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Good morning, everyone. Good morning. Okay, we're going to get started. Good morning, everyone. My name is Larry Meyer, and it's my pleasure to welcome you to today's Council on Foreign Relations meeting. Now, the meeting is part of the C. Peter McColough series on international economics, presented by the Council's corporate program and the Morris R. Greenberg Center for Geo-Economic Studies Now, the first thing I want to remind everybody is to please turn off your cell phones, BlackBerrys and other wireless devices, to be polite and not to interfere with the other electronics apparently in this room. I'd also like to remind especially the vice chairman that this meeting is on the record. And I think we're going to follow the Meyer rule here when there are press involved. So here's the rule. The rule is, the press must stay for the entire set of remarks and all the questions. It's just a safety issue, because you see the door is fairly narrow. We don't want you all rushing out at the same time. Okay, now, if this was an audience filled with central bankers from around the world, Don Kohn would certainly need no introduction. He probably doesn't for this audience as well. I think that if central bankers around the world could hold an election and elect a global group of Committee on Monetary Policy -- I don't know what they would do, but if they did that, Don Kohn would certainly occupy one of those chairs Don has served in the Federal Reserve System for almost 40 years, at the board for almost 35 years, as economist, later director of Monetary Affairs, then governor, and now vice chairman. When I was on the board and on the FOMC, he was, without question, my most valued advisor. And while I'm not a historian, I would venture to say that he is the most important non-chairman member of the FOMC probably in its history So I'm going to -- Don is going to open up with about 15 minutes of remarks. I'll follow with the first set of questions, and then we'll open it up to members for your questions. Let me introduce Vice Chairman Don Kohn. (Applause.) Thank you, Larry. And it's a pleasure to be here. When I accepted the invitation many months ago, I didn't anticipate the circumstances. But I'm glad to be here and glad to see so many familiar faces in the audience In a sense, I think, in my years at the Federal Reserve, New York has been a second home, and I've had great relationships with people at the Federal Reserve Bank in New York, at the desk there and elsewhere, and with many people who work here. And I'm glad to see so many familiar and mostly friendly faces here today So I thought it might be useful to start this session with a few thoughts on some of the issues facing central banks as they deal with the consequences of the recent turbulence in financial markets. My list is not comprehensive. I've concentrated on a few issues associated with our roles as monetary policymakers and providers of liquidity. And even in that category, I cannot address all the issues in the short time that I'm going to be talking And I want to emphasize that the views I express are my own and not necessarily those of my colleagues on the Federal Open Market Committee. Now, like every other period of financial turbulence, this one has been marked by considerable uncertainty. Central banks, other authorities, private market participants, must make decisions based on analyses made with incomplete information and partial understanding The repricing of assets is centered on relatively new instruments with limited histories, especially under conditions of stress. Many of them are complex and have reacted to changing circumstances in unanticipated ways. And those newer instruments have been held by a variety of investors and intermediaries and traded on increasingly globalized markets, complicating the difficulty of seeing where the risk is coming to rest Operating under this degree of uncertainty has many consequences. One is that the rules and criteria for taking particular actions seem a lot clearer in textbooks and to many commentators than they are to decision-makers, or at least to this decision-maker For example, the extent to which institutions face liquidity constraints, as opposed to capital constraints, or the moral-hazard consequences of policy actions, are inherently ambiguous in real time. Another consequence of operating under a high degree of uncertainty is that, more than usually, the potential actions that the Federal Reserve discusses have the character of buying insurance or managing risk; that is, weighing the possibility of especially adverse outcomes. I think the nature of financial-market upsets is that they substantially increase the risk of such especially adverse outcomes while possibly having limited effects on the most likely path for the economy. The first issue I want to discuss is moral hazard. Central banks seek to promote financial stability while avoiding the creation of moral hazard. People should bear the consequences of their decisions about lending, borrowing, managing their portfolios, both when those decisions turn out to be wise and when they turn out to be ill-advised. At the same time, however, in my view, when the decisions go poorly, innocent bystanders should not have to bear the cost. In general, I think those dual objectives -- promoting financial stability and avoiding the creation of moral hazard -- are best reconciled by central banks focusing on the macroeconomic objectives of price stability and maximum employment. Asset prices will eventually find levels consistent with the economy producing at its potential, consumer prices remaining stable, and interest rates reflecting