Key Issues for Monetary PolicymakersFed Challenge Institute

Federal Reserve Bank of New York

Raymond StoneStone & McCarthy Research Associates

February 27, 2008

The Banking Panic of 1907

• Panic prompted Congress to establish the National Monetary Commission, which ultimately resulted in the Federal Reserve Act, signed into law by Woodrow Wilson on December 23, 1913

Today the Fed’s duties fall into four general areas:

• Conducting Monetary Policy in pursuit of dual mandate

• Supervising and regulating banking institutions

• Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

• Providing financial services to banks, the US government and foreign official institutions

Fed’s Expectations (January 29/30) of Growth marked down, Unemployment marked up, and Inflation marked up since the October 31 meeting

Economic Projections of Federal Reserve Governors and Reserve Bank Presidents

2008 2009 2010

Centra l Tendency

Grow th of rea l GDP 1 .3 to 2 .0 2 .1 to 2 .7 2 .5 to 3 .0

October projections 1.8 to 2.5 2.3 to 2.7 2.5 to 2.6

Unem ploym ent ra te 5 .2 to 5 .3 5 .0 to 5 .3 4 .9 to 5 .1

October projections 4.8 to 4.9 4.8 to 4.9 4.7 to 4.9

PCE infla t ion 2 .1 to 2 .4 1 .7 to 2 .0 1 .7 to 2 .0

October projections 1.8 to 2.1 1.7 to 2.0 1.6 to 1.9

Core PCE infla t ion 2 .0 to 2 .2 1 .7 to 2 .0 1 .7 to 1 .9

October projections 1.7 to 1.9 1.7 to 1.9 1.6 to 1.9

If we could assume away the current strains in the financial markets, the job of the FOMC would simply be the dual policy mandate. The Committee’s approach to policy might be implicitly captured by the Taylor Rule

In recent years the focus of Fed Challenge teams has been the pursuit of the Fed’s dual mandate of Price Stability and Maximum Sustainable Growth/Employment…This year we should also be mindful of the financial stability consideration

Why Should We Care About Financial Stability?

• Because financial market strains impact on both the cost of credit, and the availability of credit.

• Which can adversely influence the Fed’s ability to achieve maximum sustainable growth and employment

• Thereby worsening financial strains, creating an “Adverse Feedback Loop”

“Adverse Feedback Loop”

• A situation in which a tightening of credit conditions could depress investment and consumer spending, which, in turn, could feed back to a further tightening of credit conditions.

Despite the easing of Fed policy, and the decline in Treasury yields, investment grade corporate

borrowing costs have increased..Why?

According to the January Senior Loan Officers Survey

lending standards have become more restrictive

Banks have increased lending rates over the cost of funds

Lending Standards for Commercial Real Estate more restrictive

Not Surprisingly, Banks Tightening Standards for Residential Mortgages

And for Consumer Loans

Banks Less Willing to Make Consumer Loans

The dangers of an “Adverse Feedback Loop” have encouraged the FOMC to take a “Risk Management Approach” to Policy

• The Risk Management Approach takes account of low probability, but high cost outcomes.

• Currently strains in the financial markets represent downside risks to the economic outlook

• For this reason the FOMC has already taken out “insurance” by taking the funds rate below neutral or below that implied by the Taylor Rule

• The question for the FOMC and for Fed Challenge Participants is whether more insurance is appropriate or not?

What is the cost of “Insurance” against the “Adverse Feedback Loop”?

• The cost of FOMC buying insurance is the risk of higher inflation, and/or of a de-anchoring of “inflationary expectations”

• “Members were also mindful of the need for policy to promote price stability, and some noted that, when prospects for growth had improved, a reversal of a portion of the recent easing actions, possibly even a rapid reversal, might be appropriate.” (Minutes Jan 29/30 Meeting)

Other Topical Fed Challenge Issues

• How did we get to where we are, and what is the role of housing and subprime mortgages?

• Who is responsible for the current financial market mess?

• Was the Fed too easy for too long during the 2003/2004 period?

• What steps has the Fed taken since the onset of the crisis in August 2007?

• Understand the role of the discount window in addressing bank liquidity strains.

• What is the Fed’s “Term Auction Facility” and how does it work?

• What is “Moral Hazard”, and what is its relevance?

• What “Transparency” steps has the Fed taken over the past year?