I would not advocate making it a regular practice to lean against asset price bubbles.

President's Speech

Panel discussion for the Federal Reserve Board/Journal of Money, Credit, and Banking (JMCB) conference on "Financial Markets and Monetary Policy"
Washington D.C.
By Janet L. Yellen, President and CEO, Federal Reserve Bank of
San Francisco
For delivery on Friday, June 5, 2009 at 2:15 PM Eastern time
Download PDF Version (41KB)

Closing Panel Presentation

I'm delighted to have this opportunity to help wrap up what has been a fascinating and timely macro-finance research conference. Cataclysmic events, like the current economic and financial crisis, often fundamentally alter the focus—and even the paradigm—for economic research and for monetary policymaking. The Keynesian paradigm, with its activist policy prescriptions, grew out of the pain and suffering of the Great Depression, which dealt a blow to the classical view that markets readily equilibrate. The Great Inflation of the 1970s, in turn, exposed inadequacies in the substance and methodology of Keynesian macroeconometric modeling, and helped usher in the real business cycle research program with its prescription that monetary policy should leave the economy to its own devices and focus mainly on keeping inflation low and stable. Just a decade later, the Great Disinflation of the early 1980s reminded us that monetary policy has real consequences, and a New Keynesian synthesis focused policy on both full employment and price stability, as approximately described by a Taylor rule. During the relatively stable Great Moderation, the quintessence of that synthesis—namely, the DSGE model with nominal rigidities—ascended to the position of reigning macroeconomic orthodoxy. But few things are permanent in our world. The current financial crisis raises questions about the relevance and usefulness of this paradigm too. I'd like to focus today on three of these questions.

The monetary policy transmission mechanism

The first has to do with the transmission mechanism of monetary policy. In most models used for monetary policy analysis today, "optimal" policies can be designed for pursuing full employment, and low and stable inflation. While these models allow for various real and nominal rigidities, they treat financial markets as frictionless and efficient. As a consequence, monetary policy affects the economy through a single tool—a short-term interest rate—that transmits itself across credit, equity, derivatives, and foreign exchange markets through arbitrage.

But, the hand we have been dealt today doesn't look anything like the textbook ideal that I just described. Instead, we are experiencing pervasive financial market failures with devastating macroeconomic effects. The normal monetary transmission mechanism has been hobbled by dysfunctional money and credit markets. Risk spreads have ballooned on supposedly safe assets like agency debt and mortgage-backed securities (MBS). What does optimal monetary policy look like in this situation? How do we gauge the effectiveness of policy actions, and how can we implement and communicate systematic policy responses under these conditions?

This question of how to conduct monetary policy when financial markets aren't working well is illustrated by our large-scale asset purchase program. With the funds rate pinned near zero and spreads on mortgages over Treasuries very elevated, the Federal Open Market Committee (FOMC) embarked on a program of purchases of agency-insured MBS, agency debt, and longer-term Treasury debt totaling $1.75 trillion. This program's goal is to bring down private borrowing rates and thereby stimulate the economy. In the ideal world of frictionless financial markets, such actions would be ineffective because private investors would simply readjust their portfolios to accommodate changes in the Fed's portfolio. But, in a world where financial markets are impaired, such balance sheet policies may influence asset prices and the economy.

A market test of these policies came on March 18 when the FOMC's announcement of an expansion of these purchases was met with an immediate and sharp decline in interest rates on both Treasury securities and agency-backed MBS. Rates on corporate bonds and mortgages came down as well. Similar effects on interest rates were felt in the United Kingdom after the Bank of England announced a program to buy long-term government debt there. Despite these initial successes, there is still a lot we don't know about the magnitude and duration of the effects of these policies. Our standard monetary policy models do not incorporate financial frictions that lead to asset purchases having real effects. We lack both the data and theory to provide strong guidance on these policies. Truly, we are sailing in uncharted waters, marking our maps with every bit of information along the way.

