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– November 9, 2016

Monetary policy and financial stability: rules vs. discretion

The Fed’s dual mandates and financial stability
It has been eight years since the U.S. economy went through the worst economic crisis since the Great Depression. During what became known as the Great Recession (December 2007–June 2009), the economy lost nearly 800,000 jobs monthly. Unemployment soared to 10 percent, and households’ equity in real estate declined by 55.6 percent, to nearly $6 billion by the second quarter of 2009 from its peak of $13.5 billion in the first quarter of 2006. From 2007 to 2009, 146 U.S. banks failed. This domino effect in the financial system did not even end after the recession was officially declared over. In its aftermath, another 157 and 92 banks failed in 2010 and 2011, respectively.

But what did we learn from the financial crisis? Could the Federal Reserve have done something to avoid it?

According to the Federal Reserve Reform Act of 1977 (https://www.gpo.gov/fdsys/pkg/STATUTE-91/pdf/STATUTE-91-Pg1387.pdf), the Fed’s monetary policy objectives are to achieve the goals of maximum employment, stable prices, and moderate long-term interest rates by maintaining long-run growth of the monetary and credit aggregates that ensure the economy’s potential to increase production. This act has clearly bestowed the Fed with two important dual mandates: maximum employment and stable prices. However, due to the inherent trade-offs that exist between inflation and unemployment, achieving these two objectives simultaneously is one of the key challenges of monetary policy. 

For example, under former Chairman Paul Volcker, the Fed committed to combat the double-digit inflation of the late 1970s. Monetary policy was tight (the effective federal-funds rate, by January 1981, was 19.08 percent), which put a heavy burden on borrowers and immediately led the economy into a recession (the unemployment rate rose to 10.8 percent by December 1982).

On the other hand, keeping interest rates too low for too long with the objectives of promoting growth and ensuring maximum employment has its own risks. It builds inflationary pressure and encourages excessive risk-taking behavior leading to asset price rallies. It is evident from the financial crisis of 2007 and 2008 that such excessive risk-taking behavior in a highly interconnected financial system poses systemic risk and financial instability.

Chart 4 illustrates the close relationship between the financial sector and the economy and the challenges of achieving the dual mandates. The Chicago Fed’s Adjusted National Financial Conditions Index, or ANFCI, reflects the underlying risk, credit, and leverage conditions in financial markets. Positive values indicate a tighter financial market, and negative values show relatively stable conditions. In two of the most severe recessions since the late 1970s—July 1981–November 1982 and December 2007–June 2009—gross domestic product declined 2 percent or more and financial markets were tighter than average, indicating elevated risk, tight credit conditions, and declining leverage.

Rules vs. discretion
Discussion about the role of the Fed and particularly the role of monetary policy in promoting financial stability received greater attention after the 2007–2008 financial crisis, in part because of the loss of confidence in then-existing regulations to protect the economy from such unprecedented episodes. Economists such as Michael Woodford of Columbia University argued that monetary policy, by embracing the added objective of financial stability, could achieve its dual mandates. On the other hand, Swedish economist and ex-deputy governor of the Sveriges Riksbank (Sweden’s central bank), Lars Svensson, preferred to leave the task of financial stability to macro-prudential regulation—that is, rules intended to reduce instability across an entire financial system. The debate is still unresolved.

If we assume that the Fed adds the role of financial stability to its monetary policy objectives, it is faced with two options to communicate its actions to the public and execute its policy. One is to announce its commitment to a set of policy rules, such as keeping interest rates within a certain band to achieve a target level of inflation, unemployment, and financial stability (this could be measured by a composite index such as the ANFCI or the interest-rate spread between a risky asset, i.e., a BAA corporate bond, and a safe asset, i.e., a Treasury bond) and stick to this policy indefinitely. This type of policy resembles a parent who promises to punish a child for misbehavior and fulfills it no matter what. It is called a rule-based monetary policy. With this type of policy, the Federal Reserve loses flexibility but gains credibility with the public and minimizes trade-offs between inflation and unemployment while maintaining financial stability. 

The other possibility is for the Fed to periodically update its policy based on the available information. For example, after announcing a lower interest rate, the Fed could change its policy in the middle of the course if there are signs of movement in the opposite direction in key macroeconomic indicators. This type of policy is similar to a parent who promises to punish a child for misbehavior but forgives the child after the incident happens. This is called a discretionary monetary policy. Its advantage is flexibility, but the Fed loses credibility and faces bigger trade-offs in inflation and unemployment as it stabilizes the financial system.

Considering the two options, research based on modern macroeconomic models suggests that a rule-based policy results in superior outcomes in terms of achieving target inflation, lower unemployment, and a stable financial system.

Guest writer Menelik Geremew is The Stephen B. Monroe Assistant Professor of Money and Banking at Kalamazoo College. He may be reached at menelik.geremew@kzoo.edu.

 

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