Eric S. Rosengren
President and Chief Executive Officer
Federal Reserve Bank of Boston
Randall S. Kroszner
Norman R. Bobins Professor of Economics
University of Chicago Booth School of Business
A great deal of evidence suggests that the Federal Reserve reacts to deviations from full employment and the inflation target. Before the recent crisis, to the extent that financial instability was considered in the FOMC's monetary policy deliberations, it was usually thought of as a hindrance to attaining the dual mandate, much as an oil price shock disrupts the paths of inflation and unemployment. Yet how should risks to financial stability affect the Fed's behavior? The answer depends on judgments about how financial stability may enhance the economy and promote social welfare. Should financial instability only be thought of as something that impedes the attainment of the Fed's employment and inflation goals, or does society care about averting it for other reasons?
Hence, the experience of the financial crisis raises the question of whether financial stability should be an independent third mandate of U.S. monetary policy. In what sense should monetary policymakers care about financial stability, and how should that concern affect their decisionmaking? Is there a separate and independent role for financial stability considerations to play in guiding monetary policy decisions, or is this concern only a derived demand insofar as financial instability might impact the outcomes for its policy goals related to inflation and/or employment? Is there any evidence that the Fed or other central banks have included financial stability concerns in their reaction function? If so, can we distinguish between financial stability being a third, independent mandate compared with central banks inefficiently incorporating their financial stability assessments into their inflation and employment forecasts.
In the wake of the recent crisis, it has been widely acknowledged that this event exposed underlying vulnerabilities in the global financial system. The general view holds that before this watershed event, microprudential supervision was too narrowly focused, and that stability concerns are better achieved by effectively augmenting microprudential policies with additional policies that address macroprudential considerations. While microprudential supervision ideally should incorporate the effects of macroeconomic events on the health of individual institutions, macroprudential supervision addresses additional dimensions. Macro-focused financial stability concerns require more forward-looking supervisory policies, place an additional focus on potential market failures and negative externalities, and apply increased scrutiny to the interactions among financial intermediaries and financial markets. Thus, it is important to understand how macroprudential supervisory policies should work within the existing supervisory framework, and when microprudential supervision and macroprudential supervision might be acting at cross purposes. Sorting out these issues comes down to more clearly distinguishing between macroprudential supervision and microprudential supervision. What is the objective function that supervision taken as a whole is currently attempting to maximize? In particular, are the objective functions for microprudential supervision and for macroprudential supervision different? If so, when conflicts arise, how are these respective goals reconciled within the overall supervisory framework? Does supervision try to minimize the losses from systemically important financial institutions? Does it try to stabilize financial markets? Is it minimizing the losses from a hypothetical insurance fund?
Chairman, Financial Stability Institute
Bank for International Settlements
Assuming that the ultimate goals of macroprudential policies are identical to the aims of monetary policy, what are the implications for each type of policy? If macroprudential supervisory tools are expected to maximize the objective function of monetary policy, does that ultimately make these instruments part of monetary policy? Hence, is macroprudential supervision really just macroprudential monetary policy—meaning the use of supervisory tools to achieve the monetary policy objectives? What are the short-run tradeoffs when trying to achieve the goals of financial stability, price stability, and full employment? What are the coordination issues?
Alternatively, are the two policy instruments independent? Do macroprudential tools allow the monetary authority to avoid the tradeoff between short-run and long-run objectives? For example, if macroprudential tools had been in place in 2004, could the Fed have recognized that although unemployment may have been a bit higher than desired, housing prices were accelerating too rapidly, and that these higher asset prices contained the potential for a future financial crisis? Perhaps a preferred policy mix would have included a tightening of policy targeted at the housing sector, say by lowering the acceptable loan-to-value ratio, while easing the federal funds rate to achieve full employment? If so, and since the macroeconomic policy objectives are the same, should these macroprudential tools be thought of as monetary policy tools rather than supervisory tools? If macroprudential tools are used to achieve the goals of monetary policy, does that mean macroprudential policy should be managed like monetary policy? What are the key governance issues? For example, in the United States, should using these tools be an FOMC function? How are these decisions made in other central banks, like the Bank of England, that are responsible for both functions? What are the long-run implications?
How should monetary and macroprudential policies interact, given that the suitable instruments differ and, in several countries, different authorities are responsible for conducting these policies? On the monetary policy side, it is well recognized that interest rate policies are blunt instruments. Moreover, the traditional lender-of-last-resort tool is not sufficient to address the range of potential financial instability problems that might beset an economy. Thus, what specific macroprudential tools are available and/or needed for more targeted strikes to alleviate emerging financial instabilities? How do these instruments work? How do such macroprudential tools affect the monetary policy target variables, and therefore the other instruments used to conduct monetary policy? Are the implementation lags sufficiently short to be useful? Are there costs associated with using macroprudential tools, such as adverse effects on resource allocation? What macroprudential tools have been used in other advanced economies? What can we learn from the use of such tools in the United States and other countries in terms of their success in avoiding financial crises and/or minimizing deviations from full employment and the inflation target? Do the Federal Reserve's recent bank stress tests work as a macroprudential tool for monetary policy?
Benjamin M. Friedman
William Joseph Maier Professor of Political Economy
The assumption that a central bank can avert, or at least substantially mitigate, the effects of a financial crisis depends on its ability to accurately assess the risks that current financial conditions may engender a future crisis. In light of recent history, is this a tenable view? While we have evidence that indicators of bank health can improve the conduct of monetary policy, what additional information about financial intermediaries and financial markets would be useful for identifying potential episodes of instability emanating from growing financial imbalances? Information about individual bank health does not go far enough, even when aggregated into a measure spanning the entire banking sector. We require much broader information about the interconnections among individual banks, nonbank financial intermediaries, and various domestic and international financial markets. This is particularly the case with the growth of shadow banking and the increased reliance on short-term wholesale funding. What are the broader indicators of future financial difficulties? Are such indicators reliable? If so, how much advance warning do they provide, and how well do central banks identify and interpret these indicators?
Are central banks doomed merely to clean up after financial crises—as opposed to being able to undertake preemptive actions to prevent such crises, or at least mitigate their effects on the real economy? How quickly do macroprudential policies affect the economy? Even if we can identify reliable indicators of growing financial imbalances, do central banks possess the legal authority to act in a timely manner? What are the legal/institutional constraints on the use of such macroprudential policy tools? In particular, does the Federal Reserve currently have sufficient legal authority to act, and to act quickly enough, to address potential sources of financial instability? How have recent restrictions on the ability of the Fed to act, such as those embedded in the Dodd-Frank Act, impaired the Fed's ability to address financial instability issues in a crisis? What role does the Financial Stability Oversight Council play in the recognition and response lags? What about political constraints in the current environment? Alternatively, is trying to stabilize the economy with long-term structural changes, rather than cyclical ones, the only answer? What is the evidence in the U.S. and other countries?