Handout 6 - Duke's Fuqua School of Business |coleman/macro_daytime/...Handout 6 Money, the Federal Reserve, and Financial Crisis Professor Coleman Fuqua School of Business, Duke University

Handout 6

Money the Federal Reserve and Financial Crisis

Professor Coleman Fuqua School of Business Duke University

QampAUS Monetary PolicyAn Introduction

US monetary policy affects all kinds of economic and financial decisions people make in this countrymdashwhether to get a loan to buy a new house or car or to start up a company whether

to expand a business by investing in a new plant or equipment and whether to put savings in a bank in bonds or in the stock market for example Furthermore because the US is the largest economy in the world its monetary policy also has significant economic and financial effects on other countries

The object of monetary policy is to influence the performance of the economy as reflected in such factors as inflation economic output and employment It works by affecting demand across the economymdashthat is peoplersquos and firmsrsquo willingness to spend on goods and services

While most people are familiar with the fiscal policy tools that affect demandmdashsuch as taxes and government spendingmdashmany are less famil-iar with monetary policy and its tools Monetary policy is conducted by the Federal Reserve System the nationrsquos central bank and it influences demand mainly by raising and lowering short-term interest rates

This booklet provides an introduction to US monetary policy as it is currently conducted by answering a series of questions

How is the Federal Reserve structured

What are the goals of US monetary policy

What are the tools of US monetary policy

How does monetary policy affect the US economy

How does the Fed decide the appropriate setting for the policy instrument

Federal Reserve Bank of San Francisco 2004 1

How is the Federal Reserve structured The Federal Reserve System (called the Fed for short) is the nationrsquos central bank It was established by an Act of Congress in 1913 and consists of the Board of Governors in Washington DC and twelve Federal Reserve District Banks (see the map for a discussion of the Fedrsquos overall responsibilities see The Federal Reserve System Purposes and Functions)

The Congress structured the Fed to be independent within the governmentmdashthat is although the Fed is accountable to the Congress and its goals are set by law its conduct of monetary policy is insulated from day-to-day political pressures This reflects the conviction that the people who control the countryrsquos money supply should be independent of the people who frame the governmentrsquos spending decisions

What makes the Fed independent

Three structural features give the Fed independence in its conduct of monetary policy the appointment procedure for Governors the appointment procedure for Reserve Bank Presidents and funding

Appointment procedure for Governors

The seven Governors on the Federal Reserve Board are appointed by the President of the United States and confirmed by the Senate Independence derives from a couple of factors first the appointments are staggered to reduce the chance that a single US President could ldquoloadrdquo the Board with appointees second their terms of office are 14 yearsmdashmuch longer than elected officialsrsquo terms

Appointment procedure for Reserve Bank Presidents

Each Reserve Bank President is appointed to a five-year term by that Bankrsquos Board of Directors subject to final approval by the Board of Governors This procedure adds to independence because the Directors of each Reserve Bank are not chosen by politicians but are selected to provide a cross-section of interests within the region including those of depository institutions nonfinancial businesses labor and the public

Funding

The Fed is structured to be self-sufficient in the sense that it meets its operating expenses primarily from the interest earnings on its portfolio of securities Therefore it is independent of Congressional decisions about appropriations

Federal Reserve Bank of San Francisco 2004

US Monetary Policy An Introduction

2

Federal Reserve Districts



3

1 Boston

2 New York

3 Philadelphia

4 Cleveland

5 Richmond

6 Atlanta

7 Chicago

8 St Louis

9 Minneapolis

10 Kansas City

11 Dallas

12 San Francisco

How is the Fed ldquoindependent within the governmentrdquo Even though the Fed is independent of Congressional appropriations and administrative control it is ultimately accountable to Congress and comes under government audit and review Fed officials report regularly to the Congress on monetary policy regulatory policy and a variety of other issues and they meet with senior Administration officials to discuss the Federal Reserversquos and the federal governmentrsquos economic programs The Fed also reports to Congress on its finances

Who makes monetary policy The Fedrsquos FOMC (Federal Open Market Committee) has primary responsibility for conducting monetary policy The FOMC meets in Washington DC eight times a year and has twelve members the seven members of the Board of Governors the President of the Federal Reserve Bank of New York and four of the other Reserve Bank Presidents who serve in rotation The remaining Reserve Bank Presidents contribute to the Committeersquos discussions and deliberations

In addition the Directors of each Reserve Bank contribute to monetary policy by making recommendations about the appropriate discount rate which are subject to final approval by the Governors (See ldquoWhat are the tools of US monetary policyrdquo)



4

What are the goals of US monetary policy Monetary policy has two basic goals to promote ldquomaximumrdquo sustainable output and employment and to promote ldquostablerdquo prices These goals are prescribed in a 1977 amendment to the Federal Reserve Act

What do maximum sustainable output and employment mean In the long run the amount of goods and services the economy produces (output) and the number of jobs it generates (employment) both depend on factors other than monetary policy These factors include technology and peoplersquos preferences for saving risk and work effort So maximum sustainable output and employment mean the levels consistent with these factors in the long run

But the economy goes through business cycles in which output and employment are above or below their long-run levels Even though monetary policy canrsquot affect either output or employment in the long run it can affect them in the short run For example when demand weakens and therersquos a recession the Fed can stimulate the economymdashtemporarilymdashand help push it back toward its long-run level of output by lowering interest rates Thatrsquos why stabilizing the economymdashthat is smoothing out the peaks and valleys in output and employment around their long-run growth pathsmdashis a key short-run objective for the Fed and many other central banks

If the Fed can stimulate the economy out of a recession why doesnrsquot it stimulate the economy all the time

Persistent attempts to expand the economy beyond its long-run growth path will press capacity constraints and lead to higher and higher inflation without producing lower unemployment or higher output in the long run In other words not only are there no long-term gains from persistently pursuing expansionary policies but therersquos also a pricemdashhigher inflation

Whatrsquos so bad about higher inflation High inflation is bad because it can hinder economic growth and for a lot of reasons For one thing it makes it harder to tell what a change in the price of a particular product means For example a firm that is offered higher prices for its products can have trouble telling how much of the price change is due to stronger demand for its products and how much reflects the economy-wide rise in prices



Moreover when inflation is high it also tends to vary a lot and that makes people uncertain about what inflation will be in the future That uncertainty can hinder economic growth in a couple of waysmdashit adds an inflation risk premium to long-term interest rates and it complicates further the planning and contracting by businesses and households that are so essential to capital formation

Thatrsquos not all Because many aspects of the tax system are not indexed to inflation high inflation distorts economic decisions by arbitrarily increasing or decreasing after-tax rates of return to different kinds of economic activities In addition it leads people to spend time and resources hedging against inflation instead of pursuing more productive activities

Another problem is that a surprise inflation tends to redistribute wealth For example when loans have fixed rates a surprise inflation redistributes wealth from lenders to borrowers because inflation lowers the real burden of making a stream of payments whose nominal value is fixed

So should the Fed try to get the inflation rate to zeroActually therersquos a lot of debate about that While some economists have suggested zero inflation as a target others argue that an inflation rate thatrsquos too low can be a problem For example if inflation is very low or close to zero then short-term interest rates also are likely to be very close to zero In that case the Fed might not have enough room to lower short-term interest rates if it needed to stimulate the economy Of course the Fed could conduct policy using more unconventional methods (such as trying to reduce long-term interest rates) but itrsquos not clear that those methods would be as easy to use or as effective Another problem is that when inflation is very close to zero therersquos a bigger risk of deflation

Whatrsquos so bad about deflationFirst letrsquos talk about the difference between disinflation and deflation Disinflation just means that the rate of inflation is slowingmdashsay from 3 a year to 2 a year Deflation in contrast means that therersquos a fall in prices and itrsquos not just a fall in prices in some sectorsmdashlike the familiar falling prices of a lot of computer equipment Rather in a deflation prices are falling throughout the economy so the inflation rate is negative That may sound good if yoursquore a consumer



But in fact deflation can be as bad as too much inflation And the reasons are pretty similar For example to go back to the case of the fixed-rate loan a surprise deflation also redistributes wealth but in the opposite direction from inflation that is from borrowers to lenders The reason is that deflation raises the real burden of making a stream of payments whose nominal value is fixed

A substantial prolonged deflation like the one during the Great Depression can be associated with severe problems in the financial system It can lead to significant declines in the value of collateral owned by households and firms making it more difficult to borrow And falling collateral values may force lenders to call in outstanding loans which would force firms to cut back their scale of operations and force households to cut back consumption

Finally in a deflationary episode interest rates are likely to be lower than they are during periods of low inflation which means that the Fedrsquos ability to stimulate the economy will be even more limited

So thatrsquos why the other goal is ldquostable pricesrdquo Yes Price ldquostabilityrdquo is basically a low-inflation environment where people and firms can make financial decisions without worrying about where prices are headed Moreover this is all the Fed can achieve in the long run

If low inflation is the only thing the Fed can achieve in the long run why isnrsquot it the sole focus of monetary policy

Because the Fed can determine the economyrsquos average rate of inflation some commentatorsmdashand some members of Congress as wellmdashhave emphasized the need to define the goals of monetary policy in terms of price stability which is achievable

But the Fed of course also can affect output and employment in the short run And big swings in output and employment are costly to people too So in practice the Fed like most central banks cares about both inflation and measures of the short-run performance of the economy

Are the two goals ever in conflict Yes sometimes they are One kind of conflict involves deciding which goal should take precedence at any point in time For example suppose therersquos a recession and the Fed works to prevent employment losses from being too severe this short-run success could turn into a long-run



problem if monetary policy remains expansionary too long because that could trigger inflationary pressures So itrsquos important for the Fed to find the balance between its short-run goal of stabilization and its longer-run goal of maintaining low inflation

Another kind of conflict involves the potential for pressure from the political arena For example in the day-to-day course of governing the country and making economic policy politicians may be tempted to put the emphasis on short-run results rather than on the longer-run health of the economy The Fed is somewhat insulated from such pressure however by its independence which allows it to strive for a more appropriate balance between short-run and long-run objectives

Why donrsquot the goals include helping a region of the country thatrsquos in recession

Often some state or region is going through a recession of its own while the national economy is humming along But the Fed canrsquot concentrate its efforts on expanding the weak region for two reasons First monetary policy works through credit markets and since credit markets are linked nationally the Fed simply has no way to direct stimulus only to a particular part of the country that needs help Second if the Fed stimulated whenever any state had economic hard times it would be stimulating much of the time and this would result in excessive stimulation for the overall country and higher inflation

But this focus on the well-being of the national economy doesnrsquot mean that the Fed ignores regional economic conditions It relies on extensive regional data and anecdotal information along with statistics that directly measure developments in regional economies to fit together a picture of the national economyrsquos performance This is one advantage to having regional Federal Reserve Bank Presidents sit on the FOMC Theyrsquore in close contact with economic developments in their regions of the country

Why donrsquot the goals include trying to prevent stock market ldquobubblesrdquo like the one at the end of the 1990s

In theory stock prices should reflect the value of firmsrsquo ldquofundamentalsrdquo such as their expected future earnings So itrsquos hard to come up with logical explanations for why they would get out of line that is why a bubble would form After all US stock markets are among the most efficient in the worldmdashtherersquos a lot of information available and the



trading mechanisms function very smoothly And stock market analysts and others devote huge amounts of resources to figuring out what the appropriate price of a stock is at any point in time

Even so itrsquos hard to deny the evidence of mispricing from episodes like the rise and fall of the Nasdaq over the last decade or so it went from a monthly average of a little more than 750 in January 1995 to a peak of just over 4800 in March 2000 before falling back to roughly 1350 in March 2003

Unfortunately evidence of a bubble is easy to find after it has burst but itrsquos much harder to find as the bubble is forming The reason is that policymakersmdashand other observersmdashcan find it hard to tell whether stock prices are moving up because fundamentals are changing or because prices are out of line with fundamentals

Even if the Fed suspects that a bubble has developed itrsquos not clear how monetary policy should respond Raising the funds rate by a quarter a half or even a full percentage point probably wouldnrsquot make people slow down their investments in the stock market when individual stock prices are doubling or tripling and even broad stock market indexes are going up by 20 or 30 a year Itrsquos likely that raising the funds rate enough to burst the bubble would do significant harm to the economy For instance some have argued that the Fed may have worsened the Great Depression by trying to deflate the stock market bubble of the late 1920s

Should the Fed ignore the stock market thenNot at all Stock markets provide information about the future course of the economy that the Fed may find useful in conducting policy For instance a sustained increase in the stock market is likely to make households feel wealthier which tends to make them increase their consumption For example if the economy were already at full capacity this would cause inflationary pressures So a sustained increase in the stock market could lead the Fed to modify its inflation and output forecasts and adjust its policy response accordingly

Beyond concerns about the economy the Fed also pays attention to the stock market because of its concerns about financial market stability A good example of this is what happened after the stock market crash of 1987 At that time the Fed cut interest rates and stated that it was ready to supply the liquidity needs of the market because it wanted to ensure that markets would continue to function



What are the tools of US monetary policy The Fed canrsquot control inflation or influence output and employment directly instead it affects them indirectly mainly by raising or lowering a short-term interest rate called the ldquofederal fundsrdquo rate Most often it does this through open market operations in the market for bank reserves known as the federal funds market

What are bank reserves Banks and other depository institutions (for convenience wersquoll refer to all of these as ldquobanksrdquo) keep a certain amount of funds in reserve to meet unexpected outflows Banks can keep these reserves as cash in their vaults or as deposits with the Fed In fact banks are required to hold a certain amount in reserves But typically they hold even more than theyrsquore required to in order to clear overnight checks restock ATMs and make other payments

