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T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS T HREE I SSUES IN L EARNING AND M ONETARY P OLICY James Bullard President and CEO 13 September 2008 Learning and Macroeconomic Policy University of Cambridge, UK Views expressed do not necessarily reflect official positions of the FOMC or the Federal Reserve System. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA L EARNING AND MONETARY POLICY Issue one: core versus headline inflation. S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA L EARNING AND MONETARY POLICY Issue one: core versus headline inflation. The role for learning: filtering. S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA L EARNING AND MONETARY POLICY Issue one: core versus headline inflation. The role for learning: filtering. Issue two: systemic risk. S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA L EARNING AND MONETARY POLICY Issue one: core versus headline inflation. The role for learning: filtering. Issue two: systemic risk. The role for learning: information revelation. S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA L EARNING AND MONETARY POLICY Issue one: core versus headline inflation. The role for learning: filtering. Issue two: systemic risk. The role for learning: information revelation. Issue three: optimal policy in an economy with non-fundamental equilibria. S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS L EARNING AND MONETARY POLICY Issue one: core versus headline inflation. The role for learning: filtering. Issue two: systemic risk. The role for learning: information revelation. Issue three: optimal policy in an economy with non-fundamental equilibria. The role for learning: coordination on preferred equilibria. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA W HY THESE THREE ISSUES ? Provide some focus. S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA W HY THESE THREE ISSUES ? Provide some focus. Timely in current monetary policy discussions. S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA W HY THESE THREE ISSUES ? Provide some focus. Timely in current monetary policy discussions. Each has a distinct conventional wisdom behind it. S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA W HY THESE THREE ISSUES ? Provide some focus. Timely in current monetary policy discussions. Each has a distinct conventional wisdom behind it. The conventional wisdom is probably wrong. S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA W HY THESE THREE ISSUES ? Provide some focus. Timely in current monetary policy discussions. Each has a distinct conventional wisdom behind it. The conventional wisdom is probably wrong. But the conventional wisdom is driving policy. S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA W HY THESE THREE ISSUES ? Provide some focus. Timely in current monetary policy discussions. Each has a distinct conventional wisdom behind it. The conventional wisdom is probably wrong. But the conventional wisdom is driving policy. Welfare consequences in principle could be large. S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA W HY THESE THREE ISSUES ? Provide some focus. Timely in current monetary policy discussions. Each has a distinct conventional wisdom behind it. The conventional wisdom is probably wrong. But the conventional wisdom is driving policy. Welfare consequences in principle could be large. An opening for good research to impact economic outcomes. S OME COMMENTS T HREE ISSUES A CORE ISSUE A S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS CORE ISSUE The idea that oil prices are critical to understanding U.S. and possibly G-7 business cycles has wide appeal. T HREE ISSUES A CORE ISSUE A S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS CORE ISSUE The idea that oil prices are critical to understanding U.S. and possibly G-7 business cycles has wide appeal. Hamilton (1983); subsequent revamping. T HREE ISSUES A CORE ISSUE A S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS CORE ISSUE The idea that oil prices are critical to understanding U.S. and possibly G-7 business cycles has wide appeal. Hamilton (1983); subsequent revamping. The ad hoc approach since the 70s has been to ignore energy price movements and focus on "core" inflation. T HREE ISSUES A CORE ISSUE A S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS CORE ISSUE The idea that oil prices are critical to understanding U.S. and possibly G-7 business cycles has wide appeal. Hamilton (1983); subsequent revamping. The ad hoc approach since the 70s has been to ignore energy price movements and focus on "core" inflation. In the past I would have agreed that this practice has served us well. T HREE ISSUES A CORE ISSUE A S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS CORE ISSUE The idea that oil prices are critical to understanding U.S. and possibly G-7 business cycles has wide appeal. Hamilton (1983); subsequent revamping. The ad hoc approach since the 70s has been to ignore energy price movements and focus on "core" inflation. In the past I would have agreed that this practice has served us well. Now I think the tide has turned and we need to think harder. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS B LINDER ’ S DEFENSE OF CORE Buiter’s paper at Jackson Hole 2008 included criticism of “core inflation.” T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS B LINDER ’ S DEFENSE OF CORE Buiter’s paper at Jackson Hole 2008 included criticism of “core inflation.” Alan Blinder offered a defense. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS B LINDER ’ S DEFENSE OF CORE Buiter’s paper at Jackson Hole 2008 included criticism of “core inflation.” Alan Blinder offered a defense. U.S. monetary policy cannot have a meaningful impact on global oil markets. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS B LINDER ’ S DEFENSE OF CORE Buiter’s paper at Jackson Hole 2008 included criticism of “core inflation.” Alan Blinder offered a defense. U.S. monetary policy cannot have a meaningful impact on global oil markets. If oil price movements are mainly noise then it shouldn’t matter. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS B LINDER ’ S DEFENSE OF CORE Buiter’s paper at Jackson Hole 2008 included criticism of “core inflation.” Alan Blinder offered a defense. U.S. monetary policy cannot have a meaningful impact on global oil markets. If oil price movements are mainly noise then it shouldn’t matter. A one-time shift in the level of oil prices should not have a big impact. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS B LINDER ’ S DEFENSE OF CORE Buiter’s paper at Jackson Hole 2008 included criticism of “core inflation.” Alan Blinder offered a defense. U.S. monetary policy cannot have a meaningful impact on global oil markets. If oil price movements are mainly noise then it shouldn’t matter. A one-time shift in the level of oil prices should not have a big impact. A longer term trend in energy prices would be more problematic. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS B LINDER ’ S DEFENSE OF CORE Buiter’s paper at Jackson Hole 2008 included criticism of “core inflation.” Alan Blinder offered a defense. U.S. monetary policy cannot have a meaningful impact on global oil markets. If oil price movements are mainly noise then it shouldn’t matter. A one-time shift in the level of oil prices should not have a big impact. A longer term trend in energy prices would be more problematic. But, a “theorem” says that energy prices cannot continue to increase faster than other prices forever. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS B LINDER ’ S DEFENSE OF CORE Buiter’s paper at Jackson Hole 2008 included criticism of “core inflation.” Alan Blinder offered a defense. U.S. monetary policy cannot have a meaningful impact on global oil markets. If oil price movements are mainly noise then it shouldn’t matter. A one-time shift in the level of oil prices should not have a big impact. A longer term trend in energy prices would be more problematic. But, a “theorem” says that energy prices cannot continue to increase faster than other prices forever. This is the conventional wisdom echoed at the FOMC. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OME PROBLEMS WITH THE CONVENTIONAL WISDOM Oil price movements look more like a five-year trend. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OME PROBLEMS WITH THE CONVENTIONAL WISDOM Oil price movements look more like a five-year trend. Very plausible that this is driven by increased demand from the developing world. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OME PROBLEMS WITH THE CONVENTIONAL WISDOM Oil price movements look more like a five-year trend. Very plausible that this is driven by increased demand from the developing world. (Although, why 2003?) T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OME PROBLEMS WITH THE CONVENTIONAL WISDOM Oil price movements look more like a five-year trend. Very plausible that this is driven by increased demand from the developing world. (Although, why 2003?) Also plausible that this could go on for a long time. Decades. Think Solow model. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OME PROBLEMS WITH THE CONVENTIONAL WISDOM Oil price movements look more like a five-year trend. Very plausible that this is driven by increased demand from the developing world. (Although, why 2003?) Also plausible that this could go on for a long time. Decades. Think Solow model. The “theorem” may not have much bite. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OME PROBLEMS WITH THE CONVENTIONAL WISDOM Oil price movements look more like a five-year trend. Very plausible that this is driven by increased demand from the developing world. (Although, why 2003?) Also plausible that this could go on for a long time. Decades. Think Solow model. The “theorem” may not have much bite. Empirical literature: what best predicts future headline inflation? T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OME PROBLEMS WITH THE CONVENTIONAL WISDOM Oil price movements look more like a five-year trend. Very plausible that this is driven by increased demand from the developing world. (Although, why 2003?) Also plausible that this could go on for a long time. Decades. Think Solow model. The “theorem” may not have much bite. Empirical literature: what best predicts future headline inflation? This may not work with the most recent data. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY I would like to see more theory-oriented approaches to the subject, less statistics. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY I would like to see more theory-oriented approaches to the subject, less statistics. My sense is that theory would always put some weight on each price. