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For release on delivery
6:15 p.m. EST (5:15 p.m. CST)
November 16, 2009

Policy Challenges for the Federal Reserve

Remarks by
Donald L. Kohn
Vice Chairman
Board of Governors of the Federal Reserve System
at
Kellogg Distinguished Lecture Series
Northwestern University, Kellogg School of Management
Evanston, Illinois

November 16, 2009

I titled my talk “Policy Challenges for the Federal Reserve.” I did that before I knew
what I was going to discuss, because just about any topic involving the Federal Reserve would
entail policy challenges. So let me begin by narrowing the topic just a bit: I would like to talk
about the challenges that lie at the intersection of monetary policy and financial stability.
Our economy is just beginning to recover from a horrendous episode in which mispricing
of risk--especially in home mortgage lending, but more broadly as well--led to financial
instability that in turn led to a severe recession. Much attention is, appropriately, being focused
on the implications of this episode for the reform of financial regulation. The Congress,
financial regulators, and analysts are debating those critical issues.
I will focus on some possible implications of the recent episode for monetary policy. The
questions I want to address are, first, how should we take account of financial stability in the
conduct of monetary policy--for example, should financial stability be another specific
responsibility of monetary policy, in addition to its responsibilities for promoting maximum
employment and stable prices? And second, what do the crisis and our response imply for the
monetary policy tools of the Federal Reserve? I don’t have the answers to these questions, but I
thought it would be useful to discuss them. 1 Importantly, I speak only for myself, not for my
colleagues on the Federal Open Market Committee.2
Monetary Policy and Financial Stability
Traditionally, most analysts thought that when monetary policy successfully promoted
economic stability, it would also promote financial stability. When business cycle swings are

1

I have addressed the first of these questions before--most recently a year ago in a speech given at the Cato
Institute--but in light of the experience over the past several years, it seems appropriate to reexamine the issue. (See
Donald L. Kohn (2008), “Monetary Policy and Asset Prices Revisited,” speech delivered at the Cato Institute’s 26th
Annual Monetary Policy Conference, Washington, November 19,
www.federalreserve.gov/newsevents/speech/kohn20081119a.htm.)
2
Brian Madigan of the Board’s staff contributed to these remarks.

-2moderate and inflation rates are low and predictable, households and firms can make and follow
through on long-term plans for spending, saving, and investment. Lending institutions can better
evaluate the likely profitability of capital projects, thus reducing their risk of credit loss. And the
moderate swings in long-term interest rates and other asset prices that were thought to be
fostered by such an environment should tend to limit the exposure of balance sheets.
However, although monetary policy over the past several decades did help foster
economic stability, some have questioned whether it also contributed substantially to the lax
practices that led to the buildup of financial vulnerabilities and the resulting severe recession.
Two aspects of the Federal Reserve’s conduct of monetary policy are cited by these critics. One,
some assert that we responded asymmetrically to movements in asset prices, easing aggressively
in response to declines and not tightening correspondingly when asset prices rose. This
perceived asymmetry is alleged to have given market participants the sense that they could
engage in a one-way bet--that the Federal Reserve would cushion asset-price declines with cheap
money but would not increase interest rates to make it more expensive for them to finance bets
that asset prices would rise. Second, some believe that the Federal Reserve kept policy too loose
around 2003 and then tightened too slowly and predictably in 2004 and 2005, in effect
encouraging if not underwriting the bubble in house prices that lay behind so many of our
troubles over the past two years.
My perspective is that policymakers have kept their eyes firmly on medium-term
macroeconomic stability--that is, on the legislated objectives of maximum employment and
stable prices. We responded to developments in asset and credit markets to the extent that they
affected the macroeconomic outlook, but we did not assign them extra weight in our
deliberations. In particular we did not react asymmetrically to asset-price developments; it only