Asset price bubbles and monetary policy

My second point concerns asset prices. The role of the house price bubble in precipitating the current financial crisis places new urgency on a long-standing question: Should central banks attempt to deflate asset price bubbles before they grow large enough to cause big problems? Until recently, most central bankers would have said monetary policy should respond to an asset price only to the extent that it will affect the future path of output and inflation. In essence, if you believe that financial markets work well most of the time, then you would be highly reluctant to target asset prices, let alone pop asset price bubbles. But, as I have discussed, we have vivid proof that markets sometimes don't work, and that the unwinding of a bubble can dramatically harm economic performance and threaten financial stability.

Four main issues define this debate, and the current crisis bears on each of them.1 First, some question whether bubbles even exist. They argue that asset prices reflect the collective wisdom of traders in organized markets who best understand the fundamental factors underlying asset prices. It seems to me that this argument is difficult to defend in light of the poor decisions and widespread dysfunction we have seen in many markets during the current turmoil.

Second, it's an open question whether policymakers can identify bubbles in time to act effectively given that our models of underlying fundamentals are imprecise. For example, fundamental values of housing often are estimated by comparing the ratio of house prices to rents with a long-run average.2 This is a rather crude method, and some experts doubted that a bubble existed even when this ratio reached record highs in 2006. That said, by 2005 I think most people understood that—at a minimum—there was a substantial risk that houses were overvalued, although few anticipated that house prices would fall as sharply as they have.3

Third, even if we can identify bubbles as they happen, using monetary policy to address them will reduce our ability to attain other goals, so it makes sense for monetary policy to intervene only if the fallout is likely to be quite severe and difficult to deal with after the fact. For example, fluctuations in equity prices generally affect wealth and consumer demand quite gradually. A central bank may prefer to adjust short-term interest rates after the bubble bursts to counter the depressing effects on demand. The tech stock bubble seems to fit this mold. Still, some bursting bubbles are more virulent than others. It may be that credit booms, such as the one that spurred recent house price and bond price increases, hold more dangerous systemic risks than other asset bubbles. By their nature, credit booms are especially prone to generating powerful adverse feedback loops between financial markets and real economic activity.4 If all asset bubbles are not created equal, policymakers could decide to intervene in those cases that seem especially dangerous.

Fourth, if a dangerous asset price bubble is detected and action to rein it in is warranted, is conventional monetary policy the best tool to use? Going forward, I am hopeful that capital standards and other tools of macroprudential supervision will be deployed to modulate destructive boom-bust cycles, thereby easing the burden on monetary policy.5 However, I now think that, in certain circumstances, the answer as to whether monetary policy should play a role may be a qualified yes. In the current episode, higher short-term interest rates probably would have restrained the demand for housing by raising mortgage interest rates, and this might have slowed the pace of house price increases. In addition, tighter monetary policy may be associated with reduced leverage and slower credit growth, especially in securitized markets.6 Thus, monetary policy that leans against bubble expansion may also enhance financial stability by slowing credit booms and lowering overall leverage.

Certainly there are pitfalls to trying to deflate bubbles. At the same time, policymakers often must act on the basis of incomplete knowledge, and it is now patently obvious that not dealing with some bubbles can have grave consequences. I would not advocate making it a regular practice to lean against asset price bubbles. But, in my view, recent painful experience strengthens the case for using such policies, especially when a credit boom is the driving factor.

The inflation objective and the zero bound

Finally, I will turn to the question of the appropriate long-run inflation objective—that is, the rate that best promotes the dual goals of maximum sustainable employment and price stability. This is a topic that the FOMC has discussed on numerous occasions during my tenure as a governor and as president of the San Francisco Fed. In the past, I had spoken in favor of a 1½ percent rate of PCE price inflation. In my view, though, recent events provide reason to reexamine this critical subject.

The choice of an appropriate inflation objective depends on an evaluation of the costs and benefits of very low inflation. The financial crisis and global recession have not qualitatively changed these costs and benefits, but they may affect their quantitative evaluation, which in turn might influence how policymakers view their inflation objectives. The benefits of low and stable inflation are abundantly clear to this audience and have not changed in any material way because of the recession. On the cost side, the zero lower bound on nominal interest rates is a critical concern. Japan's experience with deflation starting in the 1990s generated a large body of research on monetary policy strategy that takes account of the zero lower bound.7 Researchers emphasize the benefits of aggressively cutting rates when the prospect of reaching the zero bound emerges, and of using clear communication about the central bank's future policy intentions and its long-run inflation goals. The FOMC took this research to heart during the deflation scare of the early 2000s and the current crisis.