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY I would like to see more theory-oriented approaches to the subject, less statistics. My sense is that theory would always put some weight on each price. The ad hoc aspect of the “core” idea would be removed. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY I would like to see more theory-oriented approaches to the subject, less statistics. My sense is that theory would always put some weight on each price. The ad hoc aspect of the “core” idea would be removed. Households and policymakers would solve an optimal filtering problem. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY I would like to see more theory-oriented approaches to the subject, less statistics. My sense is that theory would always put some weight on each price. The ad hoc aspect of the “core” idea would be removed. Households and policymakers would solve an optimal filtering problem. This would itself influence the equilibrium. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA SOME THEORY, CONTINUED Households and policymakers would have to track changing relative prices. S OME COMMENTS T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY, CONTINUED Households and policymakers would have to track changing relative prices. The equilibrium would involve ongoing learning about how much weight to put on various price movements in policymaking. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY, CONTINUED Households and policymakers would have to track changing relative prices. The equilibrium would involve ongoing learning about how much weight to put on various price movements in policymaking. Imponderables: T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY, CONTINUED Households and policymakers would have to track changing relative prices. The equilibrium would involve ongoing learning about how much weight to put on various price movements in policymaking. Imponderables: Intermediate goods. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY, CONTINUED Households and policymakers would have to track changing relative prices. The equilibrium would involve ongoing learning about how much weight to put on various price movements in policymaking. Imponderables: Intermediate goods. Open economies. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY, CONTINUED Households and policymakers would have to track changing relative prices. The equilibrium would involve ongoing learning about how much weight to put on various price movements in policymaking. Imponderables: Intermediate goods. Open economies. Price stickiness. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA O NE THEORY One example without any learning: S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS O NE THEORY One example without any learning: Martin Bodenstein, Chris Erceg, and Luca Guerrieri. “Optimal Monetary Policy in a Model with Distinct Core and Headline Inflation Rates.” JME, forthcoming. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS O NE THEORY One example without any learning: Martin Bodenstein, Chris Erceg, and Luca Guerrieri. “Optimal Monetary Policy in a Model with Distinct Core and Headline Inflation Rates.” JME, forthcoming. Retail prices are Calvo-sticky, wages are Calvo-sticky, energy prices are flexible. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS O NE THEORY One example without any learning: Martin Bodenstein, Chris Erceg, and Luca Guerrieri. “Optimal Monetary Policy in a Model with Distinct Core and Headline Inflation Rates.” JME, forthcoming. Retail prices are Calvo-sticky, wages are Calvo-sticky, energy prices are flexible. This means “core prices” are sticky. This makes core inflation the key to welfare maximization. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS O NE THEORY One example without any learning: Martin Bodenstein, Chris Erceg, and Luca Guerrieri. “Optimal Monetary Policy in a Model with Distinct Core and Headline Inflation Rates.” JME, forthcoming. Retail prices are Calvo-sticky, wages are Calvo-sticky, energy prices are flexible. This means “core prices” are sticky. This makes core inflation the key to welfare maximization. This gives the main result. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS R EMARKS A trend in the relative price of energy is not part of the analysis. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS R EMARKS A trend in the relative price of energy is not part of the analysis. This theory would put a lot of emphasis on “what’s sticky?” T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS R EMARKS A trend in the relative price of energy is not part of the analysis. This theory would put a lot of emphasis on “what’s sticky?” The view of policymakers would be, “what prices do consumers actually face?” T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS R EMARKS A trend in the relative price of energy is not part of the analysis. This theory would put a lot of emphasis on “what’s sticky?” The view of policymakers would be, “what prices do consumers actually face?” “Degrees of price stickiness” would suggest optimal filtering in this setting. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS R EMARKS A trend in the relative price of energy is not part of the analysis. This theory would put a lot of emphasis on “what’s sticky?” The view of policymakers would be, “what prices do consumers actually face?” “Degrees of price stickiness” would suggest optimal filtering in this setting. Also, the final goods price contains the weighted energy input price. