The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
EMBARGOED UNTIL FRIDAY, MARCH 23, 2018 AT 7:00 P.M.; OR UPON DELIVERY Monetary, Fiscal, and Financial Stability Policy Tools: Are We Equipped for the Next Recession? Eric S. Rosengren President & CEO Federal Reserve Bank of Boston March 23, 2018 10th Conference of the International Research Forum on Monetary Policy Washington, DC bostonfed.org Introduction ▶ Much of my own research has focused on the ways that problems in the financial system can ripple through to the real economy ▶ Certainly the last financial crisis – and the ensuing Great Recession and very slow recovery – underlined the role that financial instability can play in disrupting the economy and in slowing its recovery ▶ Emphasized the need for policy tools that can be deployed to attempt to prevent financial instability, as well as minimize the effects of instability when it does emerge 2 Financial Stability Tools ▶ Generally associated with regulatory and supervisory measures ▶ Often viewed as independent from the stance of monetary and fiscal policy ▶ I view financial stability tools more holistically ▶ Integrally related to the ability to fully utilize fiscal and monetary tools to respond to adverse shocks ▶ If other tools are limited (fiscal and monetary), need greater financial stability policy buffers 3 Figure 1: Mentions of Financial Instability in FOMC Meetings and Periods of Instability February 11, 1987 - December 15, 2008 160 Number of Mentions Black Monday Bank of New England Fails Asian Crisis Russian Crisis/ LTCM Argentine Debt Default Bear Stearns Fails Lehman Fails 120 Special Session on Housing 80 40 0 11-Feb-87 06-Feb-91 01-Feb-95 03-Feb-99 Recession 28-Jan-03 31-Jan-07 FOMC Meeting Date Source: Peek, Rosengren and Tootell. (2016) “Does Fed Policy Reveal a Ternary Mandate?” Federal Reserve Bank of Boston Working Paper 16-11 4 Response to Adverse Shocks ▶ Prevention of financial stability problems is critically important but not the focus of my talk tonight ▶ Focus tonight is on tools that are available to policymakers once a significant adverse financial shock occurs (that is, crisis response) ▶ Fiscal, monetary, and financial tools can all play a role in offsetting the economic fallout ▶ If monetary and fiscal policy have limited capacity to respond to such shocks – then need greater buffers from financial stability tools 5 Responses to Large Adverse Financial Shocks Require a Broad Set of Tools ▶ Fiscal tools – cutting taxes and increasing government spending ▶ Monetary policy tools – reducing interest rates and expanding the central bank’s balance sheet ▶ Financial stability tools that provide sufficient buffers 6 Calibration of Financial Stability Tools ▶ Normally calibrated to the severity of likely economic stresses ▶ But important to take into account, how equipped fiscal and monetary policy are to respond ▶ If government-debt-to-GDP ratio is high – limits the ability or willingness to use fiscal tools to offset financial and other shocks ▶ If interest rates are already at or near the effective lower bound, and the country is unable or unwilling to use less-conventional monetary tools – limits capacity of monetary policy to respond 7 Good Current Conditions in U.S., But are we Ready for Hypothetical Adverse Shocks? ▶ U.S. has actually seen a reduction in the capacity of these so-called “buffers” across the policy tools ▶ There are implications if fiscal and monetary policy tools are likely to be limited ▶ Need to create greater capacity and flexibility within the tools currently available, including those most directly related to financial stability 8 Figure 2: Federal Funds Rate January 1987 - December 2008 12 Percent Black Monday Bank of New England Fails Russian Crisis/ LTCM Asian Crisis Argentine Debt Default Bear Stearns Fails 9 Lehman Fails 6 3 0 Jan-1987 Jan-1992 Recession Jan-1997 Jan-2002 Jan-2007 Month Source: Federal Reserve Board, NBER, Haver Analytics 9 