What is the federal funds market From day to day the amount of reserves a bank wants to hold may change as its deposits and transactions change When a bank needs additional reserves on a short-term basis it can borrow them from other banks that happen to have more reserves than they need These loans take place in a private financial market called the federal funds market

The interest rate on the overnight borrowing of reserves is called the federal funds rate or simply the ldquofunds raterdquo It adjusts to balance the supply of and demand for reserves For example if the supply of reserves in the fed funds market is greater than the demand for reserves then the funds rate falls and if the supply is less than the demand then the funds rate rises

What are open market operations The major tool the Fed uses to affect the supply of reserves in the banking system is open market operationsmdashthat is the Fed buys and sells government securities on the open market These operations are conducted by the Federal Reserve Bank of New York

Suppose the Fed wants the funds rate to fall To do this it buys government securities from a bank The Fed then pays for the securities by increasing that bankrsquos reserves As a result the bank now has more reserves than it wants So the bank can lend these unwanted reserves to



another bank in the federal funds market Thus the Fedrsquos open market purchase increases the supply of reserves to the banking system and the federal funds rate falls

When the Fed wants the funds rate to rise it does the reverse that is it sells government securities The Fed receives payment in reserves from banks which lowers the supply of reserves in the banking system and the funds rate rises

What is the discount rate Banks also can borrow reserves directly from the Federal Reserve Banks at their ldquodiscount windowsrdquo and the discount rate is the rate that financially sound banks must pay for this ldquoprimary creditrdquo The Boards of Directors of the Reserve Banks set these rates subject to the review and determination of the Federal Reserve Board (ldquoSecondary creditrdquo is offered at higher interest rates and on more restrictive terms to institutions that do not qualify for primary credit) Since January 2003 the discount rate has been set 100 basis points above the funds rate target though the difference between the two rates could vary in principle Setting the discount rate higher than the funds rate is designed to keep banks from turning to this source before they have exhausted other less expensive alternatives At the same time the (relatively) easy availability of reserves at this rate effectively places a ceiling on the funds rate

What about foreign currency operations Purchases and sales of foreign currency by the Fed are directed by the FOMC acting in cooperation with the Treasury which has overall responsibility for these operations The Fed does not have targets or desired levels for the exchange rate Instead the Fed gets involved to counter disorderly movements in foreign exchange markets such as speculative movements that may disrupt the efficient functioning of these markets or of financial markets in general For example during some periods of disorderly declines in the dollar the Fed has purchased dollars (sold foreign currency) to absorb some of the selling pressure

Intervention operations involving dollars whether initiated by the Fed the Treasury or by a foreign authority are not allowed to alter the supply of bank reserves or the funds rate The process of keeping intervention from affecting reserves and the funds rate is called the ldquosterilizationrdquo of exchange market operations As such these operations are not used as a tool of monetary policy



How does monetary policy affect the US economy The point of implementing policy through raising or lowering interest rates is to affect peoplersquos and firmsrsquo demand for goods and services This section discusses how policy actions affect real interest rates which in turn affect demand and ultimately output employment and inflation

What are real interest rates and why do they matter For the most part the demand for goods and services is not related to the market interest rates quoted in the financial pages of newspapers known as nominal rates Instead it is related to real interest ratesmdashthat is nominal interest rates minus the expected rate of inflation

For example a borrower is likely to feel a lot happier about a car loan at 8 when the inflation rate is close to 10 (as it was in the late 1970s) than when the inflation rate is close to 2 (as it was in the late 1990s) In the first case the real (or inflation-adjusted) value of the money that the borrower would pay back would actually be lower than the real value of the money when it was borrowed Borrowers of course would love this situation while lenders would be disinclined to make any loans

So why doesnrsquot the Fed just set the real interest rate on loansRemember the Fed operates only in the market for bank reserves Because it is the sole supplier of reserves it can set the nominal funds rate The Fed canrsquot set real interest rates directly because it canrsquot set inflation expectations directly even though expected inflation is closely tied to what the Fed is expected to do in the future Also in general the Fed has stayed out of the business of setting nominal rates for longer-term instruments and instead allows financial markets to determine longer-term interest rates

How can the Fed influence long-term rates thenLong-term interest rates reflect in part what people in financial markets expect the Fed to do in the future For instance if they think the Fed isnrsquot focused on containing inflation theyrsquoll be concerned that inflation might move up over the next few years So theyrsquoll add a risk premium to long-term rates which will make them higher In other words the marketsrsquo expectations about monetary policy tomorrow have a substantial impact on long-term interest rates today Researchers have pointed out that the Fed could inform markets about future values of the funds rate in a



number of ways For example the Fed could follow a policy of moving gradually once it starts changing interest rates Or the Fed could issue statements about what kinds of developments the FOMC is likely to focus on in the foreseeable future the Fed even could make more explicit statements about the future stance of policy

How do these policy-induced changes in real interest rates affect the economy

Changes in real interest rates affect the publicrsquos demand for goods and services mainly by altering borrowing costs the availability of bank loans the wealth of households and foreign exchange rates

For example a decrease in real interest rates lowers the cost of borrowing that leads businesses to increase investment spending and it leads households to buy durable goods such as autos and new homes

In addition lower real rates and a healthy economy may increase banksrsquo willingness to lend to businesses and households This may increase spending especially by smaller borrowers who have few sources of credit other than banks

Lower real rates also make common stocks and other such investments more attractive than bonds and other debt instruments as a result common stock prices tend to rise Households with stocks in their portfolios find that the value of their holdings is higher and this increase in wealth makes them willing to spend more Higher stock prices also make it more attractive for businesses to invest in plant and equipment by issuing stock

In the short run lower real interest rates in the US also tend to reduce the foreign exchange value of the dollar which lowers the prices of the US-produced goods we sell abroad and raises the prices we pay for foreign-produced goods This leads to higher aggregate spending on goods and services produced in the US

The increase in aggregate demand for the economyrsquos output through these different channels leads firms to raise production and employment which in turn increases business spending on capital goods even further by making greater demands on existing factory capacity It also boosts consumption further because of the income gains that result from the higher level of economic output



How does monetary policy affect inflationWages and prices will begin to rise at faster rates if monetary policy stimulates aggregate demand enough to push labor and capital markets beyond their long-run capacities In fact a monetary policy that persistently attempts to keep short-term real rates low will lead eventually to higher inflation and higher nominal interest rates with no permanent increases in the growth of output or decreases in unemployment As noted earlier in the long run output and employment cannot be set by monetary policy In other words while there is a trade-off between higher inflation and lower unemployment in the short run the trade-off disappears in the long run

Policy also affects inflation directly through peoplersquos expectations about future inflation For example suppose the Fed eases monetary policy If consumers and businesspeople figure that will mean higher inflation in the future theyrsquoll ask for bigger increases in wages and prices That in itself will raise inflation without big changes in employment and output

Doesnrsquot US inflation depend on worldwide capacity not just US capacity

In this era of intense global competition it might seem parochial to focus on US capacity as a determinant of US inflation rather than on world capacity For example some argue that even if unemployment in the US drops to very low levels US workers wouldnrsquot be able to push for higher wages because theyrsquore competing for jobs with workers abroad who are willing to accept much lower wages The implication is that inflation is unlikely to rise even if the Fed adopts an easier monetary policy

This reasoning doesnrsquot hold up too well however for a couple of reasons First a large proportion of what we consume in the US isnrsquot affected very much by foreign trade One example is health care which isnrsquot traded internationally and which amounts to nearly 15 of US GDP

More important perhaps is the fact that such arguments ignore the role of flexible exchange rates If the Fed were to adopt an easier policy it would tend to increase the supply of US dollars in the market Ultimately this would tend to drive down the value of the dollar relative to other countries as US consumers and firms used some of this increased money supply to buy foreign goods and foreigners got rid of the additional US currency they did not want Thus the price of foreign goods in terms of US dollars would go upmdasheven though they would



not in terms of the foreign currency The higher prices of imported goods would in turn tend to raise the prices of US goods

How long does it take a policy action to affect the economy and inflation

It can take a fairly long time for a monetary policy action to affect the economy and inflation And the lags can vary a lot too For example the major effects on output can take anywhere from three months to two years And the effects on inflation tend to involve even longer lags perhaps one to three years or more

Why are the lags so hard to predictSo far wersquove described a complex chain of events that links a change in the funds rate with subsequent changes in output and inflation Developments anywhere along this chain can alter how much a policy action will affect the economy and when

For example one link in the chain is long-term interest rates and they can respond differently to a policy action depending on the marketrsquos expectations about future Fed policy If markets expect a change in the funds rate to be the beginning of a series of moves in the same direction theyrsquoll factor in those future changes right away and long-term rates will react by more than if markets had expected the Fed to take no further action In contrast if markets had anticipated the policy action long-term rates may not move much at all because they would have factored it into the rates already As a result the same policy move can appear to have different effects on financial markets and through them on output and inflation

Similarly the effect of a policy action on the economy also depends on what people and firms outside the financial sector think the Fed action means for inflation in the future If people believe that a tightening of policy means the Fed is determined to keep inflation under control theyrsquoll immediately expect low inflation in the future so theyrsquore likely to ask for smaller wage and price increases and this will help achieve low inflation But if people arenrsquot convinced that the Fed is going to contain inflation theyrsquore likely to ask for bigger wage and price increases and that means that inflation is likely to rise In this case the only way to bring inflation down is to tighten so much and for so long that there are significant losses in employment and output



What problems do lags cause The Fedrsquos job would be much easier if monetary policy had swift and sure effects Policymakers could set policy see its effects and then adjust the settings until they eliminated any discrepancy between economic developments and the goals

But with the long lags associated with monetary policy actions the Fed must try to anticipate the effects of its policy actions into the distant future To see why suppose the Fed waits to shift its policy stance until it actually sees an increase in inflation That would mean that inflationary momentum already had developed so the task of reducing inflation would be that much harder and more costly in terms of job losses Not surprisingly anticipating policy effects in the future is a difficult task




The Fedrsquos job of stabilizing output in the short run and promoting price stability in the long run involves several steps First the Fed tries to estimate how the economy is doing now and how itrsquos likely to do in the near termmdashsay over the next couple of years or so Then it compares these estimates to its goals for the economy and inflation If therersquos a gap between the estimates and the goals the Fed then has to decide how forcefully and how swiftly to act to close that gap Of course the lags in policy complicate this process But so do a host of other things

What things complicate the process of determining how the economy is doing

Even the most up-to-date data on key variables like employment growth productivity and so on reflect conditions in the past not conditions today thatrsquos why the process of monetary policymaking has been compared to driving while looking only in the rearview mirror So to get a reasonable estimate of current and near-term economic conditions the Fed first tries to figure out what the most relevant economic developments are these might be things like the governmentrsquos taxing and spending policies economic developments abroad financial conditions at home and abroad and the use of new technologies that boost productivity These developments can then be incorporated into an economic model to see how the economy is likely to evolve over time

Sounds easymdashplug the numbers into the model and get an answer So whatrsquos the problem

There are lots of problems One problem is that models are only approximationsmdashthey canrsquot capture the full complexity of the economy Another problem is that so far no single model adequately explains the entire economymdashat least you canrsquot get economists to agree on a single model and no single model outperforms others in predicting future developments in every situation Another problem is that the forecast can be off base because of unexpected even unprecedented developmentsmdashthe September 11 attacks are a case in point So in practice the Fed tries to deal with this uncertainty by using a variety of models and indicators as well as informal methods to construct a picture of the economy These informal methods can include anecdotes and other information collected from all kinds of sources such as the Directors of the Federal Reserve Banks the Fedrsquos various advisory bodies and the press



So now are we in a position to compare the Fedrsquos estimates with its goals

Not so fast Coming up with operational measures of the goals is harder than you might think especially the goal for the rate of maximum sustainable output growth Unfortunately this is not something you can go out and measure So once again the Fed has to turn to some sort of model or indicator to estimate it And itrsquos hard to be certain about any estimate in part because itrsquos hard to be certain that the model or indicator the estimate is based on is the right one Therersquos one more important complication in estimating the rate of maximum sustainable growthmdashit can shift over time

What problems does a shift in the rate of maximum sustainable growth cause

The experience of the late 1990s provides a good example of the policy problems caused by such a shift During this period output and productivity surged at the same time that rapid innovation was transforming the information technology industry In the early stages there was no way for the Fedmdashor anybody elsemdashto tell why output was growing so fast In other words the Fed had to determine how much of the surge in output was due to unusually rapid technical progress and whether this implied an increase in the economyrsquos trend growth rate

This was a crucial issue because policy would respond differently depending on exactly why the economy was growing faster If it was largely due to the spread of new technologies that enhanced worker and capital productivity implying that the trend growth rate was higher then the economy could expand faster without creating inflationary pressures In that case monetary policy could stand pat But if it was just the econ-omy experiencing a more normal business cycle expansion then inflation could heat up In that case monetary policy would need to tighten up

The Fedrsquos job was complicated by the fact that statistical models did not find sufficient evidence to suggest a change in the trend growth rate But the Fed looked at a variety of indicators such as the profit data from firms as well as at informal evidence such as anecdotes to conclude that the majority of the evidence was consistent with an increase in the trend growth rate On that basis the Fed refrained from tightening policy as much as it would have otherwise

Does the trend growth rate ever fallYes it does A good example with a pretty bad outcome was what happened in the early 1970s a period marked by a significant slowdown



in the trend growth rate A number of economists have argued that the difficulty in determining that such a slowdown had actually taken place caused the Fed to adopt an easier monetary policy than it might otherwise have which in turn contributed to the substantial acceleration in inflation observed later in the decade

What happens when the estimates for growth and inflation are different from the Fedrsquos goals