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS T HE SYSTEMIC RISK STORY Monetary policy has been heavily influenced by ideas concerning systemic risk in the last year or so. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS T HE SYSTEMIC RISK STORY Monetary policy has been heavily influenced by ideas concerning systemic risk in the last year or so. The basic idea is that the sudden failure of a single firm may cause other, healthy, firms to fail at the same time. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS T HE SYSTEMIC RISK STORY Monetary policy has been heavily influenced by ideas concerning systemic risk in the last year or so. The basic idea is that the sudden failure of a single firm may cause other, healthy, firms to fail at the same time. This would damage the intermediation sector, and it would take a long time to recover. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS T HE SYSTEMIC RISK STORY Monetary policy has been heavily influenced by ideas concerning systemic risk in the last year or so. The basic idea is that the sudden failure of a single firm may cause other, healthy, firms to fail at the same time. This would damage the intermediation sector, and it would take a long time to recover. Macroeconomic models do not typically address this topic. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS T HE SYSTEMIC RISK STORY Monetary policy has been heavily influenced by ideas concerning systemic risk in the last year or so. The basic idea is that the sudden failure of a single firm may cause other, healthy, firms to fail at the same time. This would damage the intermediation sector, and it would take a long time to recover. Macroeconomic models do not typically address this topic. Rising or falling systemic risk is pushed into the stochastic terms. T HREE ISSUES A CORE ISSUE A S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA SLIPPERY CONCEPT The systemic risk story is difficult to cope with in the policy world. S OME COMMENTS T HREE ISSUES A CORE ISSUE A S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SLIPPERY CONCEPT The systemic risk story is difficult to cope with in the policy world. The aire of “collapse of the financial system” is worrisome. T HREE ISSUES A CORE ISSUE A S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SLIPPERY CONCEPT The systemic risk story is difficult to cope with in the policy world. The aire of “collapse of the financial system” is worrisome. At the same time, all financial firms have incentives to tell this story when necessary in order to avoid losing money. T HREE ISSUES A CORE ISSUE A S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SLIPPERY CONCEPT The systemic risk story is difficult to cope with in the policy world. The aire of “collapse of the financial system” is worrisome. At the same time, all financial firms have incentives to tell this story when necessary in order to avoid losing money. Many genuinely believe it. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS H ISTORY Recent history includes large failures without large repercussions: Drexel Burnham Lambert in 1990, Barings Bank in 1995, Long Term Capital Management in 1998, Enron in 2001, and Amaranth Advisors in 2006. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS H ISTORY Recent history includes large failures without large repercussions: Drexel Burnham Lambert in 1990, Barings Bank in 1995, Long Term Capital Management in 1998, Enron in 2001, and Amaranth Advisors in 2006. There were periodic panics in the 19th century U.S. between the Civil War and the founding of the Federal Reserve. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS H ISTORY Recent history includes large failures without large repercussions: Drexel Burnham Lambert in 1990, Barings Bank in 1995, Long Term Capital Management in 1998, Enron in 2001, and Amaranth Advisors in 2006. There were periodic panics in the 19th century U.S. between the Civil War and the founding of the Federal Reserve. There was an equilibrium, but policymakers and consumers did not like that equilibrium. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS H ISTORY Recent history includes large failures without large repercussions: Drexel Burnham Lambert in 1990, Barings Bank in 1995, Long Term Capital Management in 1998, Enron in 2001, and Amaranth Advisors in 2006. There were periodic panics in the 19th century U.S. between the Civil War and the founding of the Federal Reserve. There was an equilibrium, but policymakers and consumers did not like that equilibrium. Of course, there is the Great Depression. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS H ISTORY Recent history includes large failures without large repercussions: Drexel Burnham Lambert in 1990, Barings Bank in 1995, Long Term Capital Management in 1998, Enron in 2001, and Amaranth Advisors in 2006. There were periodic panics in the 19th century U.S. between the Civil War and the founding of the Federal Reserve. There was an equilibrium, but policymakers and consumers did not like that equilibrium. Of course, there is the Great Depression. Interested listeners might consult Gary Richardson and William Troost, “Monetary Intervention Mitigated Banking Panics During the Depression.” T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA M ULTIPLE STEADY STATES ? Jackson Hole question: How much weight should policymakers put on an implicit “financial stability” objective, relative to price stability and maximum