Figure 3: Forecasts for the Longer-Run Federal Funds Rate from the Summary of Economic Projections January 2012 - March 2018 5 Percent 4 3 Central Tendency Median Federal Funds Target Rate 2 Jan-2012 Dec-2012 Dec-2013 Dec-2014 Dec-2015 Dec-2016 Dec-2017 Date of Forecast Note: The central tendency excludes the three highest and three lowest observations. Source: FOMC, Summary of Economic Projections (SEP) 10 Figure 4: Federal Funds Rate, Noting Peaks and Troughs January 1960 - February 2018 20 Percent 19.10 17.61 15 12.92 9.85 10 9.19 9.03 6.54 5.26 5.85 5 4.61 3.29 2.92 0.07 1.17 0 Jan-1960 0.98 Jan-1970 Jan-1980 Jan-1990 Jan-2000 Jan-2010 Recession Source: Federal Reserve Board, NBER, Haver Analytics 11 Alternative Monetary Policy Framework ▶ Given low prevailing rates, could reduce likelihood of hitting effective lower bound, particularly if unconventional policy has limits ▶ Other monetary policy frameworks may reduce likelihood of hitting effective lower bound ▶ Alternatively, if monetary policy may be limited may want greater fiscal or financial stability buffers 12 Figure 5: Federal Government Surplus or Deficit as a Percentage of GDP 1987:Q1 - 2008:Q4 4 Percent Black Monday Bank of New England Fails Argentine Debt Default Asian Crisis Bear Stearns Fails Lehman Fails 0 Russian Crisis/ LTCM -4 -8 1987:Q1 1992:Q1 1997:Q1 Recession 2002:Q1 2007:Q1 Quarter Note: Figures are four-quarter moving averages. Source: BEA, U.S. Treasury, NBER, Haver Analytics 13 Fiscal Limitations ▶ Impact the choices that policymakers have to utilize potential financial stability tools ▶ In the last crisis the U.S. provided direct capital infusions into the financial system ▶ Arguably limited the severity of credit crunches ▶ Promoted a quicker recovery in the financial sector in the U.S. relative to Europe ▶ Such actions require a fiscal buffer making it possible to finance the effort 14 Figure 6: General Government Gross Debt as a Percentage of GDP 1990 - 2022 120 Percent United States France 100 United Kingdom Germany 80 60 40 20 0 1990 1995 2000 2005 2010 2015 2020 Note: Actual are through 2017 for the U.S. and 2016 for all other countries. CBO projections for the U.S. (2018 – 2022) do not include the recent tax changes and increases in the federal budget. Source: OMB (U.S.), CBO (U.S.), IMF (France, Germany, U.K.), Haver Analytics 15 European Challenges in the Last Recession ▶ Southern European countries experienced serious fiscal problems in addition to serious banking problems ▶ Those countries in Europe with less severe banking problems but substantial fiscal capacity, did not want to use their fiscal capacity to resolve banking problems in other European countries ▶ As a result, the banking problems could not be easily resolved with capital infusions ▶ Fiscal capacity problems caused difficulties in resolving financial stability problems, making both worse 16 Financial Stability Tools in the U.S. are Limited ▶ The two primary financial stability tools available to the Federal Reserve ▶ Altering the scenarios used in the bank stress tests that are applied to the largest banks ▶ Setting of the countercyclical capital buffer ▶ Other countries have much larger set of tools and more flexibility to use them 17 Bank Stress Tests ▶ The stress test is primarily a microprudential tool ▶ Designed to ensure sufficient capital for banks in the event of a large financial shock ▶ By “stressing” particular assets, the test alters the cost of capital for that asset class ▶ Firms’ post-stress capital may decrease (or increase) relative to reported capital by varying magnitudes, depending on the mix of assets and hence the mix of risks 18 Countercyclical Capital Buffer ▶ The countercyclical capital buffer is intended to be a macroprudential tool ▶ The buffer increases capital for all financial firms it applies to during periods of financial excess, but is intended to release capital during stressful periods ▶ Because it is not related to particular