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Policy Challenges for Central Banks in the Aftermath of the Crisis James Bullard President and CEO Federal Reserve Bank of St. Louis Swedbank Economic Outlook Seminar Stockholm, Sweden 27 May 2010 Any opinions expressed here are my own and do not necessarily reflect those of the Federal Open Market Committee participants. This talk In the U.S. and globally, the recovery is going well, but … European sovereign debt: Second major crisis in 21 months. Responses to the crisis are necessary, but are also harming the credibility earned through stable, rules-based policy. Credibility can take a long time to rebuild. Regulatory reform in the U.S. is likely to become law, but cannot fully resolve problems. A new, more volatile era seems to be at hand. The challenges for monetary policy will be manifold. The recovery is on track ... GDP expected to reach 2008:Q2 peak before year-end Real Gross Domestic Product and MA May 2010 Forecast 2007:Q1 = 100 104 103 102 101 100 99 98 2007 2008 2009 2010 Source: Bureau of Economic Analysis, Macroeconomic Advisers. World real GDP growth is expected to improve Onset of Credit Crisis Year-Over-Year Percent Change 7 6 2011 Est. 4.3% 5 4 2010 Est. 4.2% 3 2 1 0 2009 -0.6% -1 -2 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 Source: IMF World Economic Outlook , April 2010. Global growth Canada 5.0, 5.0, 4.0 U.S. 5.6, 3.2, 4.0 Latin America 6.5, 4.8, 4.3 Russia U.K. 15.0, 9.4, 7.0 1.8, 1.3, 2.6 China EU 9.6, 10.8, 8.4 0.2, 0.3, 1.9 Japan India -2.2, 12.0, 9.0 3.8, 5.2, 2.9 South Africa 3.2, 4.3, 4.4 Australia 1.9, 4.7, 2.5 Real GDP growth, SAAR, Percent, 2009:Q4, 2010:Q1, and 2010:Q2 Source: Barclays Capital Global Economic Weekly. Real GDP for G-7 countries Year-over-Year Percent Change 7 5 Canada U.S. 3 Euro Area 1 -11992 1994 1996 1998 2000 2002 2004 2006 2008 2010 -3 U.K. -5 -7 -9 Japan …but the EU Crisis May Be a New Shock Debt and deficits ‘Greece’ Oct 09 Euro Zone: Fiscal indicators for selected countries Euro Area: General government expenditure and revenue Cost of insurance against default by commercial banks Basis Points Citigroup 1000 Bank of America 900 Credit Suisse 800 UBS 700 JP Morgan 600 Deutsche Bank 500 Barclays 400 300 200 100 0 Jan-2008 Jul-2008 Jan-2009 Jul-2009 Jan-2010 Source: Bloomberg. The role of government guarantees Financial market contagion is a concern. One positive is that bank guarantees remain in place—the upside of “too big too fail.” Governments have made it very clear that they do not think they can allow the failure of very large financial firms at this juncture. In 2007 and earlier, “too big to fail” guarantees were not as explicit as they are today, and so markets were more likely to run on large institutions with significant exposure to problem assets. Credibility Waning Successful medium-term policy A large part of successful macroeconomic policy is clear delineation of how the government will act in various states of the world. During the financial panic of 2008 and 2009, and again today, governments have been forced to take unprecedented actions. While these policy moves were necessary, they have also eroded credibility. We know that credibility is often established only over a long period of time. Re-establishing credibility? One key problem going forward will be how to re-establish credibility for macroeconomic policy. Policymakers tried to gain credibility for policies that turned out to be unrealistic: In the U.S., ambiguity over “too big to fail.” In Europe, ambiguity over the necessity of meeting debt and deficit targets. Credible policies are more effective, but may not be possible in the near term. Medium-term policy choice will have to take this into account. Regulatory Reform in the U.S. The scope of regulatory reform The financial crisis affected firms across industries in both the U.S. and Europe. These firms operated in a variety of regulatory environments. They often owned different lines of business. Very few escaped unscathed, suggesting that a change in regulation is not a panacea. One key common denominator: exposure to securitized mortgage products. Large S&P 500 Financial Firms (As of 2007:Q4) Firm Total Assets, Bill. (2007:Q4 ) Pct. of Tot. Assets in S&P 500 Fin. Cum. Percent Citigroup Inc. $2,187 10.9% 10.9% BHC Bank of America Corp. 1,715 8.5 19.5 BHC JPM Chase & Co. 1,562 7.8 27.3 BHC Goldman Sachs Grp. 1,119 5.5 32.9 Inv. Bank AIG 1,060 5.3 38.2 Insurance Morgan Stanley 1,045 5.2 43.4 Inv. Bank Merrill Lynch 1,020 5.1 48.5 Inv. Bank Fannie Mae 882 4.4 53.9 GSE FHL Mortg. 