sustainable employment? S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA M ULTIPLE STEADY STATES ? Jackson Hole question: How much weight should policymakers put on an implicit “financial stability” objective, relative to price stability and maximum sustainable employment? To this group: S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA M ULTIPLE STEADY STATES ? Jackson Hole question: How much weight should policymakers put on an implicit “financial stability” objective, relative to price stability and maximum sustainable employment? To this group: This sounds like multiple steady states. S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS M ULTIPLE STEADY STATES ? Jackson Hole question: How much weight should policymakers put on an implicit “financial stability” objective, relative to price stability and maximum sustainable employment? To this group: This sounds like multiple steady states. Requires a notion of what drives the dynamics around each steady state. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS O NE THEORY One paper at this conference, George Evans and Seppo Honkapohja, “Robust Learning Stability with Operational Monetary Policy Rules,” takes steps in this direction. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS O NE THEORY One paper at this conference, George Evans and Seppo Honkapohja, “Robust Learning Stability with Operational Monetary Policy Rules,” takes steps in this direction. Certain policy rules, if adopted, would generate an unstable target equilibrium. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS O NE THEORY One paper at this conference, George Evans and Seppo Honkapohja, “Robust Learning Stability with Operational Monetary Policy Rules,” takes steps in this direction. Certain policy rules, if adopted, would generate an unstable target equilibrium. The policymaker community does not usually talk in these terms. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS O NE THEORY One paper at this conference, George Evans and Seppo Honkapohja, “Robust Learning Stability with Operational Monetary Policy Rules,” takes steps in this direction. Certain policy rules, if adopted, would generate an unstable target equilibrium. The policymaker community does not usually talk in these terms. No financial intermediation component. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA SOME THEORY To get closer to the financial instability story a theory needs to incorporate private information held by interlinked financial firms. S OME COMMENTS T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY To get closer to the financial instability story a theory needs to incorporate private information held by interlinked financial firms. One interpretation of financial markets is that information is being revealed every day. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY To get closer to the financial instability story a theory needs to incorporate private information held by interlinked financial firms. One interpretation of financial markets is that information is being revealed every day. All players understand the incentives to withhold information. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY To get closer to the financial instability story a theory needs to incorporate private information held by interlinked financial firms. One interpretation of financial markets is that information is being revealed every day. All players understand the incentives to withhold information. Therefore, they are Bayesian learners with respect to the announcements made by other firms. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY To get closer to the financial instability story a theory needs to incorporate private information held by interlinked financial firms. One interpretation of financial markets is that information is being revealed every day. All players understand the incentives to withhold information. Therefore, they are Bayesian learners with respect to the announcements made by other firms. They also understand the sequence of events if there is a default. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY To get closer to the financial instability story a theory needs to incorporate private information held by interlinked financial firms. One interpretation of financial markets is that information is being revealed every day. All players understand the incentives to withhold information. Therefore, they are Bayesian learners with respect to the announcements made by other firms. They also understand the sequence of events if there is a default. The endogenous debt constraints literature emphasizes that the penalty for default influences the equilibrium level of credit. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS E QUILIBRIUM Would the Bayesian equilibrium somehow be “fragile”? T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS E QUILIBRIUM Would the Bayesian equilibrium somehow be “fragile”? Would it break down in response to certain shocks and cause Evans-Honkapohja-style instability? T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS E QUILIBRIUM Would the Bayesian equilibrium somehow be “fragile”? Would it break down in response to certain shocks and cause Evans-Honkapohja-style instability? My sense is no, because the players would understand the risk of failure of a partner firm. But the conventional wisdom is yes. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS E QUILIBRIUM Would the Bayesian equilibrium somehow be “fragile”? Would it break down in response to certain shocks and cause Evans-Honkapohja-style instability? My sense is no, because the players would understand the risk of failure of a partner firm. But the conventional wisdom is yes. In other industries, the failure of a large rival is good for business. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS E QUILIBRIUM Would the Bayesian equilibrium somehow be “fragile”? Would it break down in response to certain shocks and cause Evans-Honkapohja-style instability? My sense is no, because the players would understand the risk of failure of a partner firm. But the conventional wisdom is yes. In other industries, the failure of a large rival is good for business. It is important that we get an idea of the fundamental problem we are trying to address when it comes to financial stability. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS E QUILIBRIUM Would the Bayesian equilibrium somehow be “fragile”? Would it break down in response to certain shocks and cause Evans-Honkapohja-style instability? My sense is no, because the players would understand the risk of failure of a partner firm. But the conventional wisdom is yes. In other industries, the failure of a large rival is good for business. It is important that we get an idea of the fundamental problem we are trying to address when it comes to financial stability. Interested listeners might check Franklin Allen’s overview at Jackson Hole, “Understanding Financial Crises.” T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA E CONOMISTS VERSUS THE WORLD I have worked a fair amount on non-fundamental equilibria. S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA E CONOMISTS VERSUS THE WORLD I have worked a fair amount on non-fundamental equilibria. In the literature it has been an uphill climb. S OME COMMENTS T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS E CONOMISTS VERSUS THE WORLD I have worked a fair amount on non-fundamental equilibria. In the literature it has been an uphill climb. Many economists remain skeptical of multiple equilibria. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS E CONOMISTS VERSUS THE WORLD I have worked a fair amount on non-fundamental equilibria. In the literature it has been an uphill climb. Many economists remain skeptical of multiple equilibria. But, to be fair, much more widely accepted today than it once was. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS E CONOMISTS VERSUS THE WORLD I have worked a fair amount on non-fundamental equilibria. In the literature it has been an uphill climb. Many economists remain skeptical of multiple equilibria. But, to be fair, much more widely accepted today than it once was. In the policy and financial markets worlds, “bubbles” are taken as self-evident. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS E CONOMISTS VERSUS THE WORLD I have worked a fair amount on non-fundamental equilibria. In the literature it has been an uphill climb. Many economists remain skeptical of multiple equilibria. But, to be fair, much more widely accepted today than it once was. In the policy and financial markets worlds, “bubbles” are taken as self-evident. Story: Oil at $145 a barrel. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS E CONOMISTS VERSUS THE WORLD I have worked a fair amount on non-fundamental equilibria. In the literature it has been an uphill climb. Many economists remain skeptical of multiple equilibria. But, to be fair, much more widely accepted today than it once was. In the policy and financial markets worlds, “bubbles” are taken as self-evident. Story: Oil at $145 a barrel. Market insiders told me it was wildly high and turned out to be right. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS E CONOMISTS VERSUS THE WORLD I have worked a fair amount on non-fundamental equilibria. In the literature it has been an uphill climb. Many economists remain skeptical of multiple equilibria. But, to be fair, much more widely accepted today than it once was. In the policy and financial markets worlds, “bubbles” are taken as self-evident. Story: Oil at $145 a barrel. Market insiders told me it was wildly high and turned out to be right. If you think it is persistent fundamentals, you might predict based on a random walk, otherwise you predict a crash. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS E CONOMISTS VERSUS THE WORLD I have worked a fair amount on non-fundamental equilibria. In the literature it has been an uphill climb. Many economists remain skeptical of multiple equilibria. But, to be fair, much more widely accepted today than it once was. In the policy and financial markets worlds, “bubbles” are taken as self-evident. Story: Oil at $145 a barrel. Market insiders told me it was wildly high and turned out to be right. If you think it is persistent fundamentals, you might predict based on a random walk, otherwise you predict a crash. What should policymakers do? T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS C ONVENTIONAL WISDOM The conventional wisdom is to first of all admit ignorance. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS C ONVENTIONAL WISDOM The conventional wisdom is to first of all admit ignorance. Plan to react to a crash if one should occur. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS C ONVENTIONAL WISDOM The conventional wisdom is to first of all admit ignorance. Plan to react to a crash if one should occur. It is not clear that this is the best policy. