The Blake School
After both the Panic of 1907 and the financial crisis of 2008, public attention turned to protecting the financial system from future shocks. In the twentieth century, the Federal Reserve was created as a lender of last resort.1 in the twenty-first century, the challenge of protecting the system has been complicated both by the Fed's expanded tools and by increases in size and complexity of the financial system.2 Promoting financial stability will continue to be an important question for the Federal Reserve, and analyzing the role of monetary policy in promoting financial stability is especially relevant today in the aftermath of the 2008 crisis and in celebrating the Fed's centennial anniversary.3 This paper argues that the Federal Reserve should have an explicit financial stability mandate that guides it to (1) monitor and research financial stability and (2) consider using both ex-ante and ex-post tools to address financial instabilities, such as asset bubbles.
The 2008 crisis revealed systemic risk due to interconnectedness and regulatory gaps, prompting a policy shift for many federal agencies from a traditional, microprudential focus on "the safety and soundness of individual financial institutions" to a "macroprudential approach [that] also calls for attention to the financial system as a whole."4 This shift was made explicit in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which requires regulators to take a macroprudential approach and created the Financial Stability Oversight Council (FSOC) to monitor systemic risk and orchestrate macroprudential efforts through public recommendations.5 This Act and similar reforms around the world may mark a turning point in economic policy and the start of a macroprudential era.6 In this era, the Fed needs an explicit financial stability mandate. While the Fed has long acted to promote financial stability, the 2008 crisis revealed that the current implicit mandate, which only guides the Fed to consider the stability of individual components (i.e.: a microprudential focus), is insufficient.7 An explicit financial stability mandate can guide the Fed to adopt a macroprudential focus, help avoid inter-agency disputes over policy boundaries, and allow the Fed to take difficult, yet necessary, measures without fear of backlash for overstepping its bounds.8
The mandate's first provision should guide the Federal Reserve to monitor and research financial stability, especially in the context of monetary policy's impact on stability. Many conservative economists have long written about the potential for quantitative easing to create asset bubbles, and even Chairwoman Yellen, who supports the program, acknowledged its "potential risks for financial stability" in her confirmation hearing. In a departure from Greenspan-era thinking, Yellen argued "it is important for the Fed ... to detect asset bubbles when they are forming" and respond to them.9 Monitoring bubbles, though difficult, will help shape future monetary policy, such as how to balance quantitative easing (higher risk of asset bubbles) and forward guidance over risk of bubbles).10 Continued attention and new research to improve monitoring and detection capabilities will be needed, along with monetary policy driven first and foremost by financial data.11 Although the Dodd-Frank Act houses the main financial research body (the Office of Financial Research (OFR)) in the Treasury, the Fed has an important role in macroprudential research because of its internationally renowned economic research team and unique perspective on macroprudential monetary policy. The Fed-and its newly minted Office of Financial Stability Policy and Research, in particular-can complement the Office of Financial Research by focusing on macroprudential monetary policy, while the 0FR researches macroprudential regulation. This will certainly require clear information sharing protocols.12
In addition to research, the Fed's stability mandate should guide it to consider utilizing both ex-ante and ex-post tools to address financial instabilities, such as asset bubbles. Prior to the 2008 crisis, the 'Greenspan doctrine' that "ex-ante intervention to prevent booms are too costly compared to [ex-post] 'mopping up' measures after a financial crisis" was widely accepted.13 Under this view, regulatory tools are preferred to ex-ante monetary policy because they are more targeted and less likely to slow down the overall economy; the disadvantage, however, is that such targeted approaches miss undetected financial risks.14 The new focus on macroprudential policy signifies a major departure from this doctrine and the belief that both ex-ante and ex-post measures may be necessary.15 But while ex-ante regulatory measures to prevent crises are now widely recognized as necessary, ex-ante monetary policy actions remain controversial.
Indeed, that monetary policy is a blunt tool is its blessing and its curse: using it risks slowing economic activity, but "it gets in all of the cracks" because all economic actors are affected.16 Targeted approaches may miss some cracks, either because they cannot curtail ce1tain risks or because some cracks go unnoticed.17 There are several other limitations to supervision and regulation that merit consideration of ex-ante monetary policy-for example, recent partisan gridlock could hamper ex-ante Congressional responses to bubbles.18 Further, the Fed's increased number of instruments for monetary policy enables it to act on bubbles without neglecting its original dual mandate, as critics previously worried.19 Using monetary policy to prevent bubbles is certainly not desirable in every situation; for well-identified bubbles, targeted approaches may offer comparable effectiveness without slowing down the economy. Perhaps monetary policy is best for situations of general frothiness (instability) or as a second line of defense when supervision and regulation don't suffice.20 Improved monitoring capabilities may one day obviate the need for ex-ante monetary policy to address financial instabilities, but the 2008 financial crisis makes clear that capabilities are not yet at this level. While deciding which instabilities merit ex-ante monetary policy is an ongoing debate, two things are clear: (1) this debate deserves attention, and (2) ex-ante monetary policy should at least be considered.
