Regional President Speech

.J The Federal Reserve and the Future of the Financial System I am delighted to be present this evening to share with you some of my thoughts as to what may be the future of banking and specifically what forces or events may help shape that future. It is a special privilege to share the podium with John Perkins, a distinguished banker whose thoughtful industry leadership is widely recognized and respected. As observers of the financial scene, I am sure ~l realize the rapid pace of financial innovation that~ken place in recent times. Much of what we about pay­ traditionally~understood ments services and specialized financial institutions, financial instruments, inves tment and the like has been largely strat~es ~ '~ swept away by a tide ofllinf~ati n, high interest rates, and ~ I ~ calklff~ nological progress. To illustrate the point, recently ~~ with a community banker who of his recurring nightmare. It involves one of his traditional customers that goes into her neigh­ borhood Sears store to buy a pie plate. After charging the item to her revolving credit account, she stops to deposit her paycheck into her account at Sears' savings and loan subsidiary, checks on her investment in one of ~eafS'~?Ons~mer notes, makes a payment on ~ ~tN.IeP t:.-yt4o~(UI'f&e <--..> her life insura~POliCYf\ adds a small sum to the money market fund marketed by) Sears' brokerage firm subsidiary, and so on. And she gets a good buy on her pie plate, too! While this vision may be a nightmare for the traditional banker, it highlights the incredible change in our financial system over the -2­ last 15 years or so. Moreover, this change continues unabated and is accompanied by significant ~~~t~~~11 about the role and impacts ~he ~, a~ varied participants in well as concern about stability~ TI.ti ~Q~- ~ the 'S1j ; 7 ' s In view of these legitimate concerns, I want to focus my brief comments on what I see as the primary role of the Federal Reserve during this transition period. That is, the transition from the tightly regulated financial system that was legislated in the 1930's to the more competitive - market oriented financial system which is emerging in the 1980's. I believe the Federal Reserve will be a major player in shaping the new financial system and that the Federal Reserve's primary responsibility will be to create a stable economic environment within which orderly change can take place. ~~~.#~ ~ocus~ As the central bank, I believe twofold. First to promote financial stability by pursuing an effective anti-infla­ tionary monetary policy and, second, to provide or encourage a po regulatory framework that will permit orderly change during the O')'\..t.­ transition period and~in which all participants have an equal oppor­ tunity to compete. This, of course, suggests that more freedom should be ~o the regulated participants and that some restraint Hs ,]~ be placed on the unregulated particiPant~ The ~e~~ole of monetary policy can bellillustrated t~:rating pac~ o:~a~L~ Chang~p by looking at t zr ~ ~~,..6'; ~ ~j\in~and high inte;Z:t rates whic ovide new incentives for competition and rewards for financial innovators. It is my view that the Federal Reserve's current firm anti-inflationary policy -3­ course is an absolutely essential ingredient for ~ the s~t­ ~ and long-run stability o~t-inancial insti tutions and the whole finan­ cial system. Moreover, I am convinced th~e goals of long-term ar~rmony noninflationary economic growth with goals emphasizing the stability of our financial structure. I say this because I am certain that the best way to achieve stability of our financial institutions is to bring down the level and variability of interest rates--and that means bringing inflationary forces under control while building a base for noninflationary growth. The Reserve's ability to adhere to a monetary policy ~ederal of restraint in pursuit of future stability is complicated by public pressures for action to bolster the near-term stability of certain financial institutions. Some call for the Federal Reserve to rapidly ease its restrictive policy so that an increased flow of credit can work to bring down interest rates, permitting hard-pressed thrift institutions to adjust more rapidly to the imbalance between ~ :Jle~' Jch~!~eld ..::l4 ~ 'i hi g ..h -C: st 3 fu ds ;tnd. por!'tolios. ,.-? ~ ~?:4 ~?