794 3.9 56.9 GSE Wachovia Corp. 782 3.9 60.8 BHC Type of Firm (2007: Q4) Large S&P 500 Financial Firms (As of 2007:Q4) Firm Total Assets, Bill. (2007:Q4) Pct. of Tot. Assets in S&P 500 Fin. Cum. Percent Type of Firm (2007:Q4) Lehman Bros. 691 3.4 64.2 Inv. Bank Wells Fargo 575 2.8 67.1 BHC MetLife Inc. 558 2.7 69.9 Insurance Prudential Financial 485 2.4 72.3 Fin. Adv./Ins. Hartford Financial Svcs. 360 1.8 74.1 Insurance Washington Mutual 327 1.6 75.7 Thrift U.S. Bancorp 237 1.1 76.9 BHC Countrywide Financial Corp. 211 1.0 78.0 Thrift Bank of NY Mellon Corp. 197 0.9 79.0 BHC Lincoln National 191 0.9 79.9 Insurance The who’s who of the crisis in the U.S. About 1/3 of the financial assets in the table are in bank holding companies as the crisis started. The less-regulated shadow banking sector played a huge role. New regulations need to take a view of the entire financial landscape—otherwise many activities are forced into less regulated entities. Pending legislation does not appear to be sufficiently broad in concept to address this concern. New forms of panic The hallmark of the crisis: Runs on non-bank financial firms. We know how to address bank runs: Deposit insurance plus prudential regulation. There is no analog for runs on non-bank financial firms. Additional capital requirements do not solve this problem. I expect the problem of runs on non-bank financial firms to be with us for the foreseeable future. One possible reform: Change the tax code to discourage short-term debt finance. A More Volatile Era? A more volatile era? Credibility is an important part of successful macroeconomic policy. The policy actions of the past two years, even while necessary, have eroded credibility. There are clear limits to what U.S. regulatory reform is likely to accomplish. Important problems will remain unresolved by the legislation. I expect less credible macroeconomic policies and lingering unresolved issues to combine to create a more volatile economic environment going forward. Monetary Policy Challenges Near-zero policy rates in the G-7 Percent 6 U.K 5 Canada 4 Euro Area 3 2 1 0 2007 U.S. Japan 2008 2009 2010 The near-zero rate policy The policy to keep rates near zero for an extended period can influence real activity at the zero lower bound according to modern monetary theories, such as Woodford (2003). The effects depend on the credibility of the promise. The policy carries risks that are not part of the standard analysis: Markets may confuse the policy with the “interest rate peg” policy, in which rates do not adjust in response to shocks. This is one of the worst policies according to the literature. In particular, multiple equilibria or “bubbles” are possible. Federal Reserve balance sheet Billions $ 3,000 2,500 Short-Term Lending to Financial Firms and Markets Rescue Operations Asset Purchase Program 2,000 Traditional Portfolio 1,500 Traditional Portfolio and Long-Term Assets 1,000 500 0 Jan-2007 Jul-2007 Jan-2008 Jul-2008 Jan-2009 Jul-2009 Jan-2010 Source: Board of Governors. The quantitative easing policy The near-zero interest rate policy has been supplemented with an aggressive quantitative easing policy. This program is generally regarded as effective. To the extent the QE policy has been successful, the more cumbersome “extended period” policy is called into question. The inflationary impact of the QE policy depends on the perceptions of how and when the policy will be removed. In theory, any credible commitment to remove the policy in finite time will work well. In practice, markets may well lose faith sooner than that. Federal Reserve Bank of St. Louis stlouisfed.org Federal Reserve Economic Data (FRED) research.stlouisfed.org/fred2/ James Bullard research.stlouisfed.org/econ/bullard/
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