One conclusion of the research is that, even if monetary policy acts appropriately, an inflation objective of 1 percent or lower entails some costs in terms of stabilizing output, but the impact on average macroeconomic performance at higher inflation objectives is minimal.8 However, I have not found the experience of the past several years at all reassuring on this point. We have had two deflation scares and a severe global recession in a span of seven years, with several major central banks now confronting the zero bound. Of course, this may simply reflect very bad luck that is unlikely to be repeated. But, a number of considerations make me hesitant to endorse this view. Indeed, concern about the ability of the Fed to support employment following large negative shocks may explain why most FOMC members now judge a PCE inflation rate of 2 percent to be most consistent with the Committee's dual mandate.

Calculations of the effects of the zero bound depend crucially on assumptions regarding the magnitude of disturbances that hit the economy, the level of the natural rate of interest, and the behavior of the rest of the global economy. Recent experience raises the possibility that the Great Moderation is behind us, so we must be prepared for substantial shocks. Thus, an analysis of the zero bound needs to incorporate greater volatility than experienced over the past quarter century. With respect to the equilibrium real interest rate, the global savings glut that helped restrain real interest rates may persist or even intensify after the recession is over, leaving us with only a small cushion against reaching the zero bound. And, the theory that the global economy was decoupled did not hold up in the current recession. This has weakened the transmission of monetary policy by short-circuiting the exchange rate channel in any one country. When all other countries are in recession and cutting rates, it is harder to stabilize the economy and avoid deflation.

Finally, the Fed's experience with nontraditional monetary policy tools cuts two ways in analyzing the effectiveness of monetary policy near the zero bound. On the one hand, the apparent success of the Fed's longer-term asset purchases and broader credit easing programs in lowering borrowing costs and stimulating spending suggests that the zero bound problem may not be as costly as previously thought. On the other hand, the deployment of these new policy tools comes with its own set of risks and costs. In particular, we do not yet have good estimates of the quantitative impact of such interventions. In addition, the use of nonstandard monetary policy instruments necessarily brings with it the uncertainty and risks of unintended consequences. For example, some observers worry that the ballooning of the Fed's balance sheet may raise inflation because the Fed may face political and technical challenges when it tries to unwind these policies—especially if the recession ends before the need for support of the financial markets fades.9 While I have not found these arguments convincing so far, the recent rise in Treasury rates, if it is reflective of such concerns, is disconcerting.

Clearly, the events and monetary policy dilemmas of the past two years have laid before us an urgent and compelling research agenda. We simply must understand better—and ultimately develop reliable models of—the extraordinary financial and macro linkages that produced the current crisis. In addition, we need to more fully evaluate the costs and benefits of nonstandard monetary policy actions. I'll close with an encouraging note. As the papers at this conference attest, researchers in the academic and policy worlds are rising to the occasion. These are vitally important tasks and I'm glad to see so many of my colleagues rolling up their sleeves.

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End Notes

1. Glenn D. Rudebusch, "Monetary Policy and Asset Price Bubbles," FRBSF Economic Letter 2005-18, August 5, 2005.

2. Joshua Gallin, "The Long-Run Relationship between House Prices and Rents," Finance and Economics Discussion Series 2004-50, Board of Governors of the Federal Reserve System, Washington, D.C. (forthcoming in Real Estate Economics).

3. Kristopher Gerardi, Andreas Lehnert, Shane M. Sherlund, and Paul Willen, "Making Sense of the Subprime Crisis," Brookings Papers on Economic Activity, Fall 2008, pp. 69–160.

4. Frederic S. Mishkin, "How Should We Respond to Asset Price Bubbles?" speech at the Wharton Financial Institutions Center and Oliver Wyman Institute's Annual Financial Risk Roundtable, Philadelphia, PA, May 15, 2008.

