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While by law the Federal Reserve Board must worry about price stability and unemployment, Chairman Ben Bernanke appears to have charted a third mandate for the central bank: financial stability.
April 20
WASHINGTON — Federal Reserve Board Governor Jeremy Stein on Thursday urged policymakers to consider using some of the central bank's monetary policy to help address gaps in regulation and foster greater financial stability.
"One of the most difficult jobs that central banks face is in dealing with episodes of credit market overheating that pose a potential threat to financial stability," said Stein. "As compared with inflation or unemployment, measurement is much harder, so even recognizing the extent of the problem in real time is a major challenge. Moreover, the supervisory and regulatory tools that we have, while helpful, are far from perfect."
For regulators, that means decisions will often be mired in an environment of uncertainty, said Stein, and how evidence is measured and collected by policymakers should reflect that. "Waiting for decisive proof of market overheating may amount to an implicit policy of inaction on this dimension," Stein warned.
Regulators rather should be "open-minded" in how to utilize tools at their disposal and allow "for greater overlap in the goals of monetary policy and regulation."
Stein stopped short of offering a set of recommendations to policymakers, but said he preferred to spark a policy discussion on how to combine tools used for traditional supervision and regulation with those used for monetary policy.
Yet some policymakers, he noted, have disagreed with such an approach in the past. They argue for a "decoupling approach" whereby monetary policy is limited to the central bank's dual mandate of price stability and maximum employment, and supervision is used strictly to safeguard financial stability.
They believe monetary policy can be a "blunt tool" for dealing with financial stability concerns, said Stein. One argument often made by such policymakers, Stein relayed, is "Would one really want to raise rates, and risk choking off economic activity, in an effort to rein in that one part of the market? Wouldn't it be better to use a more narrowly focused supervisory or regulatory approach, with less potential for damage to the economy?"
Another argument against such an approach is the fact that monetary policy "already has its hands full with the dual mandate" and supervisory tools are better suited and more effective than monetary policy would be, he said.
Even so, Stein suggests that policymakers "keep an open mind and avoid adhering to the decoupling philosophy too rigidly."
For example, even with recent progress made to improve supervisory and regulatory tools, they still remain "imperfect" in their capacity to quickly address different kinds of financial stability concerns, he said. Regulatory tools, Stein suggested, would be limited in keeping a financial institution from being incentivized to take on more credit risk in a reach for yield.
"These limitations arise because of the inherent fallibility of the tools in a world of regulatory arbitrage; because the scope of our regulatory authority does not extend equally to all parts of the financial system; and because risk-taking naturally tends to be structured in a nontransparent way that can make it hard to recognize," said Stein.
Secondly, monetary policy has the advantage of getting "in all the cracks" even if it may not be "the right tool for the job." The one common trait among a variety of parties — commercial banks, broker-dealers, off-shore hedge funds — is they "all face the same set of market interest rates," said Stein.
"To the extent that market rates exert an influence on risk appetite, or on the incentives to engage in maturity transformation, changes in rates may reach into corners of the market that supervision and regulation cannot," said Stein.
Finally, monetary policy tools consist of more than just one instrument like adjusting the federal funds rate. The central bank can also alter the composition of its asset holdings as it did in the maturity extension program. Doing so allowed the Fed to influence not just short-term interest rates, but also premiums and the shape of the yield curve.
"Once we move away from the zero lower bound, this second instrument might continue to be helpful, not simply in providing accommodation, but also as a complement to other efforts on the financial stability front," said Stein.