Letrsquos take the case where the forecast is that growth will be below the goal That would suggest a need to ease policy But thatrsquos not all The Fed also must decide two other things (1) how strongly to respond to this deviation from the goal and (2) how quickly to try to eliminate the gap Once again it can use its models to try to determine the effects of various policy actions And once again the Fed must deal with the problems associated with uncertainty as well as with the measurement problems we have already discussed

Uncertainty seems to be a problem at every stage How does the Fed deal with it

Uncertainty does indeed pervade every part of the monetary policy-making process There is as yet no set of policies and procedures that policymakers can use to deal with all the situations that may arise Instead policymakers must decide how to proceed by going case by case

For instance when policymakers are more uncertain about their reading of the current state of the economy they may react more gradually to economic developments than they would otherwise And because itrsquos hard to come up with unambiguous benchmarks for the economyrsquos performance the Fed may look at more than one kind of benchmark For instance because itrsquos hard to get a precise estimate of the trend growth rate of output the Fed may look at the labor market to try to figure out where the unemployment rate is relative to some kind of benchmark or ldquonatural raterdquo that is the rate that would be consistent with price stability Alternatively it might try to determine whether the stance of policy is appropriate by comparing the real funds rate to an estimate of the ldquoequilibrium interest raterdquo which can be defined as the real rate that would be consistent with maximum sustainable output in the long run

These issues are far from settled Indeed the Fed spends a great deal of time and effort in researching various ways to deal with different kinds of uncertainty and in trying to figure out what kind of model or indicator is likely to perform best in a given situation Since these issues arenrsquot likely to be resolved anytime soon the Fed is likely to continue to look at everything



Suggested ReadingFor an overview of the Federal Reserve System and its functions see

The Federal Reserve System Purposes and Functions 8th ed Washington DC Board of Governors Federal Reserve System December 1994

The Federal Reserve System in Brief Federal Reserve Bank of San Francisco

For further discussion on several of the topics in this booklet see the following issues of the Federal Reserve Bank of San Franciscorsquos FRBSF Economic Letter

Overview of Monetary Policy

94-27 ldquoA Primer on Monetary Policy Part I Goals and Instrumentsrdquo by Carl Walsh

Goals of Monetary Policy

2003-34 ldquoShould the Fed React to the Stock Marketrdquo by Kevin Lansing

2001-03 ldquoInflation The 2 Solutionrdquo by Milton Marquis

2000-24 ldquoShould Central Banks Stabilize Pricesrdquo by Carl Walsh

99-04 ldquoThe Goals of US Monetary Policyrdquo by John Judd and Glenn Rudebusch

98-18 ldquoUS Inflation Targeting Pro and Conrdquo by Glenn Rudebusch and Carl Walsh

98-17 ldquoCentral Bank Inflation Targetingrdquo by Glenn Rudebusch and Carl Walsh

98-04 ldquoThe New Output-Inflation Trade-offrdquo by Carl Walsh

97-27 ldquoWhat Is the Optimal Rate of Inflationrdquo by Timothy Cogley

97-01 ldquoNobel Views on Inflation and Unemploymentrdquo by Carl Walsh

95-16 ldquoCentral Bank Independence and Inflationrdquo by Robert T Parry

94-25 ldquoShould the Central Bank Be Responsible for Regional Stabilizationrdquo by Timothy Cogley and Desiree Schaan

94-05 ldquoIs There a Cost to Having an Independent Central Bankrdquo by Carl Walsh

93-44 ldquoInflation and Growthrdquo by Brian Motley

93-21 ldquoFederal Reserve Independence and the Accord of 1951rdquo by Carl Walsh

Monetary Policy Tools and the Transmission Mechanism

2002-30 ldquoSetting the Interest Raterdquo by Milton Marquis

97-18 ldquoInterest Rates and Monetary Policyrdquo by Glenn Rudebusch

95-23 ldquoFederal Reserve Policy and the Predictability of Interest Ratesrdquo by Glenn Rudebusch

95-05 ldquoWhat Are the Lags in Monetary Policyrdquo by Glenn Rudebusch



The Conduct of Monetary Policy

2004-05 ldquoPrecautionary Policiesrdquo by Carl Walsh

2003-32 ldquoThe Natural Rate of Interestrdquo by John Williams

2003-15 ldquoWhat Makes the Yield Curve Moverdquo by Tao Wu

2003-14 ldquoMinding the Speed Limitrdquo by Carl Walsh

2001-26 ldquoTransparency in Monetary Policyrdquo by Carl Walsh

2001-13 ldquoThe Science (and Art) of Monetary Policyrdquo by Carl Walsh

2001-05 ldquoHow Sluggish Is the Fedrdquo by Glenn Rudebusch

2000-31 ldquoMonetary Policy in a New Environment The US Experiencerdquo by Robert T Parry

2000-21 ldquoExploring the Causes of the Great Inflationrdquo by Kevin Lansing

99-33 ldquoRisks in the Economic Outlookrdquo by Robert T Parry

99-21 ldquoSupply Shocks and the Conduct of Monetary Policyrdquo by Bharat Trehan

98-38 ldquoDescribing Fed Behaviorrdquo by John Judd and Glenn Rudebusch

98-28 ldquoThe Natural Rate NAIRU and Monetary Policyrdquo by Carl Walsh

97-35 ldquoNAIRU Is It Useful for Monetary Policyrdquo by John Judd

97-29 ldquoA New Paradigmrdquo by Bharat Trehan

94-13 ldquoMonetary Policy in a Low-Inflation Regimerdquo by Timothy Cogley

93-42 ldquoMonetary Policy and Long-Term Real Interest Ratesrdquo by Timothy Cogley

93-38 ldquoReal Interest Ratesrdquo by Bharat Trehan

93-01 ldquoAn Alternative Strategy for Monetary Policyrdquo by Brian Motley and John Judd

Where to get copies of publications and articles in ldquoSuggested Readingrdquo

Links to these articles are in the online version of this pamphlet

wwwfrbsforgpublicationsfederalreservemonetaryreadinghtml

To order print copies contact

Public Information DepartmentFederal Reserve Bank of San FranciscoPO Box 7702San Francisco CA 94120

Phone (415) 974-2163Fax (415) 974-3341E-mail sfpubssffrborg



Glossary of Terms

Capital market The market in which corporate equity and longer-term debt securities (those maturing in more than one year) are issued and traded

Central bank Principal monetary authority of a nation which performs several key functions including issuing currency and regulating the supply of money and credit in the economy The Federal Reserve is the central bank of the United States

Depository institution Financial institution that obtains its funds mainly through deposits from the public includes commercial banks savings and loan associations savings banks and credit unions

Discount rate Interest rate at which an eligible depository institution may borrow funds typically for a short period directly from a Federal Reserve Bank The law requires that the Board of Directors of each Reserve Bank establish the discount rate every fourteen days subject to the approval of the Board of Governors

Excess reserves Amount of reserves held by an institution in excess of its reserve requirement and required clearing balance

Federal funds rate The interest rate at which banks borrow surplus reserves and other immediately available funds The federal funds rate is the shortest short-term interest rate with maturities on federal funds concentrated in overnight or one-day transactions

Fiscal policy Federal government policy regarding taxation and spending set by Congress and the Administration

Foreign currency operations Purchase or sale of the currencies of other nations by a central bank for the purpose of influencing foreign exchange rates or maintaining orderly foreign exchange markets Also called foreign exchange market intervention

Foreign exchange rate Price of the currency of one nation in terms of the currency of another nation

Government securities Securities issued by the US Treasury or federal agencies

Gross domestic product (GDP) The total market value of a nationrsquos final output of goods and services GDP may be expressed in terms of productmdashconsumption investment government purchases of goods and services and net exportsmdashor it may be expressed in terms of income earnedmdashwages interest and profits




Inflation The rate of increase of the general price level of all goods and services (This should not be confused with increases in the prices of specific goods relative to the prices of other goods)

Inflationary expectations The rate of increase in the general price level anticipated by the public in the period ahead

Long-term interest rates Interest rates on loan contractsmdashor debt instruments such as Treasury bonds or utility industrial or municipal bondsmdashhaving maturities greater than one year Often called capital market rates

M1 Measure of the US money stock that consists of (1) currency outside the US Treasury Federal Reserve Banks and the vaults of depository institutions (2) travelers checks of nonbank issuers (3) demand deposits at all commercial banks other than those due to depository institutions the US government and foreign banks and official institutions less cash items in the process of collection and Federal Reserve float and (4) other checkable deposits (OCDs) consisting of negotiable order of withdrawal (NOW) and automatic transfer service (ATS) accounts at depository institutions credit union share draft accounts and demand deposits at thrift institutions

M2 Measure of the US money stock that consists of M1 plus savings deposits (including money market deposit accounts) small-denomination time deposits (time depositsmdashincluding retail RPsmdashin amounts of less than $100000) and balances in retail money market mutual funds Excludes individual retirement account (IRA) and Keogh balances at depository institutions and money market funds

M3 Measure of the US money stock that consists of M2 plus large-denomination time deposits (in amounts of $100000 or more) balances in institutional money funds RP liabilities (overnight and term) issued by all depository institutions and Eurodollars (overnight and term) held by US residents at foreign branches of US banks worldwide and at all banking offices in the United Kingdom and Canada Excludes amounts held by depository institutions the US government money funds and foreign banks and official institutions

Market interest rates Rates of interest paid on deposits and other investments determined by the interaction of the supply of and demand for funds in financial markets

Monetary policy A central bankrsquos actions to influence short-term interest rates and the supply of money and credit as a means of helping to promote national economic goals Tools of US monetary policy include open market operations discount rate policy and reserve requirements


Nominal interest rates Stated rates of interest paid or earned often thought of as consisting of a real rate of interest and a premium to compensate for expected inflation

Open market operations Purchases and sales of government and certain other securities in the open market through the Domestic Trading Desk at the Federal Reserve Bank of New York as directed by the Federal Open Market Committee Open market operations influence short-term interest rates and the volume of money and credit in the economy Purchases inject reserves into the banking system and stimulate growth of money and credit sales do the opposite

Productivity The amount of output per hour of work

Real GDP The value of GDP in constant (that is inflation-adjusted) dollars which is used as a measure of the nationrsquos final output

Real interest rates Interest rates adjusted for the expected erosion of purchasing power resulting from inflation Technically defined as nominal interest rates minus the expected rate of inflation

Short-term interest rates Interest rates on loan contractsmdashor debt instruments such as Treasury bills bank certificates of deposit or commercial papermdashhaving maturities less than one year Often called money market rates

Total nonfinancial debt Includes outstanding credit market debt of federal state and local governments and of private nonfinancial sectors (including mortgages and other kinds of consumer credit and bank loans corporate bonds commercial paper bankers acceptances and other debt instruments)



Speech Governor Kevin Warsh At the Shadow Open Market Committee New York New York March 26 2010

An Ode to Independence

Thank you for welcoming me to a meeting of the Shadow Open Market Committee1

The overall profitability and balance sheet strength of large US enterprises is impressive at this stage of recovery Equity prices and credit terms in liquid markets corroborate these improved fundamentals And for these firms financial market conditions appear quite supportive of economic growth

Still significant economic challenges persist While recent trends in personal consumption and business investment trends are positive the underlying strength of the economy over the medium term is less clear Unemployment remains high and stubbornly so Small and medium-sized enterprises which have tended to lead recoveries are still hesitant to expand--revenue growth is tepid costs are uncertain and credit conditions remain more difficult than for large firms

Increases in government expenditures around the world--ostensibly instituted as a bulwark against further economic weakness--are raising fiscal deficits significantly Unsustainable projected fiscal debt loads--including large and growing implicit guarantees bestowed upon large financial firms by governments--are raising concerns in sovereign debt markets

Taking account of the broad range of economic and financial conditions there is no wonder that the electorate--in the United States and abroad--is unnerved The uncomfortable juxtaposition of financial and economic realities has caused some fundamental precepts of the so-called Anglo-American economic model to be attacked

Allow me to join your discussion on an increasingly questioned foundation of our economic system the independent status of central banks

Institutional Credibility at Stake Monetary accommodation from the worlds largest central banks remains extraordinary Policy decisions made in response to the global financial crisis resulted in dramatic changes in the size and composition of central bank balance sheets The Federal Reserves balance sheet has nearly tripled including about $12 trillion of new mortgage-related securities matched by a rise in excess reserve balances

Yet the Federal Reserves most significant asset like many other central banks is not on its swollen balance sheet Neither can it be found in the lengthy footnotes of its audited financial statements Nor is it tucked away in the recesses of the Federal Reserve Act like the long-dormant now renowned section 13(3)

The Feds greatest asset is its institutional credibility This institutional credibility is rooted in its inflation-fighting credibility but it is broader still2 It is tied up in the full range of Fed actions and balance sheet commitments This credibility is essential It increases the heft of our communications It gives weight to our economic assessments It amplifies the effect of announced changes in the short-term policy rate on longer-term rates It is in some sense the real money multiplier in the conduct of policy

Given its immense value we should not forget that the Federal Reserves hard-earned credibility is no birthright It is as much nurture as nature It was earned by our predecessors in the conduct of their duties making considered judgments consistent with the statutory mandate of price stability and maximum employment Fortunately for the asset to be burnished and bestowed upon the current crop of central bankers it did not demand perfect clairvoyance or infallible judgments But it did require fierce independence from the whims of Washington and the wants of Wall Street and from a pernicious short-termism that can undermine the proper conduct of policy This fierce independence is needed perhaps now more than ever

