NEW YORK – The Fed is carefully preparing its plan for removing the unprecedented economic stimulus at the appropriate time, Federal Reserve Vice Chairman Donald L. Kohn said today.
Communications became important after short-term rates were effectively lowered to zero in December 2008, Kohn told an audience at Carleton University in Ottawa, according to prepared text of his remarks, which was released by the Fed.
“At the March 2009 meeting, the Federal Open Market Committee (FOMC) indicated that it viewed economic conditions as likely to warrant `exceptionally low’ levels of the federal funds rate for an `extended period.’ This language was intended to provide more guidance than usual about the likely path of interest rates and to help financial markets form more accurate expectations about policy in a highly uncertain economic and financial environment,” he said. “By noting that the federal funds rate was likely to remain at `exceptionally low’ levels for an `extended period,’ the FOMC likely was able to keep long-term interest rates lower than would otherwise have been the case.”
The Fed’s decision to provide the public with their views on long-term economic growth, inflation, and the unemployment rate, “likely helped keep inflation expectations anchored during the crisis. Had expectations followed inflation down, real interest rates would have increased, restraining spending further. Had expectations risen because of concern about the Federal Reserve's ability to unwind the unusual actions it was taking, we might have needed to limit those actions and the resulting boost to spending.”
Despite the Fed’s inclusion of the language in its policy statements, market participants continue to react to economic indications, with “expectations about the timing of exit from the zero interest rate policy ... though each repetition of the extended period language has appeared to affect those expectations a little.”
Kohn said, “By contrast, the economic effects of purchasing large volumes of longer-term assets, and the accompanying expansion of the reserve base in the banking system, are much less well understood.”
The Fed’s actions to combat the crisis resulted from financial markets’ evolution that now “The task of intermediating between investors and borrowers has shifted over time from banks--which take deposits and make loans--to securities markets--where borrowers and savers meet more directly, albeit with the assistance of investment banks that help borrowers issue securities and then make markets in those securities,” Kohn said.
“An important aspect of the shift has been the growth of securitization, in which loans that might in the past have remained on the books of banks are instead converted into securities and sold to investors in global capital markets,” he continued. “Serious deficiencies with these securitizations, the associated derivative instruments, and the structures that evolved to hold securitized debt were at the heart of the financial crisis. Among other things, the structures exposed the banking system to risks that neither participants in financial markets nor regulators fully appreciated. Banks became dependent on liquid markets to distribute the loans they had originated. And some parts of the securitized loans were sold to off-balance-sheet entities in which long-term assets were funded by short-term borrowing with implicit or explicit liquidity guarantees provided by the banks. Securitization markets essentially collapsed when banks became unwilling to increase their exposure to such risks during the crisis, when the liquidity guarantees were invoked, and when other lenders in securitization markets became unwilling to supply credit.”
He defended the Fed’s actions as “based on sound legal and economic foundations.”