~ ~ ,.e.. •• To ose pres res I would respond that the Federa! Resgrve is ~ies the nation's central bank. must be tailored to accomplish the economic goals of the nation as a whole--and to promote the financial system. The Federal Reserve should the temporary problems of some particular segments of the economy. I would also point out that the rapid monetary growth which would be needed to bring interest rates down sharply/ might well have I that effect--but only for a short time. With rapid monetary easing, financial markets would anticipate the traditional by-product of -4­ too-rapid money growth--i-nf~ation--and interest rates would quickly incorporate an even larger inflationary premium. The net result, of course, would be just the reverse of what was intended. Some observers may be tempted to believe that the recent reduc­ tion in the Federal Reserve's discount rate is a signa~se, co~~e ~ or worse, abandonment of the firm anti-inflationary pursuing. However, because credit demands have moderated result of more in money marRets and in discount window borrowing. In such a context, the action, was not inconsistent with a pattern of continued restraint of growth in money and credit~ ~ Public understanding o)lan~upport for the Federal Reserve's anti-inflationary policies have suffered because of vocal criticism from some observers who disagree with the method used to conduct monetary policy. Particularly troublesome have bee~s fro~ Reserv~announce ~ some very prominent economists that the Federal monetary targets and stick to them regardless of what else may be happening in the economy. Some even suggest that the particular monetary aggregates targeted by the Federal Reserve are of no par­ ticular significance. In my view, a policy based on rigid adherence to a fixed growth • rate ~ I t fPL a particular measure of the money stock would be irresponsible. In fact, in the current environment of rapid economic and financial change, holding to a fixed monetary growth ~e could actually induce instability. Those of you who are "Fed-watchers" I'm sure recognize the inadvisability of inflexible growth targets for monetary aggregates that do not adequately capture the effects -5­ of recent financial innovation and structural change. For example, in setting long-run target ranges for monetary growth for 1981 at the beginning of the year, the FOMC was aware that NOW accounts would/h~~e . ~_~arqe .but ~predictable impact o~~owth of trans­ . ~~.c::v... p4L.o ..' .... 7 r.~t? ..Iactionsl\~a SJlre~ o f wopoy p..~l-B. Rathe} than pretending that J ' we could foretell precisely t lje NOW accountsB ean. d other ef~~~t~of ~~ ~~v r. y A changes on the composition of the PUblic~radsactions~ba nces, the Federal Reserve cautioned that these targets might need to be adjusted as warranted by incoming information. As ev'idence accumulated during the year, it became apparent that the impact of NOW accounts and the growth of other innovations such as retail repurchase agreements, money market mutual funds, .. and cash-sweep accounts for corporations was greater than initially , anticipated. As a result, the FOMC at its midyear policy review decided to aim for Ml-B growth near the lower limit of its long-run range. Had the Federal Reserve been PEP' ., committed to Ml-B growth precisely at a rate near the midpoint of its long-run range, more reserves would have been pumped into the banking system to stimulate more rapid growth of traditional transactions deposits. The resulting flood of liquidity would almost certainly have ruled out the steady progress that has been made this year against inflation -- and, perhaps more importantly, the public's expectations of future inflation. The distorting impact of financial innovations has not been limited to the narrow 82& ~ measures of money, though. It ~ is now apparent that the growth of» broader monetary aggregates such as M2 have also been affected considerably by the tidal wave of financial changes. For example, money market mutual funds account -6­ for nearly half of the total growth in M2 ove r the last year. Al­ though money market funds have certain characteristics that make them potentially close substitutes for transactions balances, they also have characteristics that make them attractive substitutes for longer-term investments like stocks and bonds. By remaining flexible, the Federal Reserve has, in my view, avoided the pitfalls that could have destabilized the economy and the financial system. Commitment to constant growth of a particular monetary aggregate in an environment of rapid change, though alluringly could s j ~ple, have cau~~d irreparable damage to our prospects for achieving both ~ short-term and long-term objectives. So there are, indeed, complications for the Federal Reserve * ...... in achieving its •••• goals. Given the inevitable strains in a financial system in transition, what can be done to promote progress and to hasten accomplishment of the objectives we have for~ discussed? In my judgement, there are three major cornerstones progress: (1) One is continued commitment to an orderly, steady course of deregulation and adjustment. (2) Another is additional legislative or regulatory changes during the transition period which will promote equity among finan­ cial institutions, address the temporary earnings and liquidity problems of some institutions, and improve the potential for effec­ tive monetary policy. (3) The third is the continued high-profile commitment of public economic policies -- both monetary and fiscal -- to the goal of reduce d inflation, despite the disagreeable near-term side effects ~ -­ -7­ that course entails. The first element -- commitmen~. to ~iaerly transition -- appears m.