Speech

THE FED'S COMMUNITY AFFAIRS ROLE Remarks by Thomas C. Melzer President, Federal Reserve Bank of St, Louis Neighborhood Housing Services of St, Louis, Inc, Annual Recognition Reception November 29, 1994 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis I am pleased to participate in this year's Neighborhood Housing Services of St. Louis Annual Recognition Reception, The Federal Reserve, as a general matter, is keenly interested in programs throughout the country that forge productive partnerships between bank lenders and their communities— partnerships that result in affordable housing and economic development. The Fed takes a particular interest in NHS programs, inasmuch as one of its Governors is, by statute, a director of Neighborhood Reinvestment Corporation, the "parent" of 182 NHS operations working in 152 U.S. cities, including St. Louis. Currently, Fed Governor Larry Lindsey is Chairman of NRC. And here locally, the St. Louis Fed's Vice President and Community Affairs Officer, Randy Sumner, is an officer and director of NHS of St. Louis. In the few minutes I have this evening, I would like to explain why the Fed is interested in housing and community development issues, how our regionalized structure facilitates effective involvement in this area and what bearing monetary policy actions have on these activities. First of all, why are we interested? Aside from the fact that affordable housing and community development can represent important underpinnings for achieving maximum sustainable economic growth, a key objective of Fed policy, the Fed is one of several federal banking regulators. Under the Community Reinvestment Act, banks are encouraged to help meet the credit needs of their communities, including low and moderate income neighborhoods, while maintaining safe and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 2 sound operations. As examiner of state-chartered banks which are Fed members, we are required to assess the performance of these banks under the Act, In addition, in considering certain applications for bank mergers and bank holding company formations, mergers and acquisitions, the Board of Governors is required to take such performance, along with other factors, into account. So the simple answer is, as a bank regulator and supervisor, we are required to be interested because banks have certain obligations with respect to community reinvestment which we must oversee and take into account in considering their applications for expansion. But this is an oversimplification, because it does not reflect how the Fed has chosen to complement its regulatory role with a Community Affairs Office at each Reserve Bank. Several years after passage of the Community Reinvestment Act, the Fed saw that it might facilitate accomplishment of the Act's objectives by i) providing training and technical assistance to bankers in various types of community development lending, ii) helping to mediate protested applications through encouraging dialog between community groups and bankers, and iii) encouraging public/private partnerships focused on community development, including affordable housing programs such as those offered by NHS. This community affairs role, which was the subject of our 1993 annual report, is quite separate and apart from our regulatory role and is based on the theory that, if CRA is to succeed, both bankers and community groups must benefit from their Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 3 alliances, and in turn, such alliances must be based on mutual interest. For those of you who have not done so, I would recommend reading our 1993 annual report, copies of which are available at the registration desk. What about the Fed/s structure? How does it facilitate the community affairs approach I just described? The Fed is a decentralized, independent government agency. At its center is the Board of Governors in Washington, D.C. which focuses primarily on policy issues. The seven Governors are appointed by the President and confirmed by the Senate, and serve 14- year, staggered terms. The 12 regional Reserve Banks, on the other hand, while subject to the general supervision of the Board of Governors, are quasi-public institutions patterned after private sector corporations. They carry out many of the System's day-to-day activities, as well as participate in certain policymaking functions, and are directly overseen by a board of directors drawn from the region. As a result, Reserve Banks and their branches—we have three in this District in Little Rock, Louisville and Memphis—are seen as integral parts of their communities, not as passive outposts of some Washington agency out of touch with what goes on "outside the Beltway." I don't need to belabor the point—our structure at the Fed and the cooperation between the Board in Washington and the Reserve Banks has indeed helped us take a community role which goes well beyond that of a pure regulator. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 4 Finally, what bearing do our monetary policy actions have on our desire to facilitate affordable housing and community development? Some might argue, for example, that actions taken by the FOMC this year which have resulted in inceases in short-term interest rates of approximately 250 basis are anything but conducive to these activities. And I can certainly appreciate that point of view, particularly if viewed in a short-term context. Most of us, I suspect, would like interest rates that are relatively low and stable, at least from the perspective of planning and financing long-term capital projects. The question is, how are interest rates determined and what is the Fed's role in that process? A common misconception is that the Fed sets interest rates. In fact, it directly influences only one market interest rate, the federal funds rate, which is the price at which banks lend reserves, a