-3looks that way on the surface because asset prices tend to rise slowly and fall rapidly. Had we
been more ready to ease than to tighten monetary policy, the economy would have tended to run
above its productive potential on average and inflation would have risen. In fact, inflation fell
over the 1980s and 1990s.
Inflation did rise from 2004 through the middle of 2008, but largely because the prices of
petroleum and other commodities increased. Those increases reflected rising demand from
rapidly industrializing emerging market economies, not easy monetary policy in the United
States. As we went through this period, a variety of measures of resource utilization, underlying
inflation rates, and market indicators of future commodities prices gave us good reason to
believe that our policy was consistent with a return of headline inflation to a low and stable
underlying trend. We did raise interest rates gradually, in accord with our announcements that
the federal funds rate was likely to rise at a “measured pace,” but following this path was
dependent on economic conditions evolving about as we anticipated. Similarly, in the current
circumstances, the Federal Open Market Committee has emphasized that its expectation that the
federal funds rate is likely to remain at an exceptionally low level “for an extended period”
depends on the outlook for resource utilization, inflation, and inflation expectations following the
trajectories we expect.
A policy focused on price and economic stability over the medium run and that responds
symmetrically to inflationary and deflationary shocks can nonetheless contribute to excessive
leverage, risk-taking, and maturity transformation, and indeed that appears to have happened; to
some extent, we were the victims of our own success. Improved monetary policy after the
1970s, along with a host of other factors, including technological advances and greater global
integration of capital and product markets, helped reduce the size and frequency of fluctuations

-4in output and lower inflation. This economic performance evidently led investors to become
complacent about economic risks--for example, the risk that house prices could fall, and the
small probability of a major downturn in the economy.
Moreover, persistently modest inflation gradually reduced inflation expectations, which
brought down nominal interest rates. The tendency toward lower interest rates was accentuated
earlier this decade by the sluggish recovery of investment from the recession of 2001, which
combined with high saving propensities in the growing economies of Asia to lower real interest
rates globally. The expectations of many investors about the returns they should be receiving
apparently adjusted slowly to the new reality of low nominal interest rates, exacerbating the socalled search for yield that contributed to these investors venturing into riskier and more complex
assets. And the benign economic environment encouraged intermediaries to lower credit
standards and to try to pick up a little extra return by borrowing for the short term to fund longterm lending, leaving them increasingly leveraged and vulnerable.
But while monetary policy may have helped establish a stable macroeconomic
environment in which investors overreached for yield, many other factors contributed to the
financial crisis. Inadequate risk assessment and management by many financial market
participants and the lagging adjustment of public oversight to the evolving structure of financial
markets and rising risk levels were, in my view, the critical causes of the most severe financial
crisis since the 1930s. And addressing these problems is the first priority and most effective
safeguard against a repetition of the severe dislocations we experienced.
But does avoiding such a repetition also require monetary policy to include financial
stability along with price stability and high employment in the objectives it tries to accomplish
with its policy adjustments? When the monetary authorities judge that important asset prices or

-5rates of credit expansion are deviating from sustainable long-run trends, should they adjust their
policy setting to damp those price and credit movements--beyond whatever actions might be
called for to preserve macroeconomic stability over the usual two- to three-year planning horizon
for monetary policy?
To preview, I don’t think we know enough to answer those questions with any
confidence--to judge whether the benefits of such extra action would outweigh the costs. Given
our state of knowledge, we should keep monetary policy focused on our mandates for maximum
employment and stable prices. I can’t rule out circumstances in which additional monetary
policy actions specifically targeted at perceived asset price or credit imbalances and
vulnerabilities would serve the pursuit of our mandate over the medium term. But given the
bluntness of monetary policy as a tool for addressing developments that could lead to financial
instability, the side effects of using policy for this purpose, and other difficulties, such
circumstances are likely to be very rare. I continue to believe that the best approach is to
promoting financial stability is to strengthen supervision and regulation.
Conducting monetary policy with additional emphasis on financial stability would imply
that inflation and economic activity would generally be somewhat more variable over the
medium run. Households and businesses might have greater difficulty planning saving and
investment because they would be less certain of the medium-term trajectory of the economy and
prices. Moreover, greater inflation variability might reduce the credibility of the central bank’s
pursuit of price stability, reducing its ability to lean against deviations in output as well. Another
analytical point that should be taken into account when contemplating extra policy action is that
the cost of using monetary policy to damp perceived asset-price or credit-driven imbalances
would depend on the prevailing conditions in the economy. In general, the further the economy

