We care about financial conditions not for themselves, but instead for how they can affect economic activity and ultimately our ability to achieve the statutory objectives of the Federal Reserve—maximum employment and price stability. Let me provide a few examples. A decline in mortgage rates can lift the demand for owner-occupied housing and support construction activity. A rise in equity prices can boost household wealth, which is one factor that underpins consumer spending. The foreign exchange value of the dollar can affect the relative competitiveness of importers and exporters, which, in turn, influences the country’s trade performance. Narrower credit spreads can reduce the cost of capital for business and help support greater business investment. 1/6  BIS central bankers' speeches  In sum, financial conditions affect households’ and firms’ saving and investment plans, and, therefore, play a key role in influencing economic activity and the economic outlook. This is why the evaluation of financial conditions is so crucial in the conduct of monetary policy. The FOMC traditionally implements monetary policy by adjusting the federal funds rate—the short-term interest rate paid by banks that borrow reserves from other financial institutions. However, few economic decisions directly depend on the federal funds rate. Rather, changes in the federal funds rate affect the economy through their impact on other interest rates, which, consequently, influence broader financial conditions. If financial conditions moved predictably with the policy rate, then there would be no need for the FOMC to focus on financial conditions.

“Global Imbalances: Is the World Economy Really at Risk?” Dexia SA. 2  Bartolini, Leonardo and Amartya Lahiri. 2006. Twin Deficits, Twenty Years Later, Federal Reserve Bank of New York Current Issues in Economics and Finance, 12, no. 7 (October). BIS Review 41/2010  3  estate assets induced entrepreneurs to produce more of those assets. In the housing market, this increase in prices was helped along by the relaxation of loan underwriting standards, which made it easier to obtain a mortgage and become a homeowner. Credit growth was the strongest among households with relatively low credit scores (Chart 5). The homeownership rate rose after being relatively stagnant for two decades (Chart 6). The increased availability of credit to lower income borrowers and the sharp rise in housing values contributed to the rise of consumption as a share of GDP and the decline of the personal saving rate 3 (Chart 7). Now, with the aid of hindsight, it is clear that we built too many houses, invested in too much commercial real estate and overvalued both significantly. The market overshot for several reasons. First, there was rampant speculative behavior. The longer these asset prices continued to rise, the stronger the belief became that they would keep rising in the future. Second, the rise in prices reinforced the initial relaxation of underwriting standards. During the period of rising prices, defaults and loan losses were very low. A homeowner who had difficulty servicing the debt could typically sell the home for a profit and pay off the loan.