william c dudley : why financial stability is a necessary prerequisite for an effective monetary policy remarks by mr william c dudley, president and chief executive officer of the federal reserve bank of new york and chairman of the committee on the global financial system ( cgfs ), at the andrew crockett memorial lecture, bank for international settlements 2013 annual general meeting, basel, 23 june 2013. * * * this panel is entitled monetary policy and banking. 1 that takes in a lot of territory. rather than try to cover the waterfront, i am going to start with a single premise : financial stability is a necessary prerequisite for an effective monetary policy. there is a critical chain of linkages from monetary policy to banking and onwards to the real economy. financial stability is a necessary condition for those linkages to operate effectively. thus, it is a necessary condition for monetary policy to be able to achieve its economic objectives. i will then outline briefly what i see as some of the major implications that stem from that premise. these include that the central bank has a major role to play in ensuring financial stability and should evaluate the stance of monetary policy in light of problems in the financial system that may impair the monetary policy transmission mechanism. 2 in my mind, the biggest lesson of the financial crisis has been that monetary policy cannot work properly when there is financial instability. when financial instability occurs, it disturbs market functioning and can also impair bank balance sheets. the result can be disruption to the financial intermediation function with resulting constraints on the availability of credit for households and businesses. this, in turn, can lead to further reductions in aggregate demand that put additional stress on the weakened financial system. obviously, this is not a favorable dynamic. financial instability can impact the conduct of monetary policy via three major channels. first, financial instability can generate a sufficiently large shock to aggregate demand that the central bank may encounter the zero lower bound constraint – the constraint that the monetary policy instrument, for example, the federal funds rate – cannot easily be pushed below zero. in such circumstances, it may not be easy to fully offset the shock through the pursuit of a more stimulative monetary policy. at the zero bound, the central bank is not powerless, and may turn to other monetary policy tools such as forward guidance and large scale asset purchases. but these tools may not be as effective as lowering the short - term rate instrument. in particular, the central bank may not be willing to use these nonconvent

caution against the mechanical use of monetary policy rules following a financial crisis. in the united states, the so - called taylor rule receives considerable attention as a guide to policy. but there are a number of reasons to believe that using it mechanically would result in too tight of a monetary policy setting. while discussing the shortcomings of the taylor rule is beyond the scope of my remarks today, let me make one simple point. if the transmission channels of monetary policy are impaired, then the equilibrium real rate associated with monetary policy neutrality is likely to be considerably lower than the 2. 25 percent real rate assumption embodied in the typical taylor rule formulation. monetary policy needs to take this onboard, even before considering other issues such as risk - management at the zero bound. i have argued today that the central bank needs to have a major role in ensuring that the financial system is sound. without this, the central bank cannot ensure that monetary policy will be effective in achieving its objectives. this is the important linkage of monetary policy to banking. now some express concern that involvement in banking regulation and supervision may lead a central bank to bias the setting of monetary policy to try to help troubled banks or other institutions. this fear is misplaced. problems in the financial sector are taken into account for monetary policy purposes only to the extent that they affect the transmission of policy to the real economy. there is a separate tool kit to address problems at the level of the banks themselves. others will argue that having the central bank involved in the oversight and regulation of the financial system puts too much power in the hands of one authority. another concern is that such a consolidation of responsibilities is dangerous for the central bank because it could threaten the central bank ’ s independence with respect to monetary policy. i think these are legitimate issues. but the bigger risks, in my view, are a monetary policy that fails to accomplish its economic objectives because of financial instability, and difficulties that stem from the inevitably imperfect coordination that takes place between multiple agencies with divided responsibilities during a crisis. in those cases, not only will the central bank own that bad outcome with the resulting negative consequences for its ongoing credibility and effectiveness, but also the economic consequences will be severe for its citizens. to address concerns about central bank power, the best approach is to ensure accountability. this means appropriate oversight by the legislature and ongoing transparency by the central bank about the motivations for its actions, what it can reasonably expect to accomplish, and an honest assessment of its successes and failures. thank you very