-6is from price stability or full employment, the greater the costs of further deviations. For
example, raising interest rates and restraining output, employment, and inflation to lean against
an incipient asset bubble will hurt more when inflation is already well below our objective or
unemployment is high than when we are contemplating small deviations around long-run steadystate values.
From this perspective, the key analytical question is whether, by accepting somewhat
larger deviations of employment and inflation from the levels otherwise attainable, we are able to
sufficiently enhance financial stability in a way that significantly reduces the probability of a
very severe financial crisis and the attendant serious economic costs. In my view, the theoretical
and empirical models that would underpin this approach and its implementation are not
adequately developed. Particularly in the absence of reliable models to guide us, policymakers
attempting to conduct such a policy would confront serious challenges in identifying threatening
imbalances and in calibrating and timing effective and appropriate policy actions.
Moreover, a cursory review of the evidence is not encouraging regarding the direct use of
monetary policy to promote financial stability. For example, would a small adjustment in policy
rates damp the optimism or complacency that was feeding the speculative excesses producing an
asset or credit bubble? We don’t know. But the impression from our experience in 1999 is that
tightening policy had no effect on the intensity of dot-com speculation. And the housing bubble
and the spread of lax mortgage lending practices built up for several years after we began raising
interest rates in 2004. If policy adjustments intended to deflate asset prices or credit expansion
only reduced inflation and output without affecting the bubble, they will have ultimately moved
the economy further from its sustainable path when the bubble breaks. And if large adjustments

-7are necessary to damp speculation, medium-term variations in the economy will be
commensurately greater.
In addition, timing policy action accurately is critical to realizing greater benefits than
costs in leaning against potential speculative excesses. Adjusting policy shortly before a bubble
breaks, when its existence will be most evident, is not likely to be optimal, as it will do little to
damp the excesses and will add to the downward pressure on the economy. Central banks would
need to spot these threats very early, when they may not be generally recognized as divergences
from fundamentals. Efforts to spot emerging imbalances early would raise the odds on
identifying developments as threats to stability, when in fact they are natural and sustainable
adaptations to changing relative prices, for example, from shifts in technology. Even with the
access to the wide range of data, sophisticated models, and market analysis enjoyed by central
banks, our ability to discern deviations of asset prices from fundamental values is very limited.
The difficulties I’ve just outlined lead me to a strong preference for using prudential
regulation to deal with potential problems in credit and asset markets. Historically, bank
supervision has been focused on individual institutions rather than on the system as a whole.
Unfortunately, such microprudential regulation in practice was not as effective as it should have
been, and an important challenge for policymakers will be to strengthen the supervision of
individual institutions. However, the experience of this crisis also strongly suggests that
policymakers need to pay close attention to developments across the financial system--that is, to
engage in macroprudential supervision and regulation. Both microprudential and
macroprudential oversight are essential to making the financial system more resilient to the
inevitable cycles in asset prices, and less prone to large cycles. In this regard, many
improvements are possible: better alignment of regulatory capital requirements with risk;