Central bank independence is precious It can be taken for granted in benign times but it is tested when times get tough And we still have tough times ahead of us My colleagues and I must demonstrate that Fed independence has not been relegated and the Feds long-term objectives not compromised Ensuring Fed independence--as the cornerstone of institutional credibility--is our charge to keep It is central to what the Federal Reserve represents and to how policy is conducted

The mantra of Fed independence is not some throw-away line that seeks to absolve the central bank of accountability To the contrary institutional credibility demands transparency so that the Feds performance of its responsibilities can be judged on the merits

But the call for central bank independence can be misunderstood its defense misconstrued its threats dismissed and the consequences of its breach underestimated In the balance of my remarks I will discuss these issues

Central Bank Actions at the Waters Edge The Congress is currently immersed in a significant policy debate on the role of the central bank as part of legislation described by its authors as comprehensive fundamental regulatory reform3 And it is worth remembering that the Federal Reserve is the nations third significant experiment with a central bank4 As the Federal Reserve nears its centennial the Feds longevity should not allow our memories to fail us on its origin and the scope of its remit Let me explain

The grant of authority to the central bank is a considered judgment of the nations elected representatives Central bankers are entrusted with a revocable privilege So declarations of independence by Fed policymakers are heartening But independence is ours to demonstrate not principally to declare And central bankers err if they presume that independence is some inalienable right some entitlement

A misconception on the nature of the central banks authority gives succor to Fed critics The Fed is not independent from government It is independent within government And elected representatives have every right to redraw the central banks authority even if a fuller reading of economic history considers it unwise

The Federal Reserves defenders also err if they seek to extend the Feds vaunted independence to the full range of its activities My reading has it that the Congress granted the Fed independence in the conduct of monetary policy In my view no particular deference is owed--no promise of non-intervention due--in the conduct of regulatory policy consumer protection or other responsibilities granted to the Federal Reserve This sharp distinction should be sustained as the Congress considers revisions to the Federal Reserves charter

So delineating that which constitutes the conduct of monetary policy--as distinct from these other activities--is critical In normal times there is less confusion The Fed establishes short-term risk-free interest rates across the economy And it does its level best to signal the appropriate path of policy to ensure low and stable prices and maximum employment over the horizon The Feds lender of last resort authority manifests itself--usually only sparingly--in the operation of the discount window lending against good collateral at a penalty rate

In times of more significant economic and financial distress the pace of monetary accommodation often increases And when liquidity becomes scarce--as was the case during the Panic of 2008--the Fed finds itself charged with more novel and significant challenges in providing liquidity to institutions and markets5

History teaches us that fiscal and monetary policies tend to blur in these times of crisis Capital and liquidity issues become difficult to disentangle at troubled institutions 6 Capital offsets losses Liquidity bridges gaps in funding And well-intentioned policymakers are compelled to make tough judgments amid significant time constraints What constitutes an emergency liquidity provision backed by good collateral at a penalty price And what is more aptly characterized as a fiscal provision to bolster capital

The Federal Reserve must do its utmost to stay foursquare within its role as liquidity provider The Feds financial stability responsibilities which may well be elevated in pending legislation should not give license to central bankers to be emergency capital providers Capital allocations should reside if anywhere with the fiscal authority and its fiscal agent the Department of Treasury

The Fed as first-responder must strongly resist the temptation to be the ultimate rescuer No matter the congressional calendar or the pleadings of the elected the Fed is not a repair shop for broken statutes or broken financial ecosystems7 And it should not be an appeals court to those seeking relief from congressional appropriators or the fiscal agents at the Treasury The Feds credibility is severely undermined if it is perceived to wander from its mission into areas more appropriately handled by other parts of government

The Panic of 2008 is now prologue The Feds actions going forward--especially when economic conditions still appear unsatisfactory--should go a long way to demonstrating its allegiance to mission There will no doubt be added pressures for policy makers to aid and comfort the aggrieved That help should be forthcoming does not address the question as to whether it is the institutional prerogative of the Fed to provide it Even if the central bank can does not mean the central bank should

Other Threats to Independence and Credibility There is no such thing as being a little bit independent or a little bit credible

So central bankers must be constantly vigilant especially during times of fiscal expansion Net global debt issuance in 2010 may be three to four times the average of the prior decade8 Ratios of government debt to gross domestic product are growing rapidly among advanced economies As I just discussed the Fed should steer clear of fiscal policy But the threats to independence do not stop there In this environment let me briefly comment on two other pressure points And note that not all of the threats to central bank independence come from outside the walls of the Federal Reserve Some pressures however well-intentioned like in the clicheacuted scary movie may come from inside the house

First governments may be tempted to influence the central bank to keep monetary policy looser longer to finance the debt and stimulate activity In the more static short-run the real burdens of nominal debt could be reduced by higher inflation The consequences just over the horizon however would be most unwelcome Higher expected inflation would lead to higher nominal interest rates increasing the financing needs of the government yet further Moreover higher expected inflation could lead to more variable inflation outcomes and reduced living standards especially for those least able to protect themselves from unexpected price movements9

Central banks must take their own counsel when deciding upon the timing and force in removing monetary policy accommodation I am confident that any attempt to influence inappropriately the conduct of Fed policy would yield a strong and forceful rebuke by Fed officials and market participants alike The only popularity central bankers should seek if at all is in the history books

The second threat in this case to central bank credibility may be better intentioned but it is no less risky Some suggest that central bankers themselves should choose to modify their definitions of price stability If inflation persisted at higher levels during normal

times the theory goes central bankers could cut rates more substantially in response to economic weakness The theory in my view fails the real test of experience

Central banks that desire just a little more inflation may well end up with a lot more Some point to a strategy to accept a little more inflation for less unemployment as a primary basis for the great inflation of the 1970s in the United States10 By definition an increase in an implicit inflation target would lead to an upward shift in inflation expectations And how would a central bank make credible its promise that such a shift would be only a one-time event

We do not understand sufficiently the determinants of inflation expectations to be confident that a regime change can be controlled Central banks here and abroad have worked for decades to get inflation down to levels consistent with price stability We should not risk these hard-won gains In changing the goal posts at this time of consequence substantial harm would be done to a central banks institutional credibility and perhaps lead to an unmooring of inflation expectations Such damage could lead investors to seek alternative currencies with prices of commodities and other hard assets likely to increase

Conclusion Independence in the conduct of monetary policy is at the core of advanced modern economies And it can be too easily forgotten by those who have only known its benefits If the Federal Reserve lost its independence its hard-earned credibility would quickly dissipate The costs to the economy would be incalculable Higher inflation lower standards of living and a currency that risks losing its reserve status

Now more than ever market participants are watching the relationship between central banks and their governments They are keenly gauging whether changes in conditions policies or practices pierce the veil of central bank independence Central bankers the world over must demonstrate that we are worthy of this moment and will be steadfast protectors of our institutions credibility That means respecting our important but circumscribed role in the conduct of policy and performing our mission with competence and consistency

1 The views expressed here are my own and not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee Nellie Liang and Dan Covitz of the Boards staff contributed to these remarks Return to text

2 In the economics literature central bank credibility generally refers to its reputation for being more averse to inflation than the fiscal authority The broad consensus is that credibility along this dimension allows better economic outcomes Credibility anchors

inflation expectations which in turn allows the central bank to keep actual inflation in check See Ben S Bernanke (2005) What Have We Learned since October 1979 (203 KB PDF) Federal Reserve Bank of St Louis Review vol 87 (March-April) part 2 pp 277-82 Return to text

3 See Kevin Warsh (2010) Regulation and Its Discontents speech delivered at the New York Association for Business Economics New York February 3 Return to text

4 The first Bank of the United States was founded in 1791 and its charter expired in 1811 The second Bank of the United States was founded in 1816 and lost its public charter in 1836 Return to text

5 Kevin Warsh (2009) The Panic of 2008 speech delivered at the Council of Institutional Investors 2009 Spring Meeting Washington April 6 Return to text

6 The Feds role as liquidity provider in the Term Asset-Backed Securities Loan Facility (TALF) exemplifies the challenge in drawing clear lines The TALF made loans to investors for the purchase of highly rated assets The assets in turn served as collateral for the loans First losses were borne by the investors as the loan was never for the full value of the assets The Department of Treasury took the second-loss position behind investors thereby acting as a fiscal agent providing credit and taking some risk The Federal Reserve was in a third-loss position and thus aimed to serve the role of liquidity provider Return to text

7 Mortgage finance deserves careful review Quasi-governmental entities like Fannie Mae and Freddie Mac are increasingly being deployed as fiscal agents The Federal Reserves actions should not slow the impetus to implement fundamental reform in housing finance Return to text

8 See for example International Monetary Fund World Economic Outlook Return to text

9 See Thomas J Sargent and Neil Wallace (1981) Some Unpleasant Monetarist Arithmetic (11 MB PDF) Federal Reserve Bank of Minneapolis Quarterly Review vol 5 (Fall) pp 1-17 Return to text

10 See for example Robert J Samuelson (2008) The Great Inflation and Its Aftermath The Past and Future of American Affluence (New York Random House) Return to text

Speech Governor Frederic S Mishkin At the Econometric Society at Duke University Lecture Durham North Carolina Governor Mishkin presented identical remarks at the New Perspectives on Financial Globalization Conference International Monetary Fund Washington DC on April 26 2007 June 23 2007

Globalization and Financial Development

In the United States and many other countries students learn that the key to success is hard work Yet when we look at many developing countries we see people who work extremely hard for long hours Their wages are low and so they remain poor And as a whole their countries remain poor If hard work does not make a country rich what does

The right institutions are essential Nobel laureate Douglass North defines institutions as the rules of the game in a society or more formally humanly devised constraints that shape human intervention (North 1990 p 3) Among the institutions that are most crucial to economic growth are those that enable a country to allocate capital to its most productive uses Such institutions establish and maintain strong property rights an effective legal system and a sound and efficient financial system

In recent years the field of economic development has come to the conclusion that institutions rule and are critical to economic growth1 An extensive literature focuses on financial development as a significant force driving economic development2

However developing good institutions that foster financial development is not easy It takes time for institutions to evolve and adapt to local circumstances In addition vested interests in poor countries often oppose the necessary reforms because they believe that such reforms will weaken their power or allow other people to cut into their profits How can poorer countries overcome these obstacles How can they change the distribution of power to forge the political will to promote institutional reform The answer is globalization

I should note that the opinions I will express today are my own and not necessarily those of my colleagues on the Federal Open Market Committee (FOMC)

Elements of Institutional Reform Before examining the role of globalization in promoting financial development letrsquos first

look briefly at what steps must be taken to build an institutional infrastructure that will ensure a well-functioning financial system

1 Develop strong property rights Strong property rights are needed to encourage productive investment because it will not be undertaken if the returns on investment are likely to be taken away by the government or others Hernando de Soto in his important book The Mystery of Capital argues that the inability of the poor in developing countries to acquire property rights is a central reason that they are unable to gain access to capital and so remain mired in poverty For example the use of collateral is a crucial tool that helps the financial system make loans because it reduces losses when loans go sour A person who would pledge land or capital for a loan must however legally own the collateral Unfortunately as de Soto has documented legalizing the ownership of capital is extremely expensive and time consuming for the poor in developing countries In one of his many astonishing examples obtaining legal title to a dwelling on urban land in the Philippines required taking 168 bureaucratic steps through 53 public and private agencies over a period of 13 to 25 years

2 Strengthen the legal system A legal system that enforces contracts quickly and fairly is an essential step in supporting strong property rights and financial development For example lenders write restrictive covenants into loan contracts to prevent borrowers from taking on too much risk but such covenants have value only if they can be legally enforced An inefficient legal system in which loan contracts cannot be enforced will prevent productive lending from taking place If setting up legitimate businesses or obtaining legal title to property is too expensive the poor will never have access to the legal system and will be cut off from lending that could help them start small businesses and escape poverty3 Setting up a simple business in the United States generally requires only filling out a form and paying a nominal licensing fee In contrast de Sotos researchers found that legally registering a small garment workshop in Peru required 289 days at 6 hours per day the cost was about $1200 which was approximately thirty times the monthly minimum wage The lack of property rights for all but the very rich as documented by de Soto is a serious impediment to financial development

3 Reduce corruption Government is often the primary source of financial repression in developing countries Rapacious governments whose rulers treat their countries as personal fiefdoms are not uncommon We have seen these governments in Saddam Husseins Iraq Robert Mugabes Zimbabwe and Ferdinand Marcoss Philippines Even officials in less tyrannical governments have been known to use the power of the state to get rich Not surprisingly then many governments pay lip service to property rights but do not encourage a rule of law to protect them

Eliminating corruption is essential to strengthening property rights and the legal system When corrupt officials demand bribes they reduce the incentives for entrepreneurs to make investments The ability to buy off judges weakens the enforcement of legal contracts that enable the economic and financial system to function smoothly4

4 Improve the quality of financial information High-quality financial information is essential to well-functioning financial markets If lenders cannot figure out what is going on in a firm they will be unable to screen out good from bad credit risks or to monitor the firm to ensure that it does not take on too much risk at the lenderrsquos expense To make reliable and accurate information more accessible accounting standards must be high enough so that prospective lenders can make sense of what is in a businessrsquos books Rules that require businesses to disclose information must be enforced to enable prospective investors to make sensible decisions about whether the business deserves to get their hard-earned money

5 Improve corporate governance For people to be willing to buy stocks another way to channel funds to business rules must be established to ensure that the managers of corporations act in the stockholdersrsquo interest If managers find it easy to steal from the corporation or to use funds for their own personal use rather than for the benefit of the company no one will want to invest in the company Finding the right balance of control between management and stockholders is a challenge with which even we in the United States continue to struggle