The 2008 financial crisis emphasized the importance of a macroprudential approach to understanding and promoting financial stability. Since then, economic researchers have explored macroprudential regulation, and governments across the world have taken steps to shift regulatory frameworks accordingly, with the United States playing a prominent role in its 2010 Dodd-Frank Act. In the next 100 years, the quintessential question will remain deciding the Fed's role in promoting financial stability, but this question, and the Fed itself, will take on an entirely different character in an era of macroprudential regulation, greater monetary policy tools, and increased complexity in the financial system. This paper argued that the Federal Reserve should have an explicit financial stability mandate that guides it to (1) monitor and research financial stability to inform monetary policy decisions, and (2) consider utilizing both ex-ante and ex-post tools (specifically, macroprudential monetary policy) to address financial instabilities, such as asset bubbles, as a complement to macroprudential regulation. Adapting the Federal Reserve to meet society's needs in this era of change will certainly be challenging, but it is of critical importance that the Federal Reserve meets this challenge.
1 Ben Bernanke, 'The Crisis as a Classic Financial Panic," (speech given at the Fourteenth Jacques Polak Annual Research Conference, Washington DC, November 8, 2013). Bernanke 2013 explores several similarities between the two crises, including the triggers and importance of immediate liquidity provision.
2 Janet Yellen, "Interconnectedness and Systemic Risk: Lessons from the Financial Crisis and Policy Implications," (speech given at the American Economic Association and American Finance Association Joint Luncheon, San Diego, California, January 4, 2013.)
3 Federal Reserve Chairwoman Janet Yellen emphasizes financial stability and calls the "greater focus on financial stability ... the largest shift in central objectives wrought by the  crisis" in Janet Yellen, ''Monetary Policy: Many Targets, Many Instruments. Where Do We Stand?" (a speech given at the International Monetary Fund's Rethinking Macro Policy II conference, Washington DC, April 16, 2013).
4 Ibid. See Yellen 2013 for more on how interconnectedness can exacerbate certain externalities and be "devastating during a crisis." Yellen notes that research on interconnectedness and systemic risk has significantly increased since the 2008 crisis. Inaddition:Janet Yellen, ''Pursuing Financial Stability at the Federal Reserve," (speech given at the Federal Reserve Bank of Chicago's Fourteenth Annual International Banking Conference, Chicago, Illinois, November 11, 2011) . Yellen 2011 provides definitions of macroprudential (quoted in paper), microprudential (quoted in paper), and systemic risk ("the risk of a financial disruption that is severe enough to inflict significant damage on the broader economy"). For more information on the idea of macroprudential focus and its origins, consult Piet Clement, "The term 'macroprudential': origins and evolution," BIS Quarterly Review (2010): 59-67, http://www.bis.org/publ/qtrpdf/r_qtl003h.pdf.
5 Ibid. For more detail on recent and proposed macroprudential regulatory measures, see Daniel Tarullo's work, e.g.: "Evaluating Progress in Regulatory Reforms to Promote Financial Stability" and ''Macrorudential Regulation." Inaddition: Stefan Ingves et al, "Central Bank Governance and Financial Stability," Bank for International Settlements (2011): 13. According to Ingves 2011, the Federal Reserve serves the role of "microprudential supervisor for all systemically important firms (including non-banks), "with the express power to adjust prudential standards for macroprudential reasons," giving it a direct responsibility for macroprudential regulation. That said, the FSOC is still the primary body for macroprudential regulation.
6 For a summary of international reforms, see Stefan lngves et al 2011, pages 12-18. For a longer history of financial crises and the recent macroprudential shift, consult This Time is Different: Eight Centuries of Financial Folly by Carmen Reinhart and Kenneth Rogoff.
7 Jeffrey Lacker, "A Look Back at the History of the Federal Reserve," (speech given at Christopher Newport University, Newport News, Virginia, August 29, 2013). Inaddition: Stefan lngves et al, "Central Bank Governance and Financial Stability," Bank for International Settlements (2011): 27. Ingves 11 argues that the Fed's "implicit" financial stability mandate is perceived by the Fed, government officials, and economics researchers alike. Further, Ingves 11 postulates that this perception may arise from the Fed's role as lender-of-last-resort and the impact of financial instability on the effectiveness of the Fed's monetary policy.
8 Ibid, 27-33. While precise wording of the mandate is beyond the scope of this paper, it is worth noting that wording the mandate will be challenging since quantifying "promotion" is difficult and financial stability is less easily measured than, for example, price stability. For more information on wording challenges for an explicit financial stability mandate, as well as preliminary suggestions, see Ingves 2011.