-8making capital requirements less procyclical; identification of systemically important
intermediaries and holding them to standards commensurate with their importance in the
financial system; improved techniques for supervision of all intermediaries; spotting emerging
increases in risk and adjusting regulation to address those problems; and addressing the elements
in the financial markets that tend to amplify cycles, such as accounting and margining practices.
The list of potential regulatory changes is long; without more experience, the efficacy of some of
these adjustments is hard to assess; and putting them into practice will be difficult. But
proceeding with careful analysis and implementation of these approaches would seem to have a
better chance of yielding net benefits to our economy than using monetary policy to damp asset
and credit cycles beyond what is required to keep our economy on an even keel.
Current circumstances well illustrate the challenges of using monetary policy as a tool to
promote financial stability. The prices of riskier assets have risen rapidly in the past few months,
with, for example, equity prices recovering a considerable portion of their earlier decline and risk
spreads on corporate bonds dropping substantially. In addition, commodities prices have risen
and the dollar has retraced a good portion of its run-up last fall and winter. These developments
have led some observers to question whether another round of potentially destabilizing assetprice movements is in train. The movements in asset prices reflect several factors. One is a
reversal of the extreme panicky conditions of late last year and earlier this year when
extraordinary uncertainty about the economy and the soundness of many counterparties led to a
widespread flight to liquidity and safety. As the economy stabilized and then began to improve,
as financial markets became less volatile, and as additional information about the health of
individual borrowers emerged, investors have become more willing to shift back into longerterm and riskier assets. The rise in commodities prices probably reflects the turnaround in

-9economic prospects, especially with many resource-importing emerging market economies
leading the rebound.
Another important factor has been the very low level of policy interest rates in the United
States and in most other industrialized economies. Indeed, one of the purposes of these policies
is to induce investors to shift into riskier and longer-term assets in order to lower the cost and
increase the availability of capital to households and businesses. The more accommodative
financial conditions, in turn, are intended to induce an increase in spending at a time when the
level of output is expected to remain depressed for some time relative to the capacity of the
economy to produce.
As I’ve already noted, our abilities to discern the “correct” values of assets is quite
limited. At present, however, the prices of assets in U.S. financial markets do not appear to be
clearly out of line with the outlook for the economy and business prospects as well as the level of
risk-free interest rates. Most bond spreads and equity premiums are still appreciably higher than
a few years ago and comparable to their levels in past recessions. Moreover, money and credit
have been quite weak, suggesting that asset price movements have not been fueled by increased
leverage that would leave financial intermediaries vulnerable to a reversal of recent gains. The
improvement in the spreads and functioning of securities markets has not been accompanied by
any loosening of very tight credit conditions for bank credit; indeed, banks have continued to
tighten terms and standards in recent months, albeit at a slowing rate.
Still, my current assessments could be wrong--asset prices may in fact be in the process
of rising excessively. However, consider the complications of using monetary policy to lean
against a presumed bubble at this time. A decision to reduce monetary accommodation now
would mean taking immediate steps to raise short-term interest rates or to reduce the support for

- 10 private credit markets by selling longer-term securities that the Federal Reserve has acquired
over the past year. Tightening financial conditions at a time when an economic recovery has just
begun, when labor markets are continuing to weaken, when inflation is below its optimal level
for the longer run, and when significant strains persist in the financial system would incur a
considerable short-run cost in order to achieve possible long-run benefits whose extent is, at best,
quite uncertain. Still, we will need to be alert to any tendencies for movements in prices for
commodities and assets to result in a sustained increase in inflation and inflation expectations;
unanchored inflation expectations would ultimately destabilize output and undermine our ability
to foster higher levels of employment. And we need to continue to work with banks to improve
their risk-management and credit-evaluation systems so that the banks are not vulnerable to
unexpected movements in interest rates or asset prices in the future.
In sum, it seems to me that under most circumstances monetary policy is not the
appropriate tool to use to address asset-price developments or growing vulnerabilities in financial
markets. As I argued earlier, microprudential and macroprudential policies seem likely to me to
be more effective and targeted at the problem than monetary policy adjustments, and in my view
these tools should be the first that policymakers deploy. From my perspective, central bankers
would need convincing evidence that such other tools would be inadequate and that significant
asset-price misalignments were developing that would have serious economic costs before
attempting to use monetary policy to address them.
Federal Reserve Tools to Provide Liquidity in Stress Situations
In addition to highlighting shortcomings in the U.S. regulatory regime, the financial
crisis also raised questions about the adequacy of the Federal Reserve’s tools for monetary policy
implementation, particularly in periods of economic stress, and for crisis management more

