donald l kohn : monetary policy and imbalances speech by mr donald l kohn, member of the board of governors of the us federal reserve system, at the banking and finance lecture series, widener university, chester, 1 april 2004. * * * interest rates in the united states have been very low for some time. the federal reserve targets the overnight federal funds rate, and for almost a year this rate has stood at 1 percent. by comparison, the funds rate averaged more than 5 percent during the 1990s, and was last at 1 percent in the 1950s. similarly, the yield on a ten - year treasury note now stands near 4 percent - a level not seen since 1963 and more than 3 percentage points below the average of the past twenty years. these low rates are no accident. the economy began to weaken in late 2000, and aggregate activity began to contract in early 2001. starting in january of 2001, the federal reserve moved to counter this weakness by lowering the funds rate to its present level in a series of steps that ended last june. this prompt and aggressive action undoubtedly served to limit the decline in economic activity, and, in fact, the recent recession was one of the mildest on record. the federal reserve recognizes that the federal funds rate is currently lower than it can be on a sustainable basis : at some point, as the economy moves back toward higher levels of employment, policy accommodation will no longer be needed and the funds rate will be raised. but it does not appear that we are as yet at that point. the federal reserve has opted to keep its policy rate quite low and has said it can be patient in removing the degree of accommodation. although the economy has indeed strengthened over the past few quarters, job growth has been anemic and considerable slack persists in labor markets. at the same time, inflation has been quite low and shows few signs that it is in the process of picking up. recently, some observers have been calling for the federal reserve to begin the tightening process sooner rather than later. in a few cases, the reasoning appears to be that we are risking a major increase in inflation by waiting. but most of the calls for a prompt policy tightening are instead based on the concern that the federal reserve, by keeping the funds rate so low and signaling that it is likely to stay low for a while, is sowing the seeds for different kinds of future problems. in particular, these critics worry that a continued environment of low interest rates is giving rise

economic research, march ). see, for example, tobias adrian and hyun song shin ( 2010 ), “ liquidity and leverage ”, journal of financial intermediation, vol. 19 ( july ), pp. 418 – 37 ; and tobias adrian and hyun song shin ( 2011 ), “ financial intermediaries and monetary economics ”, in benjamin friedman and michael woodford, eds., handbook of monetary economics, vol. 3a ( san diego, ca. : elsevier ), pp. 601 – 50. for a study emphasizing how changes in the response of monetary policy to financial vulnerabilities would likely change the relationship between bis central bankers ’ speeches vulnerabilities from excessive leverage and reliance on short - term funding in the financial sector grew rapidly through the middle of 2007, well after monetary policy had already tightened significantly relative to the accommodative policy stance of 2003 and early 2004. in my assessment, macroprudential policies, such as regulatory limits on leverage and shortterm funding, as well as stronger underwriting standards, represent far more direct and likely more effective methods to address these vulnerabilities. 5 recent international experience turning to recent experience outside the united states, a number of foreign economies have seen rapidly rising real estate prices, which has raised financial stability concerns despite, in some cases, high unemployment and shortfalls in inflation relative to the central bank ’ s inflation target. 6 these developments have prompted debate on how to best balance the use of monetary policy and macroprudential tools in promoting financial stability. for example, canada, switzerland, and the united kingdom have expressed a willingness to use monetary policy to address financial stability concerns in unusual circumstances, but they have similarly concluded that macroprudential policies should serve as the primary tool to pursue financial stability. in canada, with inflation below target and output growth quite subdued, the bank of canada has kept the policy rate at or below 1 percent, but limits on mortgage lending were tightened in each of the years from 2009 through 2012, including changes in loan - to - value and debt - to - income caps, among other measures. 7 in contrast, in norway and sweden, monetary policy decisions have been influenced somewhat by financial stability concerns, but the steps taken have been limited. in norway, policymakers increased the policy interest rate in mid - 2010 when they were facing escalating household debt despite inflation below target and output below capacity, in part as a way of “ guarding against