9 John Cassidy, "The Yellen Doctrine: Robust Growth is the Priority, But Bubbles Matter,'' The New Yorker, November 14, 2013, accessed November 25, 2013, http:/ /www.newyo rker.com /online/blogs /johncassidy/2013/11 /the-yellen-doctrine-robust -growth-is-theÂ priority-but-bubbles-matter.html.
10 For more information on quantitative easing and forward guidance, see Binyamin Applebaum, ''What the Fed Does, and Can Do,'' The New York Times, October 8, 2013, accessed November 25, 2013
11 For a detailed explanation of the motivations for and progress of the Office of Financial Stability Policy, consult Ben Bemanke, ''Monitoring the Financial System,'' (a speech given at the Federal Reserve Bank of Chicago's Forty-Ninth Annual Conference on Bank Structure and Competition, Chicago, Illinois, May 10, 2013). In addition: Jerome Powell, "Thoughts on Unconventional Monetary Policy,'' (a speech given at the Bipartisan Policy Center, Washington DC, June 27, 2013).
12 Stefan Ingves et al, "Central Bank Govemance and Financial Stability,'' Bank for Intemational Settlements (2011): 33-36.
13 Oliver Jeanne and Anton Korinek, ''Macroprudential Regulation Versus Mopping Up After the Crash,'' National Bureau of Economic Research Working Paper No. 18675 (2013): 1-2.
14 Neil Irwin, "Should the Fed Pop Bubbles By Raising Interest Rates,'' Washington Post, February 8, 2013, accessed November 25, 2013,
http:/ /www.washingtonpost.com/blogs /wonkblog/vp/2013/ 02/08/should-the-fed-pop-bubbles-byÂraising-interest-rates/ Note: Irwin 2013 presents a useful analogy for the Greenspan doctrine and ex-ante monetary policy approaches, which follows. "Hiking interest rates to combat a bubble ... would be the equivalent of fumigating an entire house after finding a small patch of mold. It may do the job, but comes at a great cost: The house is unusable for days. Similarly, if the Fed hikes interest rates to combat bubbles, it might succeed, but at the cost of slowing down the entire economy... The Bemanke approach of dealing with credit bubbles through the Fed's bank regulation tools is the equivalent of coming in in a targeted way and removing the mold that has been found. The benefit is that the whole house doesn't need to be shut down (No recession!). The downside is that there might be a lot more mold than what you can see, and you won't get it with this targeted approach (risks lurking unseen elsewhere in the financial system)."
15 Oliver Jeanne and Antc_m Korinek, ''Macroprudential Regulation Versus Mopping Up After the Crash," National Bureau of Economic Research Working Paper No. 18675 (2013): 1-2. Jeanne and Korinek 2013 summarizes relevant literature and uses "a stylized but general Ramsey setup" to show that "the optimal policy mix consists of a combination of both ex-ante prudential measures and ex-post interventions [with] the point of optimality . . . such that the marginal cost/benefit ratio of ex-ante intervention equals the expected marginal cost/benefit ratio of the ex-post intervention." Inaddition: Jeremy Stein, ''Lean, Clean, and In-Between," (a speech given at the National Bureau of Economic Research Conference on Lessons from the Financial Crisis for Monetary Policy, Boston, Massachusetts, October 18, 2013). Stein 2013 presents a brief summary of the ex-ante vs. ex-post debate (or lean vs. clean debate) and argues for an approach that uses both ex-ante lean) and ex-post (clean) measures.
16 Neil Irwin, "Should the Fed Pop Bubbles by Raising Interest Rates," Washington Post, February 8, 2013, accessed November 25, 2013, http://www.washingtonpost.com/blogs/wonkblog/wp/2013/02/08/should-the-fed-pop-bubbles-byÂraising-interest -rates/
17 Jeremy Stein, "Overheating in Credit Markets: Origins, Measurement, and Policy Responses," (a speech given at the Federal Reserve Bank of St. Louis's research symposium on Restoring Financial Stability after the Great Recession: Why Household Balance Sheets Matter, St. Louis, Missouri, February 7, 2013).
18 Ibid. Consult Stein 2013 for hypothetical examples that demonstrate the regulatory and supervisory shortcomings discussed in this paper.
20 Stein 2013 argues ex-ante monetary policy may, in cases of general frothiness, be a first line of defense, while Yellen 2013 argues that such policy should only be a second line of defense. Others have argued for even more restrictive views than Yellen. The appropriate role of ex-ante monetary policy is certainly up for debate. Another take: Irwin 2013 argues that use of ex-ante monetary policy is actually an argument for "intellectual modesty" about the ability of economic forecasters to detect financial instabilities in time to respond effectively.