- 11 generally. In routine circumstances, the Federal Reserve implements monetary policy primarily
through open market transactions, with the discount window playing an important but supporting
role. Customarily, the bulk of the Federal Reserve’s assets are U.S. Treasury securities, and the
Federal Reserve uses short-term repurchase (repo) transactions, generally in relatively small
amounts, to make the adjustments to the quantity of reserves in the banking system that are
necessary to achieve the Federal Open Market Committee’s target for the federal funds rate.
Notably, the Federal Reserve’s counterparties for these repo transactions are a small number
(currently 18) of broker-dealers, known as primary dealers. Even though these dealers do not
have reserve requirements, and indeed are not permitted to hold reserves at the Federal Reserve,
the dissemination of reserves from the Federal Reserve’s open market transactions conducted
through the primary dealers, who pass the funds on through the highly liquid money markets, is
largely sufficient in routine circumstances to implement monetary policy smoothly. Ordinarily,
little credit is extended through the discount window; banks are able to obtain their funding and
reserves in the open market and generally turn to the window only to cover very short-term
liquidity shortfalls arising from operational glitches as opposed to more fundamental funding
problems. This structure allows the Federal Reserve to implement policy quite efficiently in
routine circumstances with minimal interference in private credit markets.
However, during the financial crisis, some aspects of the Federal Reserve’s monetary
policy implementation framework worked less well than in routine circumstances. A hallmark of
the financial crisis was the impaired functioning--and in some cases, even a complete
breakdown--of critical financial markets. Market participants became highly uncertain about
several matters, such as the financial strength of their counterparties; the future value of assets,
including any collateral they might be lending against; and how their own needs for capital and

- 12 liquidity might evolve. They fled to the safest and most liquid assets and would not engage in
the trading and arbitrage that usually transmit monetary policy impulses throughout the financial
system. For example, from the early days of the crisis, trading in the interbank funding markets
for terms longer than overnight dried up considerably. The greatly reduced access of banks to
term funding likely was an important factor that contributed to a sharp pullback in their
willingness to lend to households and firms.
The fact that primary dealers rather than commercial banks were the regular
counterparties of the Federal Reserve in its open market operations, together with the fact that
the Federal Reserve ordinarily extended only modest amounts of funding through repo
agreements, meant that open market operations were not particularly useful during the crisis for
directing funding to where it was most critically needed in the financial system. The Federal
Reserve attempted to address the reduced availability of term funding to banks partly by
lowering the cost of discount window credit and by increasing the maximum maturity of such
credit from 1 day to 30 days and then later to 90 days. However, banks’ willingness to use the
discount window was greatly undermined by their concerns about the “stigma” that they would
bear if their use of the window somehow was detected by counterparties or market analysts. To
address banks’ need for term funding, the Federal Reserve created the Term Auction Facility
(TAF), under which it auctions large blocks of term funds to banks. The TAF combines aspects
of open market operations and the discount window. The legal form of the TAF is the same as
that of regular discount window loans. But by providing funds through an auction mechanism
rather than through a standing facility, the TAF resembles open market operations rather than the
standard discount window and, partly as a result, it appears to have largely avoided the stigma
problem that limited the effectiveness of the discount window. Important questions for the