form of money, to one another. The reason the Fed can directly influence the fed funds rate is that it controls the supply of reserves through its open market operations, the principal tool of monetary policy. All other interest rates, and even the fed funds rate to some extent, are determined by market forces—the interaction of supply and demand for credit in various markets. Usually when the Fed takes action to raise the federal funds rate, it is simply adjusting that rate to developments which have already taken place in financial markets. This was the case most recently when the federal funds rate was raised by 75 basis points; other short-term markets rates had already Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 5 increased by roughly that amount and changed little after the action itself, and long-term rates actually fell. Had we, however, not taken action, the demand for reserves would likely have increased because of their relatively low cost, and the Fed would have had to supply more reserves to hold the funds rate at an artificially low level. Over time this process would lead to excessive money growth, which in turn would lead to higher inflation and higher interest rates. In fact, over the long run, the only permanent impact of monetary policy actions on the economy is on the rate of inflation. The Fed cannot make the economy grow any faster than its real resources will support, but we can impede economic growth if we permit inflation to rise. Though some will argue that inflation is good for economic growth, that simply is inconsistent with the evidence. Studies of developed economies in the post-World War II period have shown that those countries which have pursued high inflation policies have grown no faster on a real basis than those pursuing low inflation policies, including the U.S. In fact, if anything, such countries have grown more slowly. The reason is that inflation impedes efficient allocation of resources in a market economy. Of course, there is another very tangible effect of inflation and inflation expectations which is very important to anyone involved in community development. That is their effect on nominal, long-term interest rates, the rates we observe day-to-day in financial markets. For an investor who Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 6 holds a Treasury bond to maturity, such rates can be divided into two components: a real rate of return, plus an expected inflation component. For other long-term rates, such as mortgage rates, one would also have to add a premium for the risk of default, which is why such instruments trade at yields higher than Treasury bonds. The real rate of return component is the rate investors receive as compensation for parting with their capital for a period of time. On average, U.S. Treasury bonds have yielded real returns—that is, inflation-adjusted returns—of 2 to 3 percent since World War II. Investors generally will not allow their real returns to be eroded by inflation. In an inflationary environment, a dollar in the future will have less purchasing power than a dollar today, and investors will demand an interest rate that compensates them for the expected decline in purchasing power. Investors must also allow for uncertainty about their estimates of future inflation, a risk premium that can vary over time. Even in a non-inflationary setting, interest rates may incorporate a premium for uncertainty about the future. Thus, the expected inflation component of a nominal interest rate embodies both estimates of future inflation and a risk premium for uncertainty associated with that estimate. We are left, then, with the notion of interest rates on U.S. government securities being composed of a real return of about 2 to 3 percent, plus an expected inflation component. With 30-year Treasuries currently around 8.0 percent, the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 7 arithmetic implies an expected inflation component of about 5- 6 percent, assuming a real return component in line with the historical average. This 5-6 percent expected inflation component compares to actual current inflation of about 3.0 percent, with the difference representing a significant disparity. While my framework is admittedly simple, it highlights the fact that expectations of future inflation play an important role in determining long-term interest rates. And this is supported by the evidence: an analysis of the data from different countries with different average inflation rates indicates that countries with high average inflation tend to have high nominal interest rates. Again, this is because investors must demand compensation for any likely reduction in the purchasing power of the funds they are lending. Thus, it is clear that if the Fed can keep inflation low and inflation uncertainty to a minimum, long-term interest rates will be lower than they would otherwise be. The economy, in turn, is more likely to achieve its maximum sustainable rate of growth, unimpeded by the distortions created by inflation, including high nominal interest rates. The Fed's monetary policy goals, then, are not at all inconsistent with community development. Indeed, they are aimed at creating an environment in terms of economic growth and interest rates which will help spur it over time. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 8 I congratulate you all on the fine job you are doing and encourage you to keep up the good work. We at the Fed will try to do our part as well. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Thomas C. Melzer (1994, November 28). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19941129_melzer

@misc{wtfs_speech_19941129_melzer,
  author = {Thomas C. Melzer},
  title = {Speech},
  year = {1994},
  month = {Nov},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19941129_melzer},
  note = {Retrieved via When the Fed Speaks corpus}
}