stress scenarios, it does not alter the cost of capital for specific assets 19 Figure 7: Unemployment Rates and Stress Tests: Actual and Severely Adverse Scenario Peak 2009 - 2018 14 Percent 7 12 6 10 5 8 4 6 3 4 2 Percentage Points Scenario Peak minus Actual Scenario Peak 2 Actual at Time of Scenario Development 0 1 0 2009 2011 2013 2015 2017 Year of Stress Test Note: There was no stress test in 2010. Source: Federal Reserve Board 2009 2011 2013 2015 2017 Year of Stress Test 20 Stress Tests and Credit Availability ▶ Stress tests as currently utilized may not effectively release capital in a crisis ▶ Could encourage banks to reduce credit availability to shrink assets to satisfy binding capital constraints ▶ Examine the possibility of unintended consequences and assess whether stress tests may work at cross purposes to other tools designed to speed the recovery from a negative financial shock ▶ Other tools may be better designed to release capital to avoid reductions in credit availability 21 Figure 8: Countercyclical Capital Buffers by Jurisdiction June 2015 - January 2019 2.5 Percent Hong Kong Norway 2.0 Sweden 1.5 Czech Republic Iceland 1.0 Slovakia U.K. 0.5 Lithuania 0.0 Jun-2015 Jun-2016 Jun-2017 Jun-2018 Note: Based on implementation date, which is generally twelve months after announcement. The U.K. initially announced a CCyB of 0.5% in March 2016, with an implementation date of March 2017, however in July 2016 the CCyB was lowered to 0%. Source: European Systemic Risk Board, Bank of England, Hong Kong Monetary Authority 22 Figure 9: Capitalization Rates by Property Type 2001:Q1 - 2017:Q4 10 Percent Industrial Office 9 Retail Apartment 8 7 6 5 4 2001:Q1 2004:Q1 2007:Q1 2010:Q1 2013:Q1 2016:Q1 Recession Note: The capitalization or “cap” rate is the ratio of net operating income produced by a property to the price paid, calculated at the time of a transaction. Based on properties of $2.5 million or more. Source: Real Capital Analytics, NBER, Haver Analytics 23 Figure 10: Real Commercial Property Price Indices by Property Type 2000:Q4 - 2017:Q4 140 Index, Previous Peak=100 120 100 80 60 Apartment 40 Industrial Office 20 Retail 0 2000:Q4 2005:Q4 2010:Q4 2015:Q4 Recession Note: Indices are adjusted for inflation using the GDP deflator. Indices are repeat-sales based and include properties of $2.5 million or more. Source: Real Capital Analytics, BEA, NBER, Haver Analytics 24 Figure 11: Distribution of S&P 500 Composite Price to Earnings Ratios June and December, 1968 - 2017 12 Number of Observations P/E Ratio, December 2017 10 8 6 4 2 0 6-7 12-13 18-19 24-25 30-31 36-37 42-43 Note: Excludes 2 outliers -- Dec 2008 (60.7) and Jun 2009 (122.4) Source: S&P, Haver Analytics 25 Figure 12: Distribution of Shiller Cyclically-Adjusted S&P 500 Composite Price to Earnings Ratios June and December, 1968 - 2017 8 Number of Observations P/E Ratio, December 2017 6 4 2 0 5-6 11-12 17-18 Source: Robert Shiller, Haver Analytics 23-24 29-30 35-36 41-42 26 Concluding Observations ▶ Now is the time to assess and strengthen the various policy tools – yet the tools have actually been diminishing ▶ Monetary policy buffer has essentially been depleted as the nominal equilibrium interest rate has fallen ▶ Government-debt-to-GDP ratio is high by historical standards in many countries, but we see that it is rising in the U.S., potentially constraining flexibility to respond to a shock ▶ Countercyclical capital buffer, which was designed to be released in response to a large adverse financial shock, is currently set at zero 27 Conclusion (continued) ▶ Many countries are not well equipped to address an adverse financial stability shock ▶ In the United States, one can see that monetary, fiscal, and macroprudential buffers are modest, and in many cases are being drawn down further ▶ Now should be the time that policymakers assess which tools could provide more potent buffers to draw upon should a large adverse financial shock occur 28
@FedFRASER