- 13 Federal Reserve going forward are whether the benefits of the TAF warrant its maintenance on
an ongoing basis or whether, now that the TAF has been developed, it can be brought off the
shelf sufficiently quickly if warranted by circumstances.
The dysfunction in money markets was by no means limited to the United States. In
globally integrated financial markets, many banks overseas had dollar obligations that they were
financing with short-term dollar borrowing. When funding markets were disrupted, the intense
bidding of these banks for dollar financing put upward pressure on interest rates in the United
States. To relieve this pressure, the Federal Reserve entered into liquidity swaps with foreign
central banks to enable those central banks to lend dollars to commercial banks in their
jurisdictions. We also need to decide whether and in what form we should keep this type of
liquidity provision readily available for possible future use.
Although the Federal Reserve routinely conducts open market operations through
primary dealers, as noted above, it also does so through an auction mechanism; that mechanism
implies both that no individual firm has any assurance of access to Federal Reserve liquidity and
that the aggregate amount of funds provided through open market operations does not bear any
direct relationship to dealers’ funding needs. The Federal Reserve does not have legal authority
to lend to firms other than depository institutions in routine circumstances. Moreover, given that
dealers are not subject to the type of regulation and supervision applied to banks, routine lending
to such firms could lead to moral hazard, with dealers’ access to central bank liquidity increasing
their incentives to take excessive risks. Thus, no regular standing facility for primary dealers is
maintained, even though, like large commercial banks, primary dealers are highly leveraged,
engage in significant maturity transformation, and are closely interconnected with the rest of the
financial system. Dealers ordinarily fund themselves primarily in the triparty repo market,

- 14 borrowing heavily to finance their securities positions. However, during the financial crisis,
dealers’ access to triparty funding declined sharply. Concerned with declining collateral values,
repo counterparties increased required interest rates and ratcheted down the lendable values of
collateral. As a consequence, dealers were forced to dump assets on the market in fire sales,
further driving down collateral values. To break this vicious cycle and head off the collapse of
the financial system that could have ensued, the Federal Reserve determined that it was
necessary to lend to primary dealers on a fully collateralized basis. Later in the crisis, the
Federal Reserve took similar actions to lend in support of money market mutual funds, which,
like primary dealers, resemble banks in their economic function but lack regular access to the
discount window.
Both of these actions were based on clear authority found in section 13(3) of the Federal
Reserve Act, but they required, consistent with the statutory provision, that a five-member
majority of the Federal Reserve Board determine that “unusual and exigent circumstances”
prevailed--a determination that had not been made in decades. An important question for the
future is what kind of authority we should have to lend to certain key groups of nonbank
financial intermediaries or in support of markets. The Federal Reserve Act was designed when
most credit flowed through banks, but over time securities markets have assumed a much more
prominent role in the distribution of credit. Our ability to preserve financial stability may be
enhanced by making sure the Federal Reserve has authority to lend against good collateral to
other classes of sound, regulated financial institutions that are central to our financial markets-not on a routine basis, but in some circumstances when the Board of Governors finds that the
absence of such lending would threaten market functioning and economic stability. The
collateral would have to be of good quality and the institutions sound to minimize any credit risk

- 15 the Federal Reserve might take. And the institutions would need to be tightly regulated and
closely supervised to limit the moral hazard of permitting access to the discount window, even
when such access is not routinely granted. I want to be quite clear that I am not referring to
lending under section 13(3) to individual troubled institutions, like American International
Group. That sort of lending is more appropriately done by the fiscal authorities and conducted
only in association with the exercise of new authority to resolve systemically important financial
institutions.
There are clear disadvantages to expanding the safety net to cover a wider range of firms
as we did in the recent crisis. But we have seen that when market functioning is or could be
substantially impaired, the effectiveness of our regular monetary policy tools is considerably
diminished, with potentially severe economic consequences. In these circumstances, lending in
support of markets and classes of important intermediaries becomes an essential extension of
monetary policy to foster our legislated mandate of promoting maximum employment and stable
prices.
Conclusion
After a serious setback to economic stability such as we have recently experienced,
monetary policymakers must ask whether the strategies and tools they have been using need to
be adapted to fulfill their responsibilities for price and economic stability in modern financial
markets. As with most interesting policy questions, the answers aren’t entirely clear. I’ve tried
to outline some of the issues here in the hope of fostering further discussion of these critical
questions.