectations in
the New York Federal Reserve's Survey of Consumer Expectations have also moved steadily
lower over the past two years, though the recent decline in energy prices may explain much of
this drift.
Notably, market-based measures of inflation compensation based on Treasury
InflationProtected Securities (TIPS) and nominal Treasury yields are at historically low levels. At the
five-year, five-year-ahead horizon, inflation compensation is 1 percentage point lower than
mid-2014 levels. Declines in swap-based measures of inflation compensation have been
similar. However, these declines appear correlated with oil prices, and it is not clear to what
extent these declines reflect a change in inflation expectations, changes in investor demand
for TIPS versus nominal Treasury securities, or an improvement in the risk characteristics of
nominal Treasury securities versus other assets.
Over the next couple of years, there are reasons to expect energy prices and the dollar to
eventually stabilize, output to increase at around the moderate pace it has averaged over the
recovery thus far, foreign growth to recover somewhat, the U.S. labor market to improve
further, and inflation to move toward our 2 percent target. However, there are risks around this
baseline forecast, the most prominent of which lie to the downside. For example, China faces
risks as it navigates a sharp slowing in its goods sector, a large buildup in corporate debt, and
an apparent surge in demand for foreign assets, although China possesses resources to deal
with these challenges. More broadly, sources of robust demand around the globe are few, and
sources of weakness relatively greater, as evidenced by persistently below target inflation in
all of the major advanced economies.
Monetary policy
In today's circumstances, policy could usefully follow two simple guidelines. First, we should
not take the strength in the U.S. labor market and consumption for granted. Given weak and
decelerating foreign demand, it is critical to carefully protect and preserve the progress we
have made here at home through prudent adjustments to the policy path. Tighter financial
conditions and softer inflation expectations may pose risks to the downside for inflation and
domestic activity. From a risk-management perspective, this argues for patience as the outlook
7
becomes clearer.6
Second, we should put a high premium on clear evidence that inflation is moving toward our
2 percent target. Inflation has persistently underperformed relative to our target. Moreover,
measures of inflation compensation and some survey-based measures of inflation
expectations suggest that inflation expectations may have edged lower. Given the currently
weak relationship between economic slack and inflation and the persistent, depressing effects
of energy price declines and exchange rate increases, we should be cautious in assessing that
a tightening labor market will soon move inflation back to 2 percent. We should verify that this
is, in fact, taking place. In this regard, core PCE inflation increased 1.7 percent over the
12 months ending in January, a noticeable step-up from an increase of 1.3 percent over the
preceding 12 months.7
Liquidity
In addition to raising uncertainty around the outlook, the recent financial market volatility has
underscored the importance of ongoing attention to the resilience of market liquidity. Although
it is fair to say that the recent uptick in volatility has in part reduced earlier concerns about
prolonged low volatility and associated reach-for-yield behavior, it has placed added focus on
the resilience of liquidity, particularly in markets, such as the market for corporate bonds, that
may be prone to gapping between liquidity demand and supply in stressed conditions.
The Federal Reserve's surveillance of liquidity conditions in financial markets has broadened
and deepened considerably since the "taper tantrum" in mid-2013 and the events of October
2014 in the Treasury market. The analysis so far suggests a few preliminary observations.
While it does not appear that day-to-day liquidity has declined notably, some characteristics of
liquidity provision are changing. Broadly, traditional price-based measures of liquidity such as
bid-asked spreads and the price effect of a given trade size generally remain in line with
precrisis norms in most markets. In contrast, both anecdotes from market participants and the
declining size of trades in some markets suggest it may have become more expensive to
conduct, and may take more time to implement, large trades.8
Moreover, there may be some deterioration in the resilience of liquidity at times of stress, along
with a greater incidence of outsized intraday price movements. Relatedly, liquidity appears to
be more segmented based on the characteristics of the securities being traded and the
underlying structure of the markets in which they are traded. Based on granular disaggregation
of the traded securities, liquidity appears little changed in secondary markets that have
traditionally been highly liquid, such as on-the-run Treasury bonds and highly rated corporate
bonds. By contrast, there has been some reduction in liquidity in the segments of these
markets that have historically been less liquid.9
The move toward somewhat greater segmentation of liquidity, in conjunction with ongoing
electronification and acceleration of trade execution, might be contributing to increased
linkages across markets. Anecdotally, it appears market participants may be using relatively
more liquid instruments to hedge exposures in other less liquid market segments, perhaps
unintentionally contributing to increased correlation across markets.10
From a broader financial stability perspective, the possible deterioration in the resilience of
liquidity suggests a special focus on segments where price gaps are most likely to arise at
times of stress between holders of relatively illiquid or thinly traded securities that want to sell
and dealers with an apparently reduced willingness to take the other side of the trade, as
indicated, for example, by leaner dealer inventory holdings.11 Mutual funds holding relatively
less liquid assets is one area of focus. Despite having share prices that move with market
prices, these funds can give rise to first-mover advantages for redeeming shareholders and
create the potential for destabilizing waves of redemptions and asset fire sales if liquidity
buffers and other tools to manage liquidity risk prove insufficient.12 In this regard, our
surveillance has been closely monitoring for any signs of liquidity strains associated with the
recent increases in spreads for high-yield corporate bonds, as well as for idiosyncratic events
affecting particular funds in this segment, such as the events surrounding the abrupt closing
of Third Avenue Management's Focused Credit Fund last December.
More broadly, the regulatory agencies in the United States and the Financial Stability Board
internationally have work under way focusing on possible fire-sale risk associated with the
growing share of less liquid bonds held in asset management portfolios on behalf of investors
who may be counting on same-day redemption when valuations fall. The recent proposal by
the Securities and Exchange Commission (SEC) to ensure mutual funds have ample liquidity
buffers under stressed scenarios and undertake measures to address the risk of heavy
redemptions and fire sales is notable in this regard. Our surveillance will continue to undertake
more granular analysis of liquidity resilience and associated risks.