~~ to be largely in place insofa r aSIl~~y institutions are con­ cerned. The landmark legiSlatio~ the Monetary Control Act sets 'a timetable for interest rate deregulation, gives depository insti­ tutions more of a market-oriented framework in which to make asset and liability decisions, and ultimat/2ly spreads the direct burden ~...t, of monetary policy among institutions through the ~pository phase-in of uniform reserve requirements. transitio~ However, neither the severity of the problems of nO~he a:celerated pace of financial innovation were fully antic­ ipated by the Monetary Control Act. As a result, earnings shortfalls, - liquidity pressures, and inequities in opportunity -- geographic ---------------------- b and otherwise -- among firms offe~ancial services have been magnified. These situations second element -- legislative sugges~the or regulatory actions -- may be needed to improve or ease the tran­ sition process. As you know, Congress is now considering legislation which would liberalize further the powers of financial institutions. In my view, much of the fundamental change being suggested, such as permitting thrif~ ii 'O S to have full banking powers, would more appropriately be considered later in the transition period, when earnings pressures on thrifts are eased and when the distortion in financial markets caused by inflation and high interest rates have smoothed out. In the short term, however, I would encourage consideration of actions such as simplified, accelerated accommodation of mergers of depository institutions -- particularly when the public interest would be served by the continued operation of the institution. As -8­ you may know, the Federal Reserve supports legislation allowing interregional or interindustry mergers in such situations. In order to improve monetary control, I would favor imposition of reserve requirements on that portion of money market funds which function as transaction balances. Such reserve requirements -­ which should be extended to transaction-type balances wherever they p~:~y are housed -- would improve the Federal Reserve's to measure and control monetary growth more accurately. Furthermore, such requirements would help bridge the competitive gap between depository institutions and those financial and nonfinancial firms who do not share the costly burden of regulation. The third and most important cornerstone for building the successful transition period is, of course, the continued commitment of public economic policies to bringing down the rate of inflation. No transition scheme I can imagine will be successful without the consistent monetary and fiscal discipline which leads to lower inflation, lower interest rates, and moderate sustainable economic growth. In my view, reducing inflation is the only way to facilitate ~orderly a~~ transition to the financial structure of the future, _ - permanently reduced inflation is a necessary pre-condition for the efficient, distortion-free functioning of that structure. Now that the Federal Re~rve's commitment to the necessary . ,----,M~J/r adjustment process is f shared bYl fiscal policymakers, it is possible tE~~. at last to foresee steady progress toward the ultimate However, should either monetary or fiscal policy waver because of short-term pressures to ease the pain of transition--or because of outside shocks or even political expediency--I have no doubt that -9­ the pace of financial change will accelerate. If that happens, the abilities of our political and financial institutions will be strained further, and our capacity to manage this process would be severely weakened. However, at the moment, I am encouraged with what I see happening on the fiscal side but I believe that additional evidence of fiscal restraint--whether further budget cuts, or perhaps rescheduled tax cuts--will contribute importantly to building the long-run anti­ inflationary bias so necessary if the nation is to achieve its economic goals.

J. Roger Guffey (1981, November 3). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19811104_j_roger_guffey

@misc{wtfs_regional_speeche_19811104_j_roger_guffey,
  author = {J. Roger Guffey},
  title = {Regional President Speech},
  year = {1981},
  month = {Nov},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19811104_j_roger_guffey},
  note = {Retrieved via When the Fed Speaks corpus}
}