speeches · February 28, 2008
Regional President Speech
Charles L. Evans · President
O ce of the President Money Museum
Last Updated: 11 25 09
Comments to the U.S. Monetary Policy Forum
U S Monetary Policy Forum
University Club of New York
New York, New York
I would like to compliment the organizers for posing a very challenging set of questions for the panel to address Although you
will quickly notice that I am not going to respond to each question explicitly, I will address what I think are the key issues
And in doing so, I think you will see how I have approached monetary policy decision-making during the challenging
environment that has inspired these questions As always, these are my own views and not those of the FOMC or my other
colleagues in the Federal Reserve System
The four questions for the panel can be boiled down to two broad issues:
1 When and how does excessive risk-taking lead to a degree of nancial instability that substantially complicates the
conduct of monetary policy?
2 Are current policy tools adequate to deal with this instability?
Let me start by summarizing my views First, because periods of nancial stress are relatively rare in economies with strong
commitments to price stability and low variability in economic activity, the normal approaches to monetary policy—as
summarized by the Taylor Rule—generally serve us quite well Second, during periods of nascent or even actual nancial stress,
it is appropriate for policy to maintain its focus on obtaining its macroeconomic goals over the medium term Third, timely
access to substantive information about nancial market participants' activities is a critical aid to policymakers when assessing
disruptions to the credit intermediation process that could adversely a ect the real economy In the United States, the Fed's
supervisory responsibilities have been a helpful tool in obtaining such information
Before I go on, allow me to quibble with the term "excessive risk-taking " As we all know, it is di cult to de ne what
"excessive" is
We need to bear in mind that risk-taking is an important ingredient in economic growth and the e cient allocation of
resources Developing new technologies and their applications requires creativity and a willingness to take risks Some
innovators will succeed and invent great things, and some will fail Resources will ow to the successful innovators, which
boosts productivity and economic growth Workers also take risks, choosing new careers and job opportunities to improve
their standard of living Clearly risk-taking is an important ingredient in well-functioning competitive economies, and living
standards are enhanced by such activities
But when is this risk-taking "excessive" and when could it have large downside economic e ects? This is di cult to know
simply by observing the decisions and investments as they are made For example, a large investment project may appear to be
relatively safe when the probability of its success is judged to be high In addition, the investment might be part of a larger
diversi ed strategy designed to reduce the overall risk pro le of the rm Of course, in the end the investment strategy may
turn out to be more risky than understood ex ante The greater risk could be due to overly optimistic assessments of the
likelihood of the investment payo s or the lack of diversi cation achieved by the portfolio as the returns to the various
investments turn out to be more correlated than had been anticipated
The nancial developments that spawned some of last summer's turmoil in subprime mortgage markets have some of these
properties The extent to which risk-taking was excessive at the outset remains unclear But the important question for today is
whether our policy responses to these events in themselves will lead to further excesses at some point in the future There is no
way to answer this question for sure But I think that we can minimize the potential for problems if monetary policy focuses
clearly on our legislative mandate to facilitate nancial conditions that promote e ectively the goals of maximum employment
and price stability
Now, let me discuss how I see nancial markets and nancial stability tting into our policy objectives There is no analogy in
nancial markets to macroeconomic price stability The prices of nancial products may change quite substantially when new
information arrives Indeed, one of the most important activities of nancial markets is price discovery—the e cient
assimilation of all available information into asset values This promotes the appropriate allocation of capital among competing
demands and supports maximum sustainable growth And it is this e cient functioning of markets that is our concern with
regard to nancial stability
Most of the time, monetary policy intersects nancial markets directly at our primary policy tool—the federal funds rate To
alter the trajectory of in ation and economic growth towards their goals, changes in the federal funds rate directly alter short-
term risk-free rates of interest Perceptions of our willingness and ability to adjust future policy then may also alter risk
premiums in xed-income markets and result in a change in the cost of nancial credit to numerous other borrowers
When the economy is weak and we lower rates to stimulate activity, we encourage risk-taking This is a natural consequence of
lowering rates At the margin, projects which previously had too much risk relative to their expected return become more
attractive for two reasons: The future returns may look better and the nancing costs are lower And this may be a good thing,
for example, if it can help stimulate an economy that is mired in a situation where overcautious businesses or households are
holding back on investment and spending These actions would further reduce macroeconomic risk
However, in principle, these e ects could go too far and encourage too much risk–taking How would we know? In my mind,
we would begin to see imbalances emerge that would put our policy goals at risk over the medium term For example, in the