productivity and thrift. Such a strategy would not forestall the correction of asset prices that are out of line with fundamentals, nor would it prevent investors from sustaining significant losses. Losses were evident early in this decade in the case of many high-tech stocks, and they are in store for houses purchases at unsustainable prices and for mortgages made on the assumption that house prices would rise indefinitely To be sure, lowering interest rates to keep the economy on an even keel when adverse financial-market developments occur will reduce the penalty incurred by some people who exercise poor judgment. But these people are still bearing the cost of their decisions, and we should not hold the economy hostage to teach a small segment of the population a lesson. The design of policies to achieve medium-term macroeconomic stability can affect the incentives for future risk-taking. To minimize moral hazards, central banks should operate as much as possible through general instruments not aimed at individual institutions Open market operations fit this description, but so too can the discount window when it is structured to make credit available only to clearly solvent institutions in support of market functioning. The Federal Reserve's reduction of the discount-rate penalty by 50 basis points in August followed this latter model. It was intended not to help particular institutions but rather to open up a source of liquidity to the financial system to complement open-market operations, which deal with a more limited set of counterparties and collateral. The second topic is the effects of financial markets on the real economy. Related developments in housing and mortgage markets are a root cause of the financial-market turbulence. Expectations of ever-rising house prices, along with increasingly lax lending standards, especially on subprime mortgages but not entirely on subprime mortgages, created an unsustainable dynamic, and that dynamic is now reversing. In that reversal, loss and fear of loss on mortgage credit have impaired the availability of new mortgage loans. This in turn has reduced the demand for housing, put downward pressure on house prices, and this has further come around to damp desires to lend. And we're following this trajectory closely. But key questions for central banks, including the Federal Reserve, are, what is happening to credit for other uses, and how much restraint are financial-market developments likely to exert on demands outside the housing sector? Some broader repricing of risk is not surprising or unwelcome in the wake of unusually thin rewards for risk-taking in several types of credit over recent years. And such a repricing in the form of wider spreads, tighter credit standards at banks and other lenders, would make some types of credit more expensive and discourage some spending. These developments would require offsetting policy actions, other things equal. Some restraint on demand from this process was a factor I took into account when I considered the economic outlook and the appropriate policy responses over the past few months An important issue now is whether concerns about losses on mortgages and some other instruments are inducing much greater restraint and thus constricting the flow of credit to a broad range of borrowers by more than seemed in train a month or two ago. In general, non-financial businesses have been in very good financial condition. And outside of variable-rate mortgages, households are meeting their obligations with, to date, only a little increase in delinquency rates, which generally remain at low levels Consequently, we might expect a moderate adjustment in the availability of credit to these key spending sectors. However, the increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. And should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses. Heightened concerns about larger losses at financial institutions that are now reflected in markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases but for other uses as well. Third topic: Liquidity provision in bank funding markets. Central banks have been confronting several issues in the provision of liquidity in bank funding. When the turbulence deepened in early August, demand for liquidity in reserve pushed overnight rates in interbank markets above monetary policy targets. The aggressive provision of reserves by a number of central banks met those demands, and rates returned to targeted levels. In the United States, strong bids by foreign banks and dollar-funding markets early in the day have complicated our management of this rate. And demands for reserves have been more variable and less flexible in an environment of heightened uncertainty, adding to volatility in the overnight rate. In addition, the Federal Reserve is limited in its ability to restrict the actual federal funds vrate to within a narrow band because we cannot, by law, pay interest on reserves for another four years. At the same time, the interbank funding markets have remained unsettled. This is evident in the much wider spread between term funding rates, like LIBOR, and the expected path of the federal funds rate. Now, this is not solely a dollar-funding phenomenon. It is being experienced in Euro and sterling markets to different degrees. Many loans are priced off of these term funding rates. The wider spreads are one development we have factored into our easing actions. Moreover, the behavior of these rates is symptomatic of caution among key market- makers about taking and funding positions. And this is probably impeding the re- establishment of broader market trading liquidity. Conditions in term markets have deteriorated some in recent