6 Develop sound prudential regulation and supervision of the banking system Banks are the main institutions that allocate credit in developing countries The skills necessary for bank officers to assess risks and make good lending decisions are critically important and often scarce Poor lending policies may cause too much capital to be channeled toward low-return projects and insufficient capital to be directed toward the high-return projects needed to propel income and growth Moreover deterioration in banks balance sheets caused by insider lending or excessive risk-taking that leads to a proliferation of bad loans can cause banks to cut back sharply on lending with negative effects on the economy If the deterioration in banksrsquo balance sheets is severe enough it can result in banking and currency crises that substantially disrupt the economy phenomena that unfortunately have been all too common in developing countries over the past several decades5 Preventing banking crises must start with prudential regulation in which rules set by the government ensure that banks have sufficient capital and manage risks well To guarantee that these regulations are enforced the government must also engage in prudential supervision in which it monitors banks by examining them on a regular basis to ensure that they are complying with government regulations

The role of microfinance in developing countries is receiving much attention these days Microfinance is a positive development it has clearly helped substantial numbers of poor people escape poverty and the Nobel Peace Prize awarded to Muhammad Yunus for his pioneering efforts in this area was certainly well deserved6 However microfinance is not a substitute for the institution building I am talking about here

Globalizing to Advance Institutional Reform Now that we understand what kinds of institutions are needed to promote financial development and economic growth letrsquos turn to the question of how developing countries can improve the likelihood that these institutions are developed

One of the most powerful weapons for stimulating institutional development is globalization Wealth is not something that can be attained by remaining closed off to the rest of the world Poorer countries would do better by embracing globalization--that is opening their financial markets and their markets for goods and services to other nations so that funds goods and often the ideas that accompany them can flow in Such inflows can help them achieve reforms that build productivity and wealth that will benefit all their citizens Of course countries need to take care that the foundations of the fundamental institutions discussed above are in place and they must monitor the pace of reform

Opening financial markets Now letrsquos look at how opening financial markets to foreigners promotes financial development

Globalizing the domestic financial system by opening financial markets to foreigners encourages financial development and growth in wealth in two ways First opening financial markets to foreign capital directly increases access to capital and lowers its cost for those with productive investments to make7 We know that labor is cheap in poor countries and so we might think that capital would be especially productive there Just think of how hugely profitable a factory might be in a country where wages are one-tenth of those in the United States Although some of that differential would likely reflect the higher productivity of American workers capital should nevertheless have extremely high returns in such countries and in principle we should expect substantial flows of capital from rich countries (where the returns on capital should be relatively low) to poor countries (where they should be far higher) Such capital flows could lead to substantial benefits for poor countries in the form of larger capital stocks higher productivity and more rapidly growing incomes

In fact as we well know at present capital flows are moving on net from poor countries to rich ones that is in a direction opposite to the one we would expect Many reasons have been proposed for this apparent paradox but one of them certainly is the weakness of financial systems in poor countries as described earlier This point leads us to a second benefit of financial globalization Opening markets to foreign financial institutions promotes reforms to the financial system that improve its functioning Allowing foreign financial institutions to operate in an emerging-market country brings in expertise and best practices such as those designed to screen good from bad credit risks and to monitor borrower activities to reduce the amount of risk they take8 Because of their familiarity with more-advanced financial systems foreign financial firms also are likely to increase the pressure on the domestic government to institute reforms that will make the financial system work more effectively

As domestic financial institutions start to lose business to better-run and more trustworthy foreign institutions they will realize the need for a better legal and accounting infrastructure that will make it easier for them to make loans to new customers Domestic financial institutions will then be far more likely to advocate for and support the reforms that achieve this result

Of course this is not to say that in a genuinely corrupt and anticompetitive environment financial globalization by itself can still engender an efficient dynamic and modern financial system Recent research has shown that when some countries opened up to international capital markets too soon in the absence of some basic supporting conditions vulnerabilities to sudden stops of capital flows increased Thus some preconditions must exist with respect to a minimum level of institutional quality financial market development and macroeconomic stability before financial globalization can further improve financial market and institutional development9 That said given these preconditions and some constituency for progress and reform financial globalization can be a powerful force in support of such efforts

Opening trade in goods Next letrsquos consider how opening domestic markets to foreign goods can promote the development of better institutions

Although not immediately obvious opening domestic markets to foreign goods known as trade liberalization can be a key driver of financial development It can weaken the political power of entrenched business interests that might otherwise block institutional reforms a point that is emphatically made by Rajan and Zingales (2004) in their book Saving Capitalism from the Capitalists Trade liberalization which promotes a more competitive environment will lower the revenue of entrenched firms so that they will need greater access to external sources of capital Thus they will be more likely to support reforms that promote a deeper and more efficient financial system In fact research indicates that a deeper financial sector is positively associated with greater trade openness (Rajan and Zingales 2003 Svaleryd and Vlachos 2002)

Free trade also promotes financial deepening by reducing corruption High tariffs breed corruption because importers have incentives to pay customs officials to look the other way when the importers avoid tariffs by smuggling in goods Not surprisingly countries that restrict international trade are found to be more corrupt (Ades and Di Tella 1994)

Even when developing countries are unwilling to tear down all barriers to imports of foreign goods they can still generate incentives for institutional reform by removing obstacles that prevent domestic producers from engaging in international trade Facilitating production for overseas markets creates a greater need for a well-functioning financial system because to compete effectively in the international arena firms need better access to capital If they canrsquot get capital they wonrsquot be able to make the investments they need to increase productivity and price their goods competitively Accordingly international trade creates a demand for reforms that will make the financial system more efficient

The case of China

We are seeing how the globalization of trade is driving financial reform in China As Chinese enterprises increasingly enter international markets they need a better financial system that can ensure that the allocation of their high domestic savings is done

efficiently and is responsive to market developments Although it has taken time globalization is helping to generate the demand for an improved financial system which is driving the reform process

The Communist leadership recognizes that the old development model must change The government has announced that state-owned banks are being put on the path to be privatized and has allowed foreign investment in Chinarsquos banking system ($20 billion in 2005)10 The government is also engaged in legal reform to make contracts more enforceable In August 2006 the National Peoplersquos Congress enacted a new bankruptcy law that gives creditors greater protection if a firm goes bankrupt and last month it approved a law that gives individuals more legal protection for their property11

China of course is an example of a country that has actively encouraged exports as a means of propelling its economic growth and development To some extent China may have gone too far in its use of policy to promote export growth Increased reliance on market-determined prices will help ensure that the allocation of resources into the export sector does not exceed their efficient use The goal should be to raise productivity toward world-class standards in all sectors of the economy Recently Chinarsquos authorities have agreed that some rebalancing of the sources of growth away from exports and toward domestic demand is in order Among Chinarsquos East Asian neighbors the importance of developing industries to meet demand for domestic uses also is receiving increasing attention

The problem of export restrictions

Nevertheless developing production for exports may still be useful for those countries at the lowest rungs of the developmental ladder and it is surprising that many of the worldrsquos poorest developing countries still not only do not encourage an export orientation but in fact maintain a regime of taxes restrictions and other policies that effectively discourage it This problem remains especially serious in some African economies and may help explain why their growth performance has been so disappointing

The primary way that governments discourage exports is by imposing large taxes on them Because high export taxes are one method of obtaining revenue governments may be attracted to them to solve their budget problems They may also use these taxes to punish their political opponents who are often involved in a particular export industry The government can then distribute the resulting revenue to their supporters

The most pernicious forms of export taxes are those that are hidden through the governmentrsquos setting a fixed official exchange rate that artificially keeps the domestic currency at a value well above what it would be worth in terms of foreign currency (say US dollars) in a free market The government then makes it illegal to sell dollars for the larger amount of domestic currency that could be obtained in the black market The difference between the official exchange rate and the free black-market rate (often called the black-market premium) imposes a tax on exporters because they are forced to sell

the dollars they earn to the government or to the central bank at the official rate and thus they receive a much lower price for their goods in terms of the domestic currency

Although in recent decades a great many countries have abandoned currency controls and dismantled their black markets such controls still exist in some of the poorest economies especially in Africa In some countries the tax from the black-market premium is confiscatory An example from history illustrates this point In 1982 Ghana had a black-market premium of more than 1000 percent and so exporters of cocoa (primarily from a tribe different from that of the ruling government party) were getting only 6 percent of the world price Given such a high tax rate it came as no surprise that cocoa exports which had accounted for 19 percent of Ghanarsquos gross domestic product in the 1950s accounted for only 3 percent by 1982 (Easterly 2001 p 222) During the twenty years when the black-market premium was so high the average income of Ghanaians fell 30 percent

Like many such unwarranted controls on economic life high black-market premiums also breed corruption with all its negative effects because they create strong incentives to bribe officials or to smuggle goods to avoid paying the black-market-premium tax (Indeed one of the reasons that governments in poorer countries often use this method of taxation rather than an explicit tax is that it allows government officials to get rich from the bribes they receive)

Other Gains from Trade Liberalization Although we have been focusing on how globalization promotes financial development we shouldnrsquot forget that trade globalization which involves both trade liberalization and an export orientation is a key driver of economic growth for reasons additional to those already mentioned12

The first economics course that college students encounter always teaches the concept of comparative advantage By trading with another country you can focus your production on what you are really good at so that your productivity will be high This higher productivity then leads to higher economic welfare

Trade liberalization more importantly promotes competition in domestic markets which in turn forces domestic firms to increase productivity and make better products both of which drive economic growth If a foreigner produces a better product that can be imported domestic firms must make a better product at a lower price to keep selling their product at home One graphic example of how trade promotes competition occurred in India which up until 1991 had protected its tool industry with a 100 percent tariff (tax on imports) After the Indian government cut the tariff sharply Taiwanese firms initially grabbed one-third of the Indian market Over the next decade however Indian firms boosted their productivity almost to the levels of Taiwanese firms thereby winning back the domestic market Eventually Indian tool firms became so efficient that they were able to start selling their goods abroad and became substantial exporters13

Decreasing barriers to imports also helps promote exports Increased competition from imports lowers the profits firms can earn by focusing solely on the domestic market and so they naturally concentrate more of their energy on exporting Moreover trade liberalization helps developing countries gain access to foreign markets in advanced countries as illustrated by the fact that the United States through free-trade agreements has been more willing to lower tariffs for countries such as Mexico and Chile if they do the same for the United States

Empirical evidence indicates that trade liberalization has positive effects on productivity and economic growth for both importing and exporting countries It has even been found to be associated with more-rapid increases in life expectancy and a reduction in infant mortality14 Yet as is often the case in economics empirical evidence is never completely clear cut Some economists question whether the evidence strongly supports a positive link between trade liberalization and growth15 Nonetheless the logic of the benefits of trade liberalization and the preponderance of the evidence supporting its positive effects lead most members of the economics profession including me to the following conclusion Trade liberalization is highly beneficial not only for the overall economy but also for its constituent sectors The resulting economic growth is a rising tide that raises all boats and is an important tool for poverty alleviation

But even if trade liberalization is not adopted giving domestic producers the opportunity to sell goods to rich countriesrsquo markets can be an important engine for growth in the worldrsquos poorest countries One crucial way that governments in developing countries can encourage exports is by providing the transportation infrastructure--ports roads and airports--that make it easier for businesses to send their goods abroad Because foreigners donrsquot have a natural predilection to buy your goods you have to be supercompetitive--your goods have to be better and cheaper than the goods made in foreign countries Domestic firms have to focus even more on being highly productive and boosting productivity will lead to rapid economic growth

Japanrsquos experience shows what focusing on exporting can accomplish In the immediate aftermath of World War II Japan was a poor country Its economic infrastructure had been destroyed by the war To convince Americans and others to buy Japanese products Japanese firms had to produce goods that were cheaper and better than their American-made counterparts As a result the export industries in Japan became enormously productive and supercompetitive Productivity grew and three decades after World War II Japan became one of the richest countries in the world

South Korea one of the great Asian success stories even with its crisis in the late 1990s had very high barriers to trade until the 1990s and its early development strategy did not include opening its domestic market to foreign goods However through its export sector South Korea has participated fully in global markets and this participation has been a key to its success South Korearsquos development strategy focused on promoting its export sector and it is the export sector that led to high productivity and economic growth Indeed all examples of successful growth stories in developing economies (China Japan South Korea Singapore Taiwan Chile) have involved export sectors that

met the test of international competition and some of these economies have also pursued trade liberalization

In almost all the industrializing East Asian economies future growth will likely have to follow a more balanced path that relies less on exports and more on production for the domestic market Such adjustments are needed not only to secure such economiesrsquo further development but also to alleviate the pattern of external imbalances around the global economy It is in the worldrsquos poorest countries--especially in Africa and Latin America--that additional participation in global markets has the highest priority

Only by embracing global markets can developing countries raise living standards16 Trade liberalization has a critical role to play in economic growth by directly stimulating domestic firms to become more productive And along with financial globalization it can also encourage emerging-market economies to develop the institutions that foster financial development Globalization should be one of the highest priorities for developing countries

The Role of Advanced Countries

Can we in the advanced countries help Yes we can do so by supporting the opening of our markets to goods and services from emerging-market countries By encouraging these countries to increase their participation in global markets we create exactly the right incentives for them to implement the hard measures that will enable them to grow rich As we have seen exporters have strong incentives to be productive so that they can take advantage of access to our markets and thus they will make the investments needed for growth They also will push for the institutional reforms to make financial markets more efficient and promote financial deepening By getting financial markets to work well exporters will have access to the capital they need to increase their business

Opening our markets to emerging-market countries is an important way that those in advanced countries can help emerging-market economies become successful While providing aid to poor countries can in the right circumstances help eradicate poverty it often will not work because it usually does not create the right incentives to promote economic growth A handout is almost never as effective as a hand up

