Fed could use rates to counter instability – Mester

The US Federal Reserve Board might have to use monetary policy to deal with instability in the financial sector, despite several major problems with this, the president of the Federal Reserve Bank of Cleveland has warned.

“I believe monetary policy should remain focused on promoting price stability and maximum employment, and not be given a third objective of financial stability,” Loretta Mester told an audience in Philadelphia on January 6.

But the goals and actions of monetary policy were “interrelated” with those of financial stability policy, she said. If the Fed thought that threats to financial stability were “sufficiently great”, then achieving its monetary policy goals would also be jeopardised. Mester is currently a voting member of the Federal Open Market Committee (FOMC), the Fed’s rate-setting body.

“The distinction between financial stability goals and monetary policy goals would be blurry” if that happened, Mester said. She said that “those using a risk-management approach to monetary policy might be compelled to act”, even though the Fed lacks an explicit financial stability mandate.

The Fed was aware that both overly loose and excessively tight monetary policy could increase risks in the financial sector, Mester said: “Since the financial crisis, the Federal Reserve has developed a framework for systematically tracking risks, and financial stability surveillance is receiving regular attention at FOMC meetings.”

The Fed’s system for monitoring financial stability risks is looked at in detail in two papers from 2013 and 2015 by Adrian, Covitz and Liang.

It was important to keep a constant eye on the financial sector, she argued, “because, as we learned during the financial crisis, even in periods when conditions look benign, vulnerabilities may be building”. The Fed had made a “lot of progress” in building the system, she said, but it was continuing to work on updating its monitoring procedures.

“Tabletop exercise”

The Fed had learned that its macro-prudential policies had considerable limitations in a 2015 “tabletop exercise”, Mester said. The financial stability subcommittee of the presidents of the Federal Reserve System had run a scenario based on “loose financial conditions”, in which the FOMC was “gradually removing accommodation, as in 2015–16”. Inflation was below the Fed’s 2% target, but the economy was at full employment.

In the scenario, falling term and risk premia had led to pressures on commercial property market values and increasing corporate debt and leveraged lending. The increased leverage had been funded by short-term wholesale funding.

Policymakers taking part in the exercise had to use available macro-prudential tools to reduce the likelihood of a financial crisis, or minimise its ill effects.

“Good in theory”

“As the scenario played out, the limits to the macro-prudential tools were illuminated,” Mester said. Tools based on capital or liquidity limits, or on debt-to-income or loan-to-value limits were “good in theory” but “deemed to have implementation challenges”.

The use of some of these tools had to be co-ordinated between multiple regulators, or had to follow “administrative procedures like public comment periods, which would slow down the process”. Some tools could be applied to banks, but not to shadow banking firms or other parts of the financial sector.

“The macro-prudential tools that ended up being favoured were stress testing, margins on repo funding and supervisory guidance,” said Mester. Her own preferences were to “start with the macro-prudential tools that can be implemented more promptly”, but “the limits on these tools suggest that, in some circumstances, monetary policy might have to be used to address financial stability concerns”.

That experience, Mester argued, meant the financial system had to be made as resilient as possible before any possible crisis occurred. The Fed also had to “continue to hone our methods of assessing financial sector vulnerabilities – in both the regulated and unregulated sectors and between the two”. Regulators should not, however, “overidentify such risks” for fear of stifling financial innovation and therefore economic growth, she warned.

Regulatory complexity hinders macro-prudential policy

There were several problems for policymakers stemming from the possible use of either macro-prudential policies or monetary policy to achieve financial stability, she concluded.

“The complexity of the US financial system, with multiple types of financial services providers and multiple regulators, complicates the application of macro-prudential policy,” argued Mester.

But monetary policy did not provide any easy answers to financial stability problems, she said: “We are still some distance away from being able to articulate a clear strategy about the circumstances under which monetary policy should be used as a tool for financial stability.”

Mester said the Fed needed to make progress both in monitoring financial stability and in developing tools to deal with any risks.