5. There is now widespread agreement among policymakers and in Congress on the need to overhaul our supervisory and regulatory system, and broad agreement on the basic elements of reform. See, for example, Timothy Geithner, testimony before the House Financial Services Committee, March 26, 2009; Ben S. Bernanke, "Financial Reform to Address Systemic Risk," speech at the Council on Foreign Relations, March 10, 2009; Daniel K. Tarullo, "Modernizing Bank Supervision and Regulation," testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, March 19, 2009; Group of Thirty, "Financial Reform: A Framework for Financial Stability," January 2009; Markus Brunnermeier, Andrew Crockett, Charles Goodhart, Avinash D. Persaud, and Hyun Shin, "The Fundamental Principles of Financial Regulation" Geneva Reports on the World Economy 11, January 2009; Congressional Oversight Panel, "Special Report on Regulatory Reform," January 2009.

6. Tobias Adrian and Hyun Song Shin, "Money, Liquidity, and Monetary Policy," American Economic Review 99(2), May 2009, pp. 600–605.

7. For example, see the special conference volume, "Monetary Policy in a Low-Inflation Environment," in the Journal of Money, Credit, and Banking 32(4, part 2), November 2000.

8. See David Reifschneider and John C. Williams, "Three Lessons for Monetary Policy in a Low Inflation Era," Journal of Money, Credit, and Banking, November 2000, and Guenter Coenen, Athanasios Orphanides, and Volker Wieland, "Price Stability and Monetary Policy Effectiveness when Nominal Interest Rates are Bounded at Zero," Advances in Macroeconomics 4(1) 2004.

9. See Jeffrey Lacker, "Government Lending and Monetary Policy," remarks to the National Association for Business Economics, 2009 Washington Economic Policy Conference, Alexandria, VA, March 2, 2009; and Charles I. Plosser, "Ensuring Sound Monetary Policy in the Aftermath of Crisis," speech to the U.S. Monetary Policy Forum, The Initiative on Global Markets, University of Chicago Booth School of Business, February 27, 2009

Needing to conserve capital and fearful that other firms might collapse soon, they largely stopped lending

TO BE NOTED: From the NY Times:

"April 29, 2009

Economic Scene
Time for Bank Creditors to Share the Pain?

By DAVID LEONHARDT

The big debate about President Obama’s financial rescue plan has centered on whether he’s been right to avoid nationalizing the country’s biggest banks. But there is another, more pressing question about the plan that has received considerably less attention.

After the Federal Reserve’s stress tests identify the country’s sickest banks next week, who will bear responsibility for shoring up their balance sheets?

Will it be solely the government? Or will the government force institutions that lent money to sick banks in better times — their creditors — to take a hit by forgiving some of the loans?

Timothy F. Geithner, the Treasury secretary, and other officials are reluctant to force losses, often called haircuts, on banks. They worry that haircuts could create a cascade, in which some of the creditors that take losses become insolvent, while creditors of healthier banks begin wondering whether they will be subject to future haircuts. In the ensuing panic, financial markets could freeze up, as they did last fall.

But relying on the government alone to shore up the banks brings risks, too. In the long term, it could leave taxpayers with an enormous bill. In the short term, it could destroy the already thin political support for the rescue plan.

Recently — and, I’d argue, fortunately — the Obama administration seems to have become more open to the idea of encouraging loan forgiveness in certain situations. Beyond those situations, officials hope that no others are needed.

Yet that may turn out to be wishful thinking. The Treasury Department has only about $130 billion remaining in its Troubled Asset Relief Program, or TARP, fund. By comparison, American banks are probably facing an additional $1 trillion in losses over the next two years, the International Monetary Fund projects.

The gap between those numbers means that the debate over haircuts could be with us for a while.

•

The case against haircuts starts with Lehman Brothers. When Lehman collapsed into bankruptcy on the night of Sept. 14, its creditors were left with billions of dollars in loans to Lehman they would never recover. Needing to conserve capital and fearful that other firms might collapse soon, they largely stopped lending.

“That’s when this crisis took a quantum leap up in terms of seriousness,” as Janet Yellen, the president of the San Francisco Fed, recently said.

So imagine that on Monday, when releasing the results of its stress tests, the Fed says that several banks need more money to survive a deep recession. Assuming private investors are not willing to put it up, the government will then have two options.

It can increase the banks’ assets, by giving them more taxpayer money in exchange for an even greater ownership stake. Or the government can reduce the banks’ debts, by using its influence to encourage, or even demand, loan forgiveness.