late 1990s, we felt that the increases in household wealth—much of it related to the booming stock market—were causing
spending to outstrip the economy's productive capacity at that time and posing a threat to price stability
When thinking about policy adjustments, a useful benchmark is the line of research on policy rules pioneered by John Taylor
This research indicates that most historical policy actions have been systematic responses to changes in the prospects for our
goal variables of output growth, employment, and in ation The main ideas are the systematic response component, and that
particular rules are benchmarks for typical policy Financial developments play a role in these systematic responses through the
normal e ects of changes in the funds rate on other credit conditions that a ect the real economy So policy responds to
economic developments that a ect the achievement of its goals As long as the goals themselves are compatible with the
structure of the economy, it is hard to see how the normal conduct of policy would generate excessive risk-taking
Of course, even Taylor's research points out that periods of nancial stress may require policy responses that di er from the
usual prescriptions It's not that we downgrade our focus on the policy goals It is that during these times we often are highly
uncertain about how unusual nancial market conditions will in uence in ation and economic activity The baseline outlook
may be only modestly a ected by the conditions, but there may be risks of substantial spillovers that could lead to persistent
declines in credit intermediation capacity or large declines in wealth These in turn would reduce business and household
spending In such cases, policy may take out insurance against these adverse risks and move the policy rate more than the usual
prescriptions of the Taylor Rule
Now if we took out such insurance too liberally or too often, then private sector markets would change their views regarding
policy and alter their base level of risk-taking But in doing so, we likely would observe in ationary imbalances emerging or
unusual volatility in output So part of our job as a central bank is to properly price these insurance premiums against the
achievement of maximum employment and price stability over the medium term Importantly, when insurance proves to be no
longer necessary, removing it promptly and recalibrating policy to appropriate levels will reiterate and reinforce our
commitment to these fundamental policy goals And if we are transparent so that markets understand that we will adhere to
this strategy, such insurance-based monetary policy will not encourage excessive risk-taking
We also must remember that we can't eliminate risk and uncertainty completely; nor would it be a good idea to do so But by
the same token, we don't want to add to uncertainty The literature on asset bubble pricking is related to this discussion of
excess risk-taking: Should a policymaker de ate a bubble before it becomes problematic? I am skeptical that we can identify
bubbles with enough accuracy and know enough about how to act to say that we wouldn't have more failures than successes
Remember that in 1996, many commented that the stock market might be overvalued; however, the then unappreciated
acceleration in productivity eventually justi ed even higher valuations Furthermore, as former Chairman Greenspan 2004
noted, in order to make sure you burst a bubble, you have to attack it aggressively, because if your attack fails, it just gets
bigger And there are big risks to the real economy of making such large moves
I would now like to say a few words about the adequacy of our toolkit during periods of nancial disruptions We have several
ways to add liquidity to the economy in addition to the normal open market operations: the discount window—extended to
term borrowing and the new Term Auction Facility—and foreign exchange swaps to help enhance liquidity abroad In these
operations we accept as collateral assets that others see as less readily marketable I do not think this adds undue risk since we
only lend to quali ed solvent institutions and the collateralization rates include appropriate haircuts on riskier assets In
addition, we sterilize the e ects of the borrowings on aggregate reserves, so that the liquidity injections are done while
maintaining the fed funds rate target This keeps the funds rate at a level we see as consistent with achieving our announced
policy goals
Another tool we have is the ability to obtain timely information directly from nancial market participants that can help us
gauge the extent and potential fallouts of nancial disruptions One way we do so is through our role as a supervisor: Our
experience here has given us a good base of understanding and timely access to a wide range of information regarding nancial
intermediaries' activities This is important, since most nancial crises involve developments in new or unusual products that
a ect the income ows and balance sheets of these institutions There seem to be synergies from the knowledge we gain
through supervision and the policy questions we are faced with during periods of unusual nancial stress In addition to
information from banking entities, it is important to have information ows from other nancial sector participants
Thanks and I look forward to a lively discussion
Note: Opinions expressed in this article are those of Charles L Evans and do not necessarily re ect the views of the
Federal Reserve Bank of Chicago or the Federal Reserve System
Cite this document
APA
Charles L. Evans (2008, February 28). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20080229_charles_l_evans
BibTeX
@misc{wtfs_regional_speeche_20080229_charles_l_evans,
author = {Charles L. Evans},
title = {Regional President Speech},
year = {2008},
month = {Feb},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/regional_speeche_20080229_charles_l_evans},
note = {Retrieved via When the Fed Speaks corpus}
}