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OMETHING SENSIBLE The theory literature has done something sensible on this question. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OMETHING SENSIBLE The theory literature has done something sensible on this question. It has focused on finding conditions under which non-fundamental equilibria may exist. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OMETHING SENSIBLE The theory literature has done something sensible on this question. It has focused on finding conditions under which non-fundamental equilibria may exist. The literature has then suggested policies that might eliminate the non-fundamental equilibria. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OMETHING SENSIBLE The theory literature has done something sensible on this question. It has focused on finding conditions under which non-fundamental equilibria may exist. The literature has then suggested policies that might eliminate the non-fundamental equilibria. This is reasonable, but very specialized to particular models. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OMETHING SENSIBLE The theory literature has done something sensible on this question. It has focused on finding conditions under which non-fundamental equilibria may exist. The literature has then suggested policies that might eliminate the non-fundamental equilibria. This is reasonable, but very specialized to particular models. And, actual policymakers may be more circumscribed in what can be done. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA SOME THEORY Suppose that for reasons exogenous to the model, equilibrium is indeterminate and so susceptible to non-fundamental shocks. S OME COMMENTS T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY Suppose that for reasons exogenous to the model, equilibrium is indeterminate and so susceptible to non-fundamental shocks. Let’s not take the route of adopting a policy to eliminate the indeterminacy. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY Suppose that for reasons exogenous to the model, equilibrium is indeterminate and so susceptible to non-fundamental shocks. Let’s not take the route of adopting a policy to eliminate the indeterminacy. Instead, is there a way to respond to an observed non-fundamental shock to improve on the equilibrium? T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY Suppose that for reasons exogenous to the model, equilibrium is indeterminate and so susceptible to non-fundamental shocks. Let’s not take the route of adopting a policy to eliminate the indeterminacy. Instead, is there a way to respond to an observed non-fundamental shock to improve on the equilibrium? In principle, there may be welfare superior equilibria available in the indeterminate region. T HREE ISSUES A CORE ISSUE N EEDED : S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS SOME THEORY Suppose that for reasons exogenous to the model, equilibrium is indeterminate and so susceptible to non-fundamental shocks. Let’s not take the route of adopting a policy to eliminate the indeterminacy. Instead, is there a way to respond to an observed non-fundamental shock to improve on the equilibrium? In principle, there may be welfare superior equilibria available in the indeterminate region. Commentators were talking about housing bubbles for years before prices began falling. Similarly with recent commodity price increases. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OME COMMENTS I have outlined some thoughts on research topics related to learning and monetary policy. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OME COMMENTS I have outlined some thoughts on research topics related to learning and monetary policy. One idea concerns ways to get rid of the ad hoc filtering done in the core inflation measures. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OME COMMENTS I have outlined some thoughts on research topics related to learning and monetary policy. One idea concerns ways to get rid of the ad hoc filtering done in the core inflation measures. Another suggested ways to get a better handle on the concept of systemic risk. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OME COMMENTS I have outlined some thoughts on research topics related to learning and monetary policy. One idea concerns ways to get rid of the ad hoc filtering done in the core inflation measures. Another suggested ways to get a better handle on the concept of systemic risk. And a third was an appeal to provide advice from existing models on how to react to a non-fundamental shock, if policymakers were willing to bet that an observed price movement was not driven by fundamentals. T HREE ISSUES A CORE ISSUE S YSTEMIC RISK N ON - FUNDAMENTAL EQUILIBRIA S OME COMMENTS S OME COMMENTS I have outlined some thoughts on research topics related to learning and monetary policy. One idea concerns ways to get rid of the ad hoc filtering done in the core inflation measures. Another suggested ways to get a better handle on the concept of systemic risk. And a third was an appeal to provide advice from existing models on how to react to a non-fundamental shock, if policymakers were willing to bet that an observed price movement was not driven by fundamentals. All of these topics are part of the current policy debate.
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