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Congress wouldn't intervene in a baseball manager's plan for his pitcher's strategy, which is prone to change. The same should be true for monetary policy decisions.
December 11 -
Not only do rules imposed under the Dodd-Frank Act threaten regional banks' lending capabilities, they could actually wind up increasing risk to the financial system.
September 17 -
Regulators have come to view macroprudential regulations as the guiding light of financial policy. But whether that strategy is working is open to debate.
January 22
Editor's note: The following is adapted from a speech the author gave in November.
As markets have focused monomaniacally on the Federal Market Open Committee, the Federal Reserve System held two little-noticed conferences recently in which every important senior Fed official participated because of the gravity of the events' topics. Together, the two highly relevant sessions – one focused on financial stability and the other on monetary policy – prompt this provocative question: Does the Fed even matter?
One conference looked at whether the Fed's vaunted macroprudential regulation – a bedrock reform designed to avert crises – is functional. The other targeted an equally critical and even more immediate concern: whether the Fed can still transmit its monetary policy edicts because financial markets have changed so profoundly so fast. Both of these questions arise because big commercial banks just aren't what they used to be, with nonbanks increasingly taking over market share. The
If the Fed can't ensure financial stability or set monetary policy, then what good is it? We need a functional Fed, but that means the Fed must quickly reckon with the new financial market created in large part by its own rules.
Any suggestion that new rules have reshaped the U.S. financial market is usually taken as a backdoor plea for regulatory lenience. If, though, the Fed is finding that the new market confounds its ability to constrain risk or secure growth, far more urgent questions must be asked. Do some rules so fundamentally redefine the Fed's policy premises that those rules should be rethought? Does the new market warrant changes to how the Fed conducts itself? Are both rules changes and reform of the Fed necessary? I think so and here's why.
Monetary Policy Is Off the Rails
U.S. monetary policy is premised on the essential role of banks as the channels through which the Fed's will is exerted. The Fed has long relied on interest rates and reserves, but each of these tools assumes that the cost of funds depends on banks and that the reserves banks post with the central bank affect how much money is available for loans and thus to promote economic growth.
However, banks are no longer the prime repositories of the nation's money, meaning that trying to change how the market expends liquidity by altering bank incentives is an increasingly blunt Fed tool. A recent Federal Reserve Bank of Atlanta conference took a hard look at this, with an important paper there on "
Several new studies, including those presented at the Fed Board's conference and a study recently released by the
Theory would have it that macroeconomic growth would drain excess reserves because demand for credit would grow, resulting in a higher return than what banks achieve by storing funds with the central bank. However, even as growth has improved, excess reserves have grown at an even faster pace. One reason for this is the combined cost of new capital and liquidity requirements, which not only create
Market Shifts Are Destabilizing
The Fed's monetary-policy problems translate immediately into its macroprudential worries. If nonbanks now can drive rates and originate credit with little regard to FOMC action, while avoiding microprudential capital and liquidity rules, markets are irresistibly drawn to boom-bust cycles. This was of course the procyclicality that preceded the 2008 cataclysm, with much of the fevered demand for high-risk subprime mortgage-backed securities coming from nonbanks (GSEs very much included). Now, we are seeing these same procyclical trends in other credit markets where yield-chasing may be more desperate than it was eight years ago. Look at syndicated loans where banks thought they could hand off the merchandise, commercial real estate where nonbanks play a huge role, and subprime auto finance where investors have seemingly insatiable demand.
Rebalancing Rules May Be the Answer
Can the Fed curb this high-risk enthusiasm? An important
The tabletop exercise also looked at whether monetary policy could be used in lieu of macroprudential regulation as a countercyclical force if macroprudential rules don't work. But it found that monetary policy also can't transmit the Fed's edicts.
In short, neither monetary policy nor macroprudential rules matters. Is this because some fundamental economic principle now stymies central banks both as economic and financial-market safeguards? Looking at what's different between periods when both monetary policy and prudential rules worked and now – when they clearly don't – a critical variable is a lot of new rules applied only to banks. Taking those rules in concert with technology changes that empower nonbanks and the challenge is clear: Rebalance the rules or figure out a new way to secure stable growth and sound markets.
Karen Shaw Petrou is managing partner of Federal Financial Analytics.