Debt reduction, in exchange for an equity stake, is a standard strategy for dealing with failing companies. It’s what the Obama administration is trying to do with Chrysler’s and G.M.’s creditors. Under the tentative deal worked out on Tuesday, Chrysler’s creditors would receive about 28 cents in stock for every dollar of loans they forgave.

But banks aren’t like other companies. Like it or not, they are the heart of the credit system and thus the economy. No matter what happens to Chrysler’s creditors, Honda won’t stop making cars, and people won’t stop buying them. Imposing losses on Bank of America’s creditors, though, has the potential to freeze the financial markets.

One sign that such concerns are legitimate is the fact that they’re shared by some economists who saw the financial crisis coming well before Fed officials or Mr. Obama’s current advisers. At a Fed conference in 2005, Raghuram Rajan — then the director of research at the I.M.F. and now a University of Chicago professor — criticized Alan Greenspan for turning a blind eye to risk (and was in turn criticized by Lawrence H. Summers, now Mr. Obama’s lead economic adviser). Today, Mr. Rajan says that haircuts really do have the potential to make some financial firms insolvent and cause worldwide problems.

Yet he also says that the government should study whether it can sensibly impose any losses on creditors, rather than unquestioningly accepting Wall Street’s self-interested view that haircuts would be bad for the economy. “We constantly have to question the arguments the Street puts forward,” he said, “and ask whether they are really these holy cows who can’t be touched.”

Ever so gradually, the administration may be moving toward this more skeptical position.

In February, the Treasury began twisting the arms of some holders of Citigroup preferred stock to get them to convert it into common stock. (Preferred stock, despite its name, is something between a loan and stock.) The credit markets hiccupped, but quickly returned to their previous state. In the wake of the stress tests, the Fed and the administration may well push for more conversions along these lines.

The trickier issue is what to do with holders of so-called subordinate debt. In the spectrum of investments, subordinate debt is considered safer than preferred stock and tends to be subject to haircuts only when a company slides toward bankruptcy. Pushing a bank to the brink of bankruptcy would raise the specter of Lehman Brothers.

Now, some debtholders may be fearful enough of bankruptcy that they would willingly accept haircuts, figuring they are better than the alternative. On “Meet the Press” on April 19, Mr. Summers said one option for increasing the banks’ capital was “asset liability swaps,” by which he meant a voluntary exchange of loan forgiveness for equity.

The government’s main role would be to force existing equity holders to offer the swaps to creditors. Equity holders often oppose such swaps because their own stake is diluted. But government regulators could insist that the offer be made and then allow debtholders to accept or reject it. If the offer were, say, 60 cents on the dollar and the market price of the debt only 50 cents, the creditors might accept.

If steps like these, along with TARP, are enough to repair the financial system, haircuts won’t be needed. If not, the only remaining options will be more taxpayer money, more haircuts or both.

We already know what the bankers will say about haircuts, regardless of how carefully they’re devised: that they’ll end up hurting the rest of us. Remember, though, they said the same thing about stronger financial regulation, and they turned out to be spectacularly wrong. Stronger regulation would indeed have hurt many bankers. It would have benefited the rest of us.

This month, I interviewed Mr. Obama for a Q. and A. to be published Sunday in The New York Times Magazine, and I asked him why his economic inner circle was dominated by protégés of Robert Rubin. These protégés, like Mr. Geithner and Mr. Summers, are deeply thoughtful people, just as Mr. Rubin is. But in retrospect, they all gave too much deference to Wall Street.

Mr. Obama replied that his economic team also included people from outside the Rubin circle, which is certainly true. Still, Mr. Geithner and Mr. Summers remain the dominant forces in the team.

When they — and the president — consider Wall Street’s warnings about haircuts, I hope they also consider its track record. Lately, taxpayers haven’t done very well when they’ve listened to Wall Street’s advice.

E-mail: leonhardt@nytimes.com"

the firm was “too big to fail” and its bankruptcy caused a “quantum” jump in the magnitude of the financial crisis.

TO BE NOTED: From Bloomberg:

"Yellen Signals Fed’s Decision to Let Lehman Fail Was a Mistake

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By Michael McKee and Vivien Lou Chen

April 17 (Bloomberg) -- Federal Reserve Bank of San Francisco President Janet Yellen signaled that it was a mistake to allow Lehman Brothers Holdings Inc. to collapse, saying the firm was “too big to fail” and its bankruptcy caused a “quantum” jump in the magnitude of the financial crisis.