Some are concerned about the consequences for us if we in the United States allow free competition in our markets for goods and services from countries where wages are low Keeping many countries poor and their workers unproductive may seem to be to our benefit But as shown in the examples of post-World War II recovery in Europe and Japan and in the rapid growth in the 1970s and 1980s in the newly industrialized economies of Asia higher standards of living throughout the global economy actually work to our benefit Prosperity in our trading partners creates growing markets for US exports of high-value goods And over time as workersrsquo productivity abroad rises so will their wages and incomes It is true that the changes brought about in our economy by globalization impose significant costs on some domestic workers We need to develop policies to help those workers without undermining the global trading system The costs

to us of damaging that system would far outweigh the benefits that some might gain from protectionist measures Promoting trade liberalization helps us not only do good but also do well

References

Acemoglu Daron Simon Johnson and James A Robinson (2001) The Colonial Origins of Comparative Development An Empirical Investigation American Economic Review vol 91 (December) pp 1369-1401

Acemoglu Daron Simon Johnson and James A Robinson (2005) Institutions as the Fundamental Cause of Long-Run Growth in Philippe Aghion and Steven N Durlauf eds Handbook of Economic Growth vol 1 part 1 Amsterdam North Holland pp 385-472

Ades Alberto and Rafael Di Tella (1994) Competition and Corruption Institute of Economics and Statistics Discussion Paper Series 169 Oxford University of Oxford

Alfaro Laura and others (2004) FDI and Economic Growth The Role of Local Financial Markets Journal of International Economics vol 64 (October) pp 89-112

Armendariz de Aghion Beatriz and Jonathan Morduch (2005) The Economics of Microfinance Cambridge Mass MIT Press

Bekaert Geert Campbell R Harvey and Robin L Lumsdaine (2002) Dating the Integration of World Equity Markets Journal of Financial Economics vol 65 (August) pp 203-47

Bhagwati Jagdish N (2004) In Defense of Globalization New York Oxford University Press

Bourguignon Francois Diane Coyle Raquel Fernandez Francesco Giavazzi Dalia Marin Kevin OrsquoRourke Richard Portes Paul Seabright Anthony Venables Thierry Verdier and L Alan Winters (2002) Making Sense of Globalization A Guide to the Economic Issues CEPR Policy Paper Series 8 London Centre for Economic Policy Research July

DellrsquoAriccia Giovanni and Robert Marquez (2006) Lending Booms and Lending Standards Journal of Finance vol 61 (October) pp 2511-46

Demirguc-Kunt Asli and Enrica Detragiache (2005) Cross-Country Empirical Studies of Systemic Bank Distress A Survey (422 KB PDF) IMF Working Paper Series WP 0596 Washington International Monetary Fund May

de Soto Hernando (2000) The Mystery of Capital Why Capitalism Triumphs in the West and Fails Everywhere Else New York Basic Books

Dollar David (1992) Outward-Oriented Developing Economies Really Do Grow More Rapidly Evidence from 95 LDCs 1976-1985 Economic Development and Cultural Change vol 40 (April) pp 523-44

Dollar David and Paul Collier (2001) Globalization Growth and Poverty Building an Inclusive World Economy New York Oxford University Press

Easterly William (2001) The Elusive Quest for Growth Economistsrsquo Adventures and Misadventures in the Tropics Cambridge Mass MIT Press

Easterly William and Ross Levine (2001) Itrsquos Not Factor Accumulation Stylized Facts and Growth Models World Bank Economic Review vol 15 (2) pp 177-219

Easterly William and Ross Levine (2003) Tropics Germs and Crops How Endowments Influence Economic Development Journal of Monetary Economics vol 50 (January) pp 3-39

Edwards Sebastian (1998) Openness Productivity and Growth What Do We Really Know Economic Journal vol 108 (March) pp 383-98

Eichengreen Barry (2001) Capital Account Liberalization What Do Cross-Country Studies Tell Us World Bank Economic Review vol 15 (3) pp 341-65

Frankel Jeffrey A and David Romer (1999) Does Trade Cause Growth American Economic Review vol 89 (June) pp 379-99

Glaeser Edward L Rafael La Porta Florencio Lopez-de-Silanes and Andrei Shleifer (2004) Do Institutions Cause Growth NBER Working Paper Series 10568 Cambridge Mass National Bureau of Economic Research June

Goldberg Linda (2004) Financial-Sector FDI and Host Countries New and Old Lessons NBER Working Paper Series 10441 Cambridge Mass National Bureau of Economic Research April

Hall Robert E and Charles I Jones (1999) Why Do Some Countries Produce So Much More Output per Worker Than Others Quarterly Journal of Economics vol 114 (February) pp 83-116

Harrison Ann (1996) Openness and Growth A Time-Series Cross-Country Analysis for Developing Countries Journal of Development Economics vol 48 (March) pp 419-47

Henry Peter Blair (2000a) Stock Market Liberalization Economic Reform and Emerging Market Equity Prices Journal of Finance vol 55 (2) pp 529-64

Henry Peter Blair (2000b) Do Stock Market Liberalizations Cause Investment Booms Journal of Financial Economics 58 (1-2) pp 301-34

Jones Benjamin F and Benjamin A Olken (2005) The Anatomy of Start-Stop Growth NBER Working Paper Series 11528 Cambridge Mass National Bureau of Economic Research July

Kaufmann Daniel Aart Kray and Pablo Zoido-Lobaton (1999) Governance Matters Policy Research Working Paper Series 2196 Washington World Bank October

Kearl James R Clayne L Pope Gordon C Whiting and Larry T Wimmer (1979) A Confusion of Economists American Economic Review vol 69 (May Papers and Proceedings) pp 28-37

Klein Michael W (2005) Capital Account Liberalization Institutional Quality and Economic Growth Theory and Evidence NBER Working Paper Series 11112 Cambridge Mass National Bureau of Economic Research February

Kose M Ayhan Eswar Prasad Kenneth Rogoff and Shang-Jin Wei (2006) Financial Globalization A Reappraisal (758 KB PDF) IMF Working Paper Series WP 06189 Washington International Monetary Fund August

Lee Ha Yan Luca Antonio Ricci and Roberto Rigobon (2004) Once Again Is Openness Good for Growth Journal of Development Economics vol 75 (December) pp 451-72

Levine Ross (2004) Finance and Growth NBER Working Paper Series 10766 Cambridge Mass National Bureau of Economic Research September forthcoming in Philippe Aghion and Steven N Durlauf eds Handbook of Economic Growth Amsterdam North Holland

Levine Ross and Sara Zervos (1998) Capital Control Liberalization and Stock Market Development World Development 26 pp 1169-84

Mauro Paolo (1995) Corruption and Growth Quarterly Journal of Economics vol 110 (August) pp 681-712

North Douglass C (1990) Institutions Institutional Change and Economic Performance Cambridge Cambridge University Press

North Douglass C and Robert Paul Thomas (1973) The Rise of the Western World A New Economic History Cambridge Cambridge University Press

Rajan Raghuram and Luigi Zingales (2003) The Great Reversals the Politics of Financial Development in the 20th Century Journal of Financial Economics 69 (1) pp 5-50

Rajan Raghuram and Luigi Zingales (2004) Saving Capitalism from the Capitalists Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity Princeton Princeton University Press

Rodriguez Francisco and Dani Rodrik (2001) Trade Policy and Economic Growth A Skepticrsquos Guide to the Evidence in Ben S Bernanke and Kenneth Rogoff eds NBER Macroeconomics Annual 2000 Cambridge Mass MIT Press

Rodrik Dani Arvind Subramanian and Francesco Trebbi (2002) Institutions Rule The Primacy of Institutions over Geography and Integration in Economic Development NBER Working Paper Series 9305 Cambridge Mass National Bureau of Economic Research November

Sachs Jeffrey D and Andrew M Warner (1995) Economic Reform and the Process of Global Integration Brookings Papers on Economic Activity 19951 pp 1-118

Schmukler Sergio L (2004) Financial Globalization Gain and Pain for Developing Countries (307 KB PDF) Federal Reserve Bank of Atlanta Economic Review vol 89 (Q2) pp 39-66

Svaleryd Helena and Jonas Vlachos (2002) Markets for Risk and Openness to Trade How Are They Related Journal of International Economics vol 57 (August) pp 369-95

Temple Jonathan (1999) The New Growth Evidence Journal of Economic Literature vol 37 (March) pp 112-56

Wei Shangjin (1997) How Taxing Is Corruption on International Investors NBER Working Paper Series 6030 Cambridge Mass National Bureau of Economic Research May

Weil David N (2005) Economic Growth Boston Addison-Wesley

Winters L Alan Neil McCulloch and Andrew McKay (2004) Trade Liberalization and Poverty The Evidence So Far Journal of Economic Literature vol 42 (March) pp 72-115

Wolf Martin (2004) Why Globalization Works New Haven Yale University Press

World Bank (2001) Finance for Growth Policy Choices in a Volatile World New York Oxford University Press

World Bank (2005) Doing Business in 2005 Removing Obstacles to Growth Washington World Bank

Footnotes

1 A large literature shows the importance of good institutions to economic growth See for example North and Thomas (1973) Hall and Jones (1999) Acemoglu Johnson and Robinson (2001) Easterly and Levine (2001) Rodrik Subramanian and Trebbi (2002) Easterly and Levine (2003) Glaeser and others (2004) and the recent survey by Acemoglu Johnson and Robinson (2005) Kaufmann and others (1999) also point to the importance of various aspects of good governance Return to text

2 An excellent nontechnical survey of the extensive empirical evidence on the link between financial development and economic growth can be found in World Bank (2001) See also Levine (2004) and Schmukler (2004) Return to text

3 A discussion of how the costs of doing business vary across a number of countries is in World Bank (2005) Return to text

4 Research finds that increases in corruption are associated with lower growth (for example Mauro 1995) Wei (1997) also finds that corruption significantly reduces foreign direct investment which is generally considered to be beneficial to growth Return to text

5 A survey of the literature that links a lack of sufficient prudential regulation and supporting institutions to excessive risk-taking and the possibility of a subsequent banking crisis is in Demirguc-Kunt and Detragiache (2005) DellrsquoAriccia and Marquez (2006) also argue that under certain circumstances lending booms can make the banking system more unstable and can lead to a higher probability of a banking crisis Return to text

6 The literature on microfinance is vast One thorough discussion is in Armendariz de Aghion and Morduch (2005) Return to text

7 When stock markets in emerging-market countries are opened to foreign capital dividend yields fall average stock prices increase and liquidity goes up See Levine and Zervos (1998) Bekaert Harvey and Lumsdaine (2002) and Henry (2000ab) Return to text

8 This argument is made in World Bank (2001) and Goldberg (2004) Return to text

9 An excellent discussion of the literature on financial globalization using a unified conceptual framework is in Kose and others (2006) Studies focusing more specifically on the necessary preconditions for and the appropriate sequencing of financial reforms

macroeconomic policies and institutional development on the one hand and capital account liberalization on the other include Eichengreen (2001) Alfaro and others (2004) and Klein (2005) Return to text

10 The four largest state-owned banks with 70 percent of Chinarsquos bank deposits are scheduled to be privatized in the following order the Construction Bank the Bank of China the Industrial and Commercial Bank and the Agricultural Bank Return to text

11 The new law becomes effective on June 1 2007 but reportedly will not apply to state-owned enterprises until 2008 Return to text

12 Indeed almost all economists think that trade liberalization a key element of globalization is a good thing For example in Kearl and others (1979) 97 percent of economists agreed (generally or with some provisions) with the statement that tariffs and import quotas reduce general economic welfare A typical view advocating trade liberalization is expressed by Jagdish Bhagwati one of the most prominent trade theorists in the world in Bhagwati (2004) Return to text

13 This example comes from Weil (2005 p 322) and is described more extensively in Dollar and Collier (2001) Return to text

14 The literature on the effects of trade liberalization on growth and poverty is immense See the surveys in Temple (1999) Bourguignon and others (2002) Winters McCulloch and McKay (2004) and Wolf (2004) Earlier studies found that trade openness was associated with higher growth rates (Dollar 1992 Sachs and Warner 1995 and Edwards 1998) However because the direction of causation from this evidence is difficult to establish other researchers have used instrumental variable procedures to establish causality from trade liberalization to growth (for example Frankel and Romer 1999) Using a different approach to identify the direction of causation Lee Ricci and Rigobon (2004) also find that trade openness has a positive effect on growth Return to text

15 For example Harrison (1996) and especially Rodriguez and Rodrik (2000) Return to text

16 The finding in Jones and Olken (2005) that growth take-offs are primarily associated with large and steady expansions in international trade provides further support for this view Return to text

Speech Vice Chairman Donald L Kohn At the Carleton University Ottawa Canada May 13 2010

The Federal Reserves Policy Actions during the Financial Crisis and Lessons for the Future

The financial and economic crisis that started in 2007 tested central banks as they had not been tested for many decades We needed to take swift and decisive action to limit the damage to the economy from the spreading distress in financial markets Because the financial distress was so deep and pervasive and because it took place in financial markets whose structure had evolved dramatically our actions also needed to be innovative if they were to have a chance of being effective Many central banks made substantial changes to traditional policy tools as the crisis unfolded But the epicenter of the financial shock was in US mortgage markets with severe effects on many of our financial institutions and our financial markets had perhaps evolved more than many others As a consequence no central bank innovated more dramatically than the Federal Reserve

