NEW YORK – The U.S. economy and financial system remain vulnerable to another asset bubble, and there is “significant risk” of one developing, according to Federal Reserve Bank of San Francisco President and CEO John C. Williams.
Noting that many “glaring weaknesses” were addressed by regulatory reform, Williams told the International Monetary Fund Annual Research Conference “These reforms are vital. But I am not convinced they will be enough to forestall another major crisis.”
It’s been said “financial markets are driven by fear and greed. Evidently, no law or regulation can completely contain this dynamic. Second, recent reforms do not fully address a basic fact bared during the financial crisis: the funding system rooted in the capital markets is inherently at risk for runs, contagions, and panics,” Williams said, according to prepared text of his speech, which was released by the Fed.
He added, “it remains untested whether supervisors can successfully complete an orderly resolution of complex, systemically important international financial institutions during a period of heightened uncertainty.”
Also, some tools used in past crises may not be available in the future. He noted, Dodd-Frank will stop the Fed from providing “liquidity to individual institutions and to nonbank segments of the financial system.” In addition, getting the needed “action by the fiscal authority” to guarantee debt, could take too long.
Financial stability and macroeconomic stability are linked. “Risks to financial stability are first and foremost risks to future economic activity and inflation.”
To fight financial instability, macroprudential policies should be the “first line of defense,” but “monetary policy will need to play a more active role. “The main reason we care so much about financial stability is because financial crises can have devastating consequences for standard macroeconomic variables, such as employment, output, and inflation,” he said.
“Therefore, in thinking about the role of monetary policy in maintaining financial stability, we need to integrate financial stability into our models of the macroeconomy. We can’t think of them as separate spheres. Approached this way, the answer to the question whether monetary policy should be concerned with financial stability seems obvious. To the extent that monetary policy actions influence the emergence of risks to financial stability, these actions also indirectly affect the future path of economic activity and inflation,” he added. “Only in the extreme case that monetary policy actions have no effect on risks to financial stability, or financial instability has no effects on the macroeconomy, could one maintain that monetary policy should not take into account financial stability.”
When analyzing monetary policy, potential outcomes need to be considered.
“The past approach to studying monetary policy is not up to the task of accounting for financial instability and needs to be revamped,” Williams said. “Research should extend to all key channels by which monetary and supervisory policies affect asset prices, credit flows, and the real economy.”
“The framework used to analyze the relationship between monetary policy, financial instability, and the macroeconomy needs to be revamped.” Williams said. “That framework must take more fully into account the life cycles of asset, credit, and leverage bubbles, and it should consider the role monetary policy plays in feeding or restraining these bubbles.”
Williams suggested researchers and policymakers must discover a new design for “monetary policy strategies that complement macroprudential policies and contribute to financial and macroeconomic stability.”
