In a speech in Hawaii this morning, Philadelphia Fed President Charles Plosser the Fed’s views on stability and monetary policy, and his words were cold cheer to anyone expecting a rate cut. Calculated Risk noted that it was unusual for for a Fed president to speak so directly about monetary policy.
Plosser noted that monthly data is noisy, that markets are volatile, and the Fed’s job is not to reduce volatility or manage asset prices:
When financial shocks threaten financial stability, a central bank must be prepared to act promptly to forestall any subsequent large adverse effects to the economy or financial system.
However, the term “stability” in this context can be a bit misleading. While an effectively functioning financial system is usually associated with financial stability, it is not appropriate for the Fed to ensure against financial volatility per se, or against individuals or firms taking losses or failing. Policymakers must be careful to allow the marketplace to make necessary corrections in asset prices. To do otherwise would risk misallocating resources and risk-bearing, as well as raise moral hazard problems. This could ultimately increase, rather than reduce, risks to the financial system.
Thus, the Fed does not seek to remove volatility from the financial markets or to determine the price of any particular asset; our goal is to help the financial markets function in an orderly manner. I agree with Chairman Bernanke that we should not seek to protect financial market participants, either individuals or firms, from the consequences of their financial choices. The success of free markets in generating wealth and an efficient allocation of resources depends on individuals and firms having the freedom to be successful and reap the rewards of their efforts. But just as important, those same individuals must also have the freedom to fail. Both of these freedoms must exist if the marketplace is to work its magic. When either one of these freedoms is missing, incentives will be distorted and outcomes will be less beneficial for society.
So in the face of a sharp decline in housing and severe problems in the subprime market, the central bank must let markets reassess and re-price risk, which will ultimately lead to the establishment of new levels of prices of housing-related financial assets. During this adjustment process, the central bank must also ensure the orderly functioning of financial markets so that this process of price discovery — the mechanism through which markets reallocate risk—takes place, while also ensuring that other financial markets are not disrupted and the broader economy is not harmed by spillover effects. As you could tell from events in August, this is not always an easy task and can at times involve the Fed providing above-normal amounts of liquidity to financial markets….
Providing liquidity in the face of a financial shock that threatens the orderly functioning of markets is an important function of the central bank. The Fed has taken extraordinary steps at other times in the past two decades to help keep financial markets functioning. It is important to realize that doing so does not necessarily require a change in the target fed funds rate. The Fed provided substantial liquidity to the financial system in the months leading up to Y2K, for instance, without a change in the fed funds target. Indeed, providing liquidity to the financial system in a timely manner in times of financial stress may serve to limit spillover effects into the broader macro economy and thus obviate the need for a change in monetary policy. In those cases when financial shocks lead to substantial and sustained reassessments of the economic outlook in relation to the Fed’s ultimate objectives for price stability and economic growth, the Fed may have to take actions, not only to address the financial shock, but to change monetary policy as well.
Freedom to fail? That’s not something most Masters of the Universe take very seriously.
The remarks about the housing market are telling. Plosser argues that housing prices are correcting, and that may cause some disruption, but the Fed’s role is not to shore up asset prices, merely to make sure that other markets continue to operate and to address any harm to the broader economy. He also presents his views as being aligned with Bernanke’s, at least on the question of moral hazard. However, there remains the question of how you draw the line between assuring some degree of order in the markets versus unduly aiding the industry members. It may prove hard to discern where that boundary lies.
If this speech winds up being a preview of what the Fed does – use daily market operations to inject liquidity when needed and to adjust the Fed funds rate only as the needs of the broader economy dictate – it is going to face a tremendous amount of pressure from the housing and financial services industries for relief. If they do choose this route, it’s an open question as to how long they can stay the course.
Update 9/9, 12:10 AM: Per Mark Thoma’s comment below, the Philly Fed website, after providing the full text of the speech, has the customary disclaimer, “The views expressed today are my own and not necessarily those of the Federal Reserve System or the FOMC,” which was not in the pdf version I saw. Oops.
I have amended the post accordingly.
Update 9/9, 1:30 AM: Par for the course, the Wall Street Journal has put a chipper spin on Plosser’s speech, devoting three quarters of the story to the Q&A afterwards, which included comments about the Fed’s inflation outlook.
The last line of the piece was priceless: “Such adjustments to stabilize volatility are ‘not always an easy task,’ he said in his speech. ‘And can at times involve the Federal Reserve providing above normal liquidity to the markets.’
Per his remarks above, Plosser specifically said the Fed was not about to “remove volatility” but would intervene to make sure markets continued to function. Somehow that distinction seems too difficult for a WSJ reporter to convey accurately.