Across financial markets, it is difficult to disentangle the effects on liquidity of changes in
technology and market structure and changes in broker-dealer risk-management practices in
the wake of the crisis on the one hand and enhanced regulation on the other. While the
leverage ratio and other Dodd-Frank Act requirements likely are encouraging broker-dealers
to be more rigorous about risk management in allocating balance sheet capacity to certain
trading activities, the growing presence of proprietary firms using algorithmic trading in many
of these markets, which predated the crisis, is also influencing trading dynamics in important
ways.13 The Request for Information issued by the U.S. Treasury and the recent proposals
from the Commodity Futures Trading Commission and the SEC will be important in deepening
our understanding. While acknowledging the role of regulation as a possible contributor, it is
important to recognize that this regulation was designed to reduce the concentration of liquidity
risk on the balance sheets of the large, interconnected banking organizations that proved to
be a major amplifier of financial instability at the height of the crisis.
Resilience and resolvability
This brings me to the last item on my agenda: an update on efforts to strengthen the resilience
and resolvability of these systemic banking organizations. With recent and upcoming
proposals, much of the new regulatory architecture will be in the process of implementation or
in train. Even so, I would expect the rules and their application to continue to be strengthened
and modified as financial risks evolve, just as I would expect these rules to be increasingly
tailored over time to better reflect risk profiles.
As a result of the capital and liquidity regulations already in place as well as the associated
stress tests, the eight most systemic U.S. banking organizations are now holding $800 billion
more in high-quality liquid assets than they were in 2011 and $500 billion more in common
equity capital than they were in 2008. These liquidity and capital buffers are designed to
strengthen the going-concern resilience of systemic banking organizations during periods of
market volatility and financial stress. In addition, we recently released our proposed framework
for determining the application of an additional countercyclical buffer to our large banking firms
and made the first determination under the rule.
On top of this, the capital surcharge we have proposed, which is designed to ensure the
largest, most systemic banking organizations internalize the risk they pose to the system, is
estimated to range from 1.0 to 4.5 percent of risk-weighted assets, based on 2013 data, over
and above the 7 percent minimum and capital conservation buffers under Basel III. Indeed, it
appears that some institutions may have already reduced their systemic footprint in anticipation
of these additional charges.
Of course, the crisis starkly illustrated that what seem like thick capital cushions in good times
can become uncomfortably thin in the face of financial stress. Our Comprehensive Capital
Analysis and Review (CCAR) stress-testing framework is arguably our most powerful tool for
ensuring that these capital buffers remain robust to a variety of possible shocks to the trading
and banking book exposures of the large, interconnected banking organizations. Therefore, as
we work to fine-tune and strengthen this framework, I would hope to see the capital surcharge
for systemic banking organizations integrated into CCAR to ensure robustness, even as
adjustments might be made on other parameters of the framework.
Although today's greatly enhanced common equity capital requirements should materially
reduce the probability that a large bank might fail in response to a severe economic downturn
or financial stress, it is not enough to reduce the risks of failure. In parallel, our supervisory and
regulatory efforts are raising the bar on ensuring that the large, interconnected banking
organizations have in place credible plans and preparations as well as properly calibrated and
positioned liquidity and loss absorbing capacity to ensure failure can take place in an orderly
manner.
To that end, we have proposed a Total Loss-Absorbing Capacity rule that contains a long-term
debt requirement that is critical to the feasibility of bankruptcy for the systemic banking
organizations. It is a necessary counterpart to the Dodd-Frank Act requirement that large
banking organizations have credible resolution plans and undertake preparations to make
those plans operationally feasible. In particular it requires the top-tier holding companies of
systemic banking organizations to maintain a sufficiently large buffer of long-term debt that can
be converted into equity and used to fully recapitalize their important operating subsidiaries in
the event of bankruptcy. The proposed levels of long-term debt are calibrated to the specific
riskiness and scale of each institution's activities, taking into account the likely shrinkage of the
operations of their subsidiaries in resolution.
The requirement is designed to mitigate contagion, fire-sale, and run risks by providing comfort
to depositors, short-term debt holders, and counterparties of the operating subsidiaries of the
firm, since the long-term unsecured debt issued by the top-tier holding company would be
structurally subordinated to the claims on the operating subsidiaries. The presence of
longterm debt holders that will be bailed in ensures that taxpayer resources will not be used and
should provide incentives to preserve the firm's value as it approaches insolvency, thus
aligning the firm's interests with the public's broader interest in financial stability.
The Board has received many detailed comments on the proposed long-term debt rule. Some
have commented on the existing stock of outstanding long-term debt with acceleration clauses
that might not qualify under the rule's criteria and have proposed grandfathering as a possible
solution. Others have raised questions about whether the leverage ratio or the risk-based
capital framework provides the more appropriate calibration benchmark for the minimum
longterm debt requirement. Comments from foreign banks have also addressed our proposal to
impose internal long-term debt requirements on the U.S. intermediate holding companies of
foreign banks and have asked, among other things, whether the proposed requirement should
vary more depending on the resolution strategy of the parent foreign bank. We are currently
carefully reviewing these comments. One thing is clear: the long-term debt requirement is a
critical component in ending too big to fail.
The long-term debt requirement together with rigorous resolution plans and operational
preparedness, the capital surcharges along with the capital stress tests, and the availability of
sufficient amounts of high-quality liquidity where it is most likely to be needed will all
substantially decrease the risk that a large financial institution's distress could pose to the
broader financial system and help ensure that no banking institution is too large and too
complex to fail. They will move us closer to our goal of a safer, more responsible, and more
resilient financial system.
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