We traditionally have provided backup liquidity to sound depository institutions But in the crisis to support financial markets we had to provide liquidity to nonbank financial institutions as well Just as we were forced to adapt and innovate in meeting our liquidity provision responsibilities we also needed to adapt and innovate in the conduct of monetary policy Very early in the crisis it became evident that lowering short-term policy rates alone would not be sufficient to counter the adverse shock to the US economy and financial system We needed to go further--much further in fact--to ease financial conditions and thus encourage spending and support employment We took steps to reinforce public understanding of our inflation objective to prevent the development of deflationary expectations we provided guidance on the possible future course of our policy interest rate and we purchased large amounts of longer-term securities and in the process created unprecedented volumes of bank reserves Now careful planning is under way to remove that stimulus at the appropriate time My discussion today will focus on innovations in both our role as liquidity provider and in our monetary policy tools their motivation their effectiveness and their lessons for the future 1

The Federal Reserves Liquidity Tools Before the crisis the implementation of monetary policy was fairly straightforward and our approach minimized its footprint on financial markets The Federal Reserve adjusted the liquidity it provided to the banking system through daily operations with a relatively

small set of broker-dealers against a very narrow set of collateral--Treasury and agency securities These transactions had the effect of changing the aggregate quantity of reserve balances that banks held at the Federal Reserve and that liquidity was distributed by interbank funding markets through the banking system in the United States and around the world In addition the Federal Reserve stood ready to lend directly to commercial banks and other depository institutions at the discount window where at their discretion banks could borrow overnight at an above-market rate against a broad range of collateral when they had a need for very short-term funding Ordinarily however little credit was extended through the discount window Banks were able to obtain their funding and reserves in the open market and generally turned to the window only to cover very short-term liquidity shortfalls arising from operational glitches or transitory marketwide supply shortfalls as opposed to more fundamental funding problems

During the financial crisis however market participants became highly uncertain about the financial strength of their counterparties the future value of assets (including any collateral they might be lending against) and how their own needs for capital and liquidity might evolve They fled to the safest and most liquid assets and as a result interbank markets stopped functioning as an effective means to distribute liquidity increasing the importance of direct lending through the discount window At the same time however banks became extremely reluctant to borrow from the Federal Reserve for fear that their borrowing would become known and thus cast doubt on their financial condition Importantly the crisis also involved major disruptions of important funding markets for other institutions Commercial paper markets no longer channeled funds to lenders or to nonfinancial businesses investment banks encountered difficulties borrowing even on a short-term and secured basis as lenders began to have doubts about some of the underlying collateral banks overseas could not rely on the foreign currency swap market to fund their dollar assets beyond the very shortest terms investors pulled out from money market mutual funds and most securitization markets shut down These disruptions to financing markets posed the same threats to the availability of credit to households and businesses that runs on banks created in the more bank-centric financial system of the 1800s and most of the 1900s As a result intermediaries unable to fund themselves were forced to sell assets driving down prices and exacerbating the crisis moreover they were unwilling to assume the risks necessary to make markets in the debt and securitization instruments that were critical channels supporting household and business borrowing--and households and businesses unable to borrow were thus unable to spend thereby deepening the recession

These liquidity pressures were evident in nearly every major country and every central bank had to adapt its liquidity facilities to some degree in addressing these strains At the Federal Reserve we had to adapt somewhat more than most partly because the scope of our activities prior to the crisis was fairly narrow--particularly relative to the expanding scope of intermediation outside the banking sector--and partly because the effect of the crisis was heaviest on dollar funding markets Initially to make credit more available to banks we reduced the spread of the discount rate over the target federal funds rate lengthened the maximum maturity of loans to banks from overnight to 90 days and provided discount window credit through regular auctions in an effort to overcome banks

reluctance to borrow at the window due to concerns about the stigma of borrowing from the Federal Reserve We also lent dollars to other central banks so that they could provide dollar liquidity to banks in their jurisdictions thus easing pressures on US money markets As the crisis intensified however the Federal Reserve recognized that lending to banks alone would not be sufficient to address the severe strains affecting many participants in short-term financing markets Ultimately the Federal Reserve responded to the crisis by creating a range of emergency liquidity facilities to meet the funding needs of key nonbank market participants including primary securities dealers money market mutual funds and other users of short-term funding markets including purchasers of securitized loans2

Why couldnt the Federal Reserve maintain its routine lending practices and rely on lending to commercial banks which in turn lend to nonbank firms The reason is that financial markets have evolved substantially in recent decades--and in retrospect by more than we had recognized prior to the crisis The task of intermediating between investors and borrowers has shifted over time from banks--which take deposits and make loans--to securities markets--where borrowers and savers meet more directly albeit with the assistance of investment banks that help borrowers issue securities and then make markets in those securities An important aspect of the shift has been the growth of securitization in which loans that might in the past have remained on the books of banks are instead converted into securities and sold to investors in global capital markets Serious deficiencies with these securitizations the associated derivative instruments and the structures that evolved to hold securitized debt were at the heart of the financial crisis Among other things the structures exposed the banking system to risks that neither participants in financial markets nor regulators fully appreciated Banks became dependent on liquid markets to distribute the loans they had originated And some parts of the securitized loans were sold to off-balance-sheet entities in which long-term assets were funded by short-term borrowing with implicit or explicit liquidity guarantees provided by the banks Securitization markets essentially collapsed when banks became unwilling to increase their exposure to such risks during the crisis when the liquidity guarantees were invoked and when other lenders in securitization markets became unwilling to supply credit

Although the Federal Reserves lending actions during the crisis were innovative and to some degree unprecedented they were based on sound legal and economic foundations Our lending to nonbank institutions was grounded in clear authority found in section 13(3) of the Federal Reserve Act permitting a five-member majority of the Federal Reserve Board to authorize a Reserve Bank to lend to individuals partnerships or corporations in unusual and exigent circumstances These actions also generally adhered to Walter Bagehots dictum a time-honored central banking principle for countering a financial panic Lend early and freely to solvent institutions at a penalty rate and against good collateral3 Central banks are uniquely equipped to carry out this mission They regularly lend to commercial banks against a wide variety of collateral and have the infrastructure to value and perfect their interest in the underlying collateral During a panic market functioning is typically severely impaired with investors fleeing toward the safest and most liquid assets and the resulting lack of liquidity even for

sound banks with sound assets can result in funding pressures for financial institutions and others By lending to solvent institutions against illiquid collateral central banks effectively step in to assume the liquidity risk of such assets--that is the risk that assets can only be sold in the near term at fire sale prices And their ability to substitute for private-sector intermediation in a panic is unlimited since they create reserves For the most part the Federal Reserve priced these facilities to be attractive when markets were disrupted but not economical to potential borrowers as market functioning improved

Importantly lending against good collateral to solvent institutions supplies liquidity not capital to the financial system To be sure limiting a panic mitigates the erosion of asset prices and hence capital but central banks are not the appropriate authorities to supply capital directly if government capital is necessary to promote financial stability then that is a fiscal function This division of responsibilities presented challenges in the crisis The securitization markets were impaired by both a lack of liquid funding and by concerns about the value of the underlying loans and broad-based concerns about the integrity of the securitization process To restart these markets the Federal Reserve worked with the Treasury in establishing the Term Asset-Backed Securities Loan Facility (TALF) The Federal Reserve supplied the liquid funding while the Treasury assumed the credit risk The issue of the appropriate role of the central bank and fiscal authority was present in other contexts as well We were well aware that we were possibly assuming a risk of loss when we lent to stabilize the systemically important firms of Bear Stearns and American International Group (AIG) Unfortunately at the time alternative mechanisms were not available and we lent with the explicit support of the Secretary of the Treasury including a letter from him acknowledging the risks

An important task before us now is to assess the effectiveness of these actions Not surprisingly rigorous studies that evaluate the extent to which the emergency liquidity facilities contributed to improved financial conditions are just beginning to emerge Nonetheless market reactions to the announcement of the emergency facilities anecdotal evidence and a number of the studies we do have suggest that the facilities forestalled potentially much worse outcomes and encouraged improvements For example some asset-backed securities (ABS) spreads such as those for consumer ABS and commercial mortgage-backed securities narrowed significantly following the creation of the TALF and activity in ABS markets has picked up While the overall improvement in the economic outlook has no doubt contributed to the improvement in ABS markets it does appear that the TALF helped to buoy the availability of credit to firms and households and thus supported economic activity Indeed following the kick-start from the TALF a number of these markets are now operating without any governmental backing Another example is the reduction in pressures in US dollar funding markets (as evidenced by the sharp narrowing of spreads between Libor (London interbank offered rates) and OIS (overnight index swap) rates and the decline in premiums paid for US dollars in foreign exchange swap markets) These developments followed the establishment of the Term Auction Facility (which auctioned discount window credit to depository institutions) and also of liquidity swaps between the Federal Reserve and foreign central banks which enabled those banks to lend dollars to commercial banks in their jurisdictions Our willingness to lend in support of the commercial paper and asset-backed commercial

paper markets helped to stem the runs on money market funds and other nonbank providers of short-term credit Of note usage of these emergency liquidity facilities declined markedly as conditions in financial markets improved indicating that they were indeed priced at a penalty to more normal market conditions They were successfully closed suggesting that market participants had not become overly reliant on these programs and were able to regain access to funding markets Except for the TALF and the special Bear Stearns and AIG loans all were repaid without any losses to the Federal Reserve The funding markets evidently remain somewhat vulnerable however Just this week with the reemergence of strains in US dollar short-term funding markets in Europe the Federal Reserve reestablished temporary US dollar liquidity swap facilities with the Bank of Canada the Bank of England the European Central Bank the Bank of Japan and the Swiss National Bank4

Lessons for Handling Future Liquidity Disruptions What lessons can be drawn from the Federal Reserves experience in the financial crisis when designing a toolbox for dealing with future systemic liquidity disruptions First the crisis has demonstrated that in a financial system so dependent on securities markets and not just banks for the distribution of credit our ability to preserve financial stability may be enhanced by making sure the Federal Reserve has authority to lend against good collateral to other classes of sound regulated financial institutions that are central to our financial markets--not on a routine basis but when the absence of such lending would threaten market functioning and economic stability Thus it would seem that authority similar to that provided by section 13(3) will continue to be necessary

Second we recognize that holding open this possibility is not without cost With credit potentially available from the Federal Reserve institutions would have insufficient incentives to manage their liquidity to protect against unusual market events Hence emergency credit should generally be available only to groups of institutions that are tightly regulated and closely supervised to limit the moral hazard of permitting access to the discount window even when such access is not routinely granted If the Federal Reserve did not directly supervise the institutions that would potentially receive emergency discount window credit it would need an ongoing and collaborative relationship with the supervisor The supervisor should ensure that any institution with potential access to emergency discount window credit maintained conservative liquidity policies The supervisor would also provide critical insight into the financial condition of the borrower and the quality of the available collateral and more generally whether lending was necessary and appropriate Most importantly no such institution should be considered too big or too interconnected to fail and any losses should be shouldered by shareholders and other providers of capital by management and where consistent with financial stability by creditors as well

Third the United States needs a resolution facility for systemically important institutions that meets the criteria I just enunciated That authority must have access to liquidity to stabilize situations where necessary but the fiscal authorities not the central bank should be the ones deciding whether to take on the credit risk of lending to troubled institutions in order to forestall financial instability

Fourth transparency about unusual liquidity facilities is critical The public appropriately expects that when a central bank takes innovative actions--especially actions that might appear to involve more risk than normal lending operations--then it will receive enough information to judge whether the central bank has carried out the policy safely and fairly The required degree of transparency might well involve more-detailed types of reporting than for normal ongoing lending facilities

Finally the problem of discount window stigma is real and serious The intense caution that banks displayed in managing their liquidity beginning in early August 2007 was partly a result of their extreme reluctance to rely on standard discount mechanisms Absent such reluctance conditions in interbank funding markets might have been significantly less stressed with less contagion to financial markets more generally Central banks eventually were able to partially circumvent this stigma by designing additional lending facilities for depository institutions but analyzing the problem developing these programs and gathering the evidence to support a conclusion that they were necessary took valuable time Going forward if measures are adopted that could further exacerbate the stigma of using central bank lending facilities the ability of central banks to perform their traditional functions to stabilize the financial system in a panic may well be impaired

Monetary Policy and the Zero Bound The Federal Reserve and other central banks reacted to the deepening crisis in the fall of 2008 not only by opening new emergency liquidity facilities but also by reducing policy interest rates to close to zero and taking other steps to ease financial conditions Such rapid and aggressive responses were expected to cushion the shock to the economy by reducing the cost of borrowing for households and businesses thereby encouraging them to keep spending

After short-term rates reached the effective zero bound in December 2008 the Federal Reserve also acted to shape interest rate and inflation expectations through various communications At the March 2009 meeting the Federal Open Market Committee (FOMC) indicated that it viewed economic conditions as likely to warrant exceptionally low levels of the federal funds rate for an extended period This language was intended to provide more guidance than usual about the likely path of interest rates and to help financial markets form more accurate expectations about policy in a highly uncertain economic and financial environment By noting that the federal funds rate was likely to remain at exceptionally low levels for an extended period the FOMC likely was able to keep long-term interest rates lower than would otherwise have been the case

To provide the public with more context for understanding monetary policy decisions Board members and Reserve Bank presidents agreed in late 2007 to prepare more frequent forecasts covering longer time spans and explain those forecasts In January 2009 the policymakers also added information about their views of the long-run levels to which economic growth inflation and the unemployment rate were likely to converge over time The additional clarity about the long-run level for inflation in particular likely helped keep inflation expectations anchored during the crisis Had expectations followed

inflation down real interest rates would have increased restraining spending further Had expectations risen because of concern about the Federal Reserves ability to unwind the unusual actions it was taking we might have needed to limit those actions and the resulting boost to spending

