Monetary Policy And Ending Too-Big-To-Fail
My successor as Minneapolis Fed President, Neel Kashkari, gave his first speech in his new role today. I congratulate him on a well-worded and stimulating set of remarks. He argued passionately in favor of imposing much tighter restrictions on the nation’s largest financial institutions, including possibly requiring them to hold a lot more capital or breaking them up.
In this post, I’ll comment on two monetary policy aspects of his proposals. The first is how they would interact with the effective lower bound on nominal interest rates. The second is that monetary policymakers need to get even better at “cleaning up” after crises, given how hard crises are to prevent.
My first comment is that adopting President Kashkari’s proposals when interest rates remain near their lower bound would have adverse macroeconomic consequences. Almost by design, higher capital standards mean that banks face higher financing costs (in part because debt is subsidized by the tax code). At least some of those higher financing costs would be passed along in the form of lower rates of return to savers and higher interest rates to borrowers.
To compensate for these effects, the Fed would have to target a lower range for the fed funds rate. That would not be a problem if the fed funds rate were well into positive territory. But it could create distinct macroeconomic challenges when the Fed is constrained in terms of the stimulus that it can provide. (Admittedly, judicious fiscal policy could be used instead of monetary policy to offset the macroeconomic effects that I’ve described.)
I’ve focused on the idea of higher capital standards. But, to the extent that we believe that there are returns to scale in the US, breaking up the banks would also generate higher intermediation costs. The consequences for monetary policy would be the same.
My second comment has to do with “cleaning up” after crises using monetary policy. I completely agree with President Kashkari that policymakers should work to reduce the probability of financial crises. But I’m skeptical of their ability to eliminate such crises entirely (not that President Kashkari suggested that they had such an ability). I am sure that, at some point in the future, the public, lenders, and governments will again become convinced that “This Time Is Different,” in Reinhart and Rogoff’s evocative phrase. And that “different” time will be followed by a financial crisis.
In contrast, I do think that policymakers have become considerably better at responding to financial crises. Thus, the Federal Reserve’s response to the 2007-09 crisis was, in my estimation, a big improvement on its response to the events of 1929-33.. (It is worrisome, though, that Congress has taken away so many of the Fed’s crisis response tools since 2009. Puzzlingly, both sides of the aisle seem to feel that it would have been better for the world to have suffered through a much deeper financial crisis.)
But there is certainly room for further improvement in the policy response to crises. The financial crisis of 2007-09 began over eight years ago. Yet, monetary policymakers are still struggling to deal with its aftermath. The fraction of Americans aged 25 to 54 with a job remains well below its level in 2007. Perhaps even more tellingly, Inflation remains unduly low relative to the Federal Open Market Committee’s 2% target (and seems likely to stay low for several more years).
In my view, and with the benefit of hindsight, I think that the FOMC’s monetary policy response was constrained by its strong desire to normalize the level and form of accommodation as rapidly as possible. Going forward, the Committee needs to develop a monetary framework that automatically leads to a more appropriate degree of patience in the removal of accommodation.
President Kashkari was right to emphasize financial regulation in his first speech – it does matter a lot for all of us. I see my point as complementary to his: the ultimate impact of financial regulation on the macro-economy is shaped in important ways by the constraints on monetary policy – both actual and self-imposed – faced by central banks.
(very snowy) Rochester, NY, February 16, 2016
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