The impact of Lehman’s failure “was devastating,” Yellen said yesterday after a speech in New York. “That’s when this crisis took a quantum leap up in terms of seriousness.”

Lehman was forced into bankruptcy on Sept. 15 after a weekend of negotiations at the Federal Reserve Bank of New York failed to produce a buyer and Fed and Treasury officials decided not to provide the firm with a loan.

Credit markets froze in the days after Lehman’s failure. Commercial paper markets almost ceased functioning as lenders shunned risk and the spread between the London Interbank Offered Rate, a measure of banks’ willingness to lend, and the average rate on overnight swaps rose 360 basis points in two weeks.

Yellen said she disagrees with Fed officials who argued in September that a government bailout of Lehman would encourage excessive risk-taking among investors. She commented in response to an audience question after a speech sponsored by the Levy Economics Institute of Bard College

“Lehman was a systemically important institution,” Yellen said, noting she was “sitting in California” at the time of Fed deliberations and “wasn’t involved in anything having to do with it.”

Yellen, echoing Fed Chairman Ben S. Bernanke and other federal regulators, said government officials need the authority to close down non-bank financial institutions.

‘Orderly Wind-Down’

Congress should “pass legislation that would provide for the orderly wind-down of a non-bank institution,” she said. “I’m sure it would have been used in the case of Lehman,” Yellen said, while declining to label the decision not to rescue Lehman an error.

Without a suitable “tool box,” Fed officials have been forced to improvise throughout the credit crisis.

“Bear Stearns, Lehman, AIG -- these have all been horrendous, miserable situations,” Yellen said. “We’re pushing the envelope of our powers, but we’re choosing to do that because the consequence of failing to do that seem unthinkable.”

Before joining the San Francisco Fed, Yellen served as a member of the Fed’s Board of Governors from 1994 to 1997. She left that post to become Chairman of the White House Council of Economic Advisers under former President Bill Clinton.

Policy Tools

Yellen also said she no longer opposes using the central bank’s policy tools to avert harmful asset-price bubbles similar to the one in U.S. housing this decade.

“Now that we face the tangible and tragic consequences of the bursting of the house price bubble, I think it is time to take another look,” she said in her speech. “What has become patently obvious is that not dealing with certain kinds of bubbles before they get big can have grave consequences.”

Yellen’s remarks make her at least the second Fed official after Gary Stern, of Minneapolis, to rethink the central bank’s hands-off approach toward bubbles, an article of faith during former Chairman Alan Greenspan’s 18-year tenure. The Fed’s low interest-rate targets between 2002 and 2004 were partly to blame for the easy credit and housing-price escalation that led to the current financial crisis, the San Francisco bank president said.

“I would not advocate making it a regular practice to use monetary policy to lean against asset price bubbles,” Yellen said in a speech at the conference. “However, recent experience has made me more open to action. I can now imagine circumstances that would justify leaning against a bubble with tighter monetary policy.”

Long-Held Ideas

While Yellen’s remarks are unlikely to result in immediate monetary-policy changes, they demonstrate how officials are questioning long-held ideas about the Fed’s role in markets. Yellen has led the San Francisco Fed since 2004.

A report yesterday showed that San Francisco Bay Area home prices fell a record 46 percent in March from a year earlier, the 16th month of declines.

Data released this week on employment and other areas of the economy suggest that the U.S. slump is easing. The reports buttress Bernanke’s assessment this week that the “sharp decline” in the economy appears to be moderating.

The economy, in areas such as home sales and consumer confidence, is showing “tentative signs” that the decline is slowing, Bernanke said in an April 14 speech in Atlanta. He added that “a leveling out of economic activity is the first step toward recovery.”

The central bank said in its Beige Book business survey on April 15 that the contraction slowed across several of the biggest regional economies last month, with some industries “stabilizing at a low level.”

“While we’ve seen some tentative signs of improvement in the economic data very recently, it’s still impossible to know how deep the contraction will ultimately be,” said Yellen, 62, who votes on rates this year."