Given the severity of the downturn however it soon became clear that lowering short-term policy rates and attempting to shape expectations would not be sufficient alone to counter the macroeconomic effects of the financial shocks Indeed once the Federal Reserve reduced the federal funds rate to zero no further conventional policy easing was possible The Federal Reserve needed to use alternative methods to ease financial conditions and encourage spending Thus to reduce longer-term interest rates like those on mortgages the Federal Reserve initiated large-scale purchases of longer-term securities specifically Treasury securities agency mortgage-backed securities (MBS) and agency debt All told the Federal Reserve purchased $300 billion of Treasury securities about $175 billion of agency debt obligations and $125 trillion of agency MBS In the process we ended up supplying about $12 trillion of reserve balances to the banking system--a huge increase from the normal level of about $15 billion over the few years just prior to the crisis

How effective have these various steps been in reducing the cost of borrowing for households and businesses while maintaining price stability Central banks have lots of experience guiding the economy by adjusting short-term policy rates and influencing expectations about future policy rates and the underlying theory and practice behind those actions are well understood The reduction of the policy interest rate to close to zero led to a sharp decline in the cost of funds in money markets--especially when combined with the creation of emergency liquidity facilities and the establishment of liquidity swaps with foreign central banks that greatly narrowed spreads in short-term funding markets Event studies at the time of the release of the March 2009 FOMC statement (when the extended period language was first introduced) indicate that the expected path of policy rates moved down substantially Market participants reportedly interpreted the characterization of the federal funds rate as likely to remain low for an extended period as stronger than the for some time language included in the previous statement5 Nonetheless the extended period language has not prevented interest rates and market participants expectations about the timing of exit from the zero interest rate policy from reacting to incoming economic information though each repetition of the extended period language has appeared to affect those expectations a little

By contrast the economic effects of purchasing large volumes of longer-term assets and the accompanying expansion of the reserve base in the banking system are much less well understood One question involves the direct effects of the large-scale asset purchases themselves The theory behind the Federal Reserves actions was fairly clear Arbitrage between short- and long-term markets is not perfect even when markets are functioning smoothly and arbitrage is especially impaired during panics when investors are putting an unusually large premium on the liquidity and safety of short-term instruments In these circumstances purchasing longer-term assets (and thus taking interest rate risk from the market) pushes up the prices of the securities thereby lowering

their yields But by how much and for how long Good studies of these sorts of actions also are sparse Currently we are relying in large part on event studies analyzing how much interest rates declined when purchases were announced in the United States or abroad According to these studies spreads on mortgage-related assets fell sharply on November 25 2008 when the Federal Reserve announced that it would initiate a program to purchase agency debt and agency MBS A similar pattern for Treasury yields was observed following the release of the March 2009 FOMC statement when purchases of longer-term Treasury securities were announced6 Effectiveness however is hard to quantify partly because we are uncertain about how exactly the purchases put downward pressure on interest rates My presumption has been that the effect comes mainly from the total amount we purchase relative to the total stock of debt outstanding However others have argued that the market effect derives importantly from the flow of our purchases relative to the amount of new issuance in the market Some evidence for the primacy of the stock channel has accumulated recently as the recent end of the MBS purchase program does not appear to have had significant adverse effects in mortgage markets

A second issue involves the effects of the large volume of reserves created as we purchased assets The Federal Reserve has funded its securities purchases by crediting the accounts that banks hold with us In explanations of our actions during the crisis we have focused on the effects of our purchases on the prices of the assets that we bought and on the spillover to the prices of related assets as I have just done The huge quantity of bank reserves that were created has been seen largely as a byproduct of the purchases that would be unlikely to have a significant independent effect on financial markets and the economy This view however is not consistent with the simple models in many textbooks or the monetarist tradition in monetary policy which emphasizes a line of causation from reserves to the money supply to economic activity and inflation According to these theories extra reserves should induce banks to diversify into additional lending and purchases of securities reducing the cost of borrowing for households and businesses and so should spark an increase in the money supply and spending To date this channel does not seem to have been effective Interest rates on bank loans relative to the usual benchmarks remain elevated the quantity of bank loans is still falling and money supply growth has been subdued Banks behavior appears more consistent with the standard Keynesian model of the liquidity trap in which demand for reserves becomes perfectly elastic when short-term interest rates approach zero But the portfolio behavior of banks might shift as the economy and confidence recover and we will need to watch and study this channel carefully

Another uncertainty deserving of additional examination involves the effect of large-scale purchases of longer-term assets on inflation expectations The more we buy the more reserves we will ultimately need to absorb and the more assets we will ultimately need to dispose of before the conduct of monetary policy the behavior of interbank markets and the Federal Reserves balance sheet can return completely to normal As a consequence these types of purchases can increase inflation expectations among some observers who may see a risk that we will not reduce reserves and raise interest rates in a timely fashion So far longer-term inflation expectations have generally been well anchored over the

past few years of unusual Federal Reserve actions However many unsettled issues remain regarding the linkage between central bank actions and inflation expectations and concerns about the effect of the size of our balance sheet are often heard in financial market commentary

Lesson from Conducting Monetary Policy in a Crisis It is certainly too soon to fully assess all the lessons learned concerning the conduct of monetary policy during the crisis but a few observations seem worth noting even at this early stage

First commitments to maintain interest rates at a given level must be properly conditioned on the evolution of the economy If they are to achieve their objectives central banks cannot make unconditional interest rate commitments based only on a time dimension The Bank of Canada has recently illustrated that need by revising its time commitment based on changing circumstances To further clarify that the extended period language is conditional on the evolution of the economy the FOMC emphasized in the November 2009 statement that its expectation that the federal funds rate is likely to remain at an exceptionally low level for an extended period depended on the outlook for resource utilization inflation and inflation expectations following the anticipated trajectories

Second as I previously pointed out firmly anchored inflation expectations are essential to successful monetary policy at any time Thats why central banks have not followed the standard academic recommendation to set a higher inflation target--either temporarily or as has been recently suggested over the longer run--to reduce the likelihood of hitting the zero lower bound Although I agree that hitting the zero bound presents challenges to monetary policy I do not believe central banks should raise their inflation targets Central banks around the world have been working for 30 years to get inflation down to levels where it can largely be ignored by businesses and households when making decisions about the future Moreover inflation expectations are well anchored at those low levels

Increasing our inflation targets could result in more-variable inflation and worse economic outcomes over time Inflation expectations would necessarily have to become unanchored as inflation moved up I doubt households and businesses would immediately raise their expectations to the new targets and that expectations would then be well anchored at the new higher levels Instead I fear there could be a long learning process just as when inflation trended down over recent decades Moreover a higher inflation target might also mean that inflation would be higher than can be ignored and businesses and households may take inflation more into account when writing contracts and making investments increasing the odds that otherwise transitory inflation would become more persistent

For both these reasons raising the longer-term objective for inflation could make expectations more sensitive to recent realized inflation to central bank actions and to other economic conditions That greater sensitivity would reduce the ability of central banks to buffer the economy from bad shocks It could also lead to more-volatile inflation

over the longer run and therefore higher inflation risk premiums in nominal interest rates It is notable that while the theoretical economic arguments for raising inflation targets are well understood no major central bank has raised its target in response to the recent financial crisis

Third it appears that large-scale asset purchases at the zero bound do help to ease financial conditions Our best judgment is that longer-term yields were reduced as a result of our asset purchases The lower rates on mortgages helped households that could refinance and supported demand to help stabilize the housing market Moreover low rates on corporate bonds contributed to a wave of longer-term business financing that has strengthened the financial condition of firms that could access securities markets and contributed to the turnaround in business investment

Fourth central banks also need to be mindful of the potential effects on inflation expectations of the expansion of their balance sheet Most policymakers do not tend to put too much stock in the very simple theories relating excess reserves to money and inflation that I mentioned earlier But we are aware that the size of our balance sheet is a potential source of policy stimulus and we need to be alert to the risk that households businesses and investors could begin to expect higher inflation based partly on an expanded central bank balance sheet As always the Federal Reserve monitors inflation developments and inflation expectations very closely and any signs of a significant deterioration in the inflation outlook would be a matter of concern to the FOMC

Fifth central banks need to have the tools to reverse unusual actions--to drain reserves and raise interest rates--when the time comes Confidence in those tools should help allay any fears by the public that unusual actions will necessarily lead to inflation And having or developing those tools is essential to allow aggressive action to ease financial conditions as the economy heads into recession In the case of the Federal Reserve our ability to pay interest on excess reserves which we received only in September 2008 is a very important tool that made us more comfortable taking extraordinary steps when they were needed it allows us to put upward pressure on short-term interest rates even with very elevated levels of reserves In addition we are developing new tools including reverse repurchase agreements and term deposits that will allow us to drain significant quantities of reserves when necessary

Finally let me close with some comments on a lesson learned that some observers have emphasized--that long periods of low interest rates inevitably lead to financial imbalances and that the Federal Reserve should adjust its policy setting to avoid the buildup of such imbalances As I have indicated at other times I dont think we know enough at this point to answer with any confidence the question of whether monetary policy should include financial stability along with price stability and high employment in its objectives Given the bluntness of monetary policy as a tool for addressing developments that could lead to financial instability given the side effects of using policy for this purpose (including the likely increase in variability of inflation and economic activity over the medium term) and given the need for timely policy action to realize greater benefits than costs in leaning against potential speculative excesses my

preference at this time is to use prudential regulation and supervision to strengthen the financial system and lean against developing financial imbalances I dont minimize the difficulties of executing effective macroprudential supervision nor do I rule out using interest rate policy in circumstances in which dangerous imbalances are building and prudential steps seem to be delayed or ineffective but I do think regulation can be better targeted to the developing problem and the balance of costs and benefits from using these types of instruments are far more likely to be favorable than from using monetary policy to achieve financial stability

Conclusion The most severe financial crisis since the Great Depression has caused suffering around the world It also has been a difficult learning experience for central bankers Monetary policymakers must ask whether the strategies and tools at their disposal need to be adapted to fulfill their responsibilities for price and economic stability in modern financial markets As with the most interesting questions the answers arent at all clear But we should use our experience to foster a constructive discussion of these critical questions because addressing these issues will enable central banks to more effectively promote financial stability and reduce the odds of future crises

1 The views expressed are my own and not necessarily those of my colleagues on the Federal Open Market Committee James Clouse and Fabio Natalucci of the Boards staff contributed to these remarks Return to text

2 Primary dealers are broker-dealers that trade in US government securities with the Federal Reserve Bank of New York Return to text

3 Walter Bagehot ([1873] 1897) Lombard Street A Description of the Money Market (New York Charles Scribners Sons) Return to text

4 See Board of Governors of the Federal Reserve System (2010) Federal Reserve European Central Bank Bank of Canada Bank of England and Swiss National Bank Announce Re-establishment of Temporary US Dollar Liquidity Swap Facilities press release May 9 and Board of Governors of the Federal Reserve System (2010) FOMC Authorizes Re-establishment of Temporary US Dollar Liquidity Swap Arrangement with the Bank of Japan press release May 10 Return to text

5 A clear-cut assessment of the effects of the introduction of the extended period language however is complicated by the fact that the FOMC also decided at the March 2009 meeting to increase the size of the Federal Reserve balance sheet further by purchasing up to an additional $750 billion of agency MBS bringing its total purchases

of these securities to up to $125 trillion and to increase its purchases of agency debt by up to $100 billion to a total of up to $200 billion Return to text

6 Treasury yields also declined notably on December 1 2008 following a speech by the Chairman noting that the Federal Reserve could purchase longer-term Treasury securities in substantial quantities See Ben S Bernanke (2008) Federal Reserve Policies in the Financial Crisis speech delivered at the Greater Austin Chamber of Commerce Austin Tex December 1 Return to text

QampAUS Monetary PolicyAn Introduction

US monetary policy affects all kinds of economic and financial decisions people make in this countrymdashwhether to get a loan to buy a new house or car or to start up a company whether

to expand a business by investing in a new plant or equipment and whether to put savings in a bank in bonds or in the stock market for example Furthermore because the US is the largest economy in the world its monetary policy also has significant economic and financial effects on other countries

The object of monetary policy is to influence the performance of the economy as reflected in such factors as inflation economic output and employment It works by affecting demand across the economymdashthat is peoplersquos and firmsrsquo willingness to spend on goods and services

While most people are familiar with the fiscal policy tools that affect demandmdashsuch as taxes and government spendingmdashmany are less famil-iar with monetary policy and its tools Monetary policy is conducted by the Federal Reserve System the nationrsquos central bank and it influences demand mainly by raising and lowering short-term interest rates

This booklet provides an introduction to US monetary policy as it is currently conducted by answering a series of questions

How is the Federal Reserve structured

What are the goals of US monetary policy

What are the tools of US monetary policy

How does monetary policy affect the US economy











Funding




2




3

1 Boston

2 New York

3 Philadelphia

4 Cleveland

5 Richmond

6 Atlanta

7 Chicago

8 St Louis

9 Minneapolis

10 Kansas City

11 Dallas

12 San Francisco






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Glossary of Terms











































































































The case of China




























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Funding




2




3

1 Boston

2 New York

3 Philadelphia

4 Cleveland

5 Richmond

6 Atlanta

7 Chicago

8 St Louis

9 Minneapolis

10 Kansas City

11 Dallas

12 San Francisco






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1 Boston

2 New York

3 Philadelphia

4 Cleveland

5 Richmond

6 Atlanta

7 Chicago

8 St Louis

9 Minneapolis

10 Kansas City

11 Dallas

12 San Francisco






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Documents

Handout 6 - Duke's Fuqua School of Business |coleman/macro_daytime/...Handout 6 Money, the Federal Reserve, and Financial Crisis Professor Coleman Fuqua School of Business, Duke University