weeks. This deterioration partly reflects portfolio adjustments for the publication of year-end balance sheets. And our announcement on Monday of term open-market operations was designed to alleviate some of the concerns about year-end pressures. The underlying causes of the persistence of relatively wide term-funding spreads are not yet clear. Several factors probably have been contributing. One may be potential counterparty risk, while ultimate size and location of credit losses on subprime mortgages and other lending are yet to be determined. Another probably is balance sheet risk or capital risk that is cautioned about retaining greater control over the size of balance sheets and capital ratios, given uncertainty about the ultimate demands for bank credit to meet liquidity (backstop ?) and other obligations. Favoring overnight or very short-term loans to other depositories and limiting term loans give banks the flexibility to reduce one type of asset if others grow, or to reduce the entire size of the balance sheet to maintain capital leverage ratios if losses unexpectedly subtract from capital. Finally, banks may be worried about access to liquidity in turbulent markets. Such a concern would lead to increased demands and reduce supplies of term funding, and that would put upward pressure on rates. This last concern is one that central banks should be able to address. The Federal Reserve attempted to deal with it when, as I already noted, we reduced the penalty for discount window borrowing 50 basis points in August and made term loans available. The success of such a program lies not in the quantity of loans extended but rather in the extent to which the existence of this facility helps reassure market participants. And in that regard, I think we had some success, at least for a time. But the usefulness of the discount window as a source of liquidity has been limited in part by banks' fears that their borrowing might be mistaken for accessing emergency loans for troubled institutions. And this stigma problem is not peculiar to the United States. And central banks, including the Federal Reserve, need to give some thought to how all their liquidity facilities can remain effective when financial markets are under stress. Now, in response to developments in financial markets, the Federal Reserve has adjusted financial markets. These adjustments have been designed to foster price stability and maximum sustainable growth and to restore better functioning of financial markets in support of those economic objectives. My discussion today was intended to highlight some of the issues we will be looking at in financial markets as we weigh the necessity of future actions. We will need to assess the implications of these developments along with a vast array of incoming information on economic activity and prices for the future path of the U.S. economy. As the Federal Open Market Committee noted at its last meeting, uncertainties about the economic outlook are unusually high right now. In my view, these uncertainties require flexible and pragmatic policymaking. "Nimble" is the adjective I used a few weeks ago in a speech. In the conduct of policy, as Chairman Bernanke has emphasized, we will act as needed to foster both price stability and full employment. Thank you. (Applause.) Okay. Well, I hope you appreciate that that was an absolutely brilliant speech. It was incredibly forthcoming. It sounded nothing like anything you've heard since the last meeting from other FOMC members. That's not a surprise, because the only FOMC members that can change the message are the vice chairman and the chairman. And that was an absolutely brilliant speech. I'm breathless. This has answered all the questions I had, so I don't know what I'm doing up here. (Laughter.) We can go back and eat breakfast, Larry. Yeah, we could. But nevertheless -- (laughter) -- I want to give him a chance to just reinforce some of the things that he said. I think, if you go back to the October meeting and the statement after that meeting, it had a tone that said, "We think we may be done. And in any case, we're strongly inclined not to move in December." You've got to read between the lines. You can look at the minutes. The minutes said it was a very close call, much closer than the markets believed, between not moving and going 25 basis points. So I just wanted to give the vice chairman a chance to sort of reinforce what he said. Many FOMC members have taking the line that nothing has changed since the last meeting. Those in the markets would beg to differ. So I take it that this is a recognition that there have been important changes in the market. It's a long time for the meeting. Lots of things can happen. It doesn't give away what the policy decision is going to be, but there have been important changes in the market, deteriorations in the credit markets in particular, that are relevant when the committee sits down again. Right. (Laughter.) May I expand on that answer? not unusual that my questions turn out to be longer than the answers. So we've gotten a lot of information since the last FOMC meeting, and we have a lot of information to come in until the next FOMC meeting. I think the economic information we've gotten about the path of the economy has been kind of mixed since the last meeting. If I think about labor markets, I think we and many people in this room were surprised -- maybe even including you, Larry -- at the strength of the employment gain in October. And since then, initial claims for unemployment insurance have edged higher on a kind of a moving average basis, but they remain pretty low. So I don't know if we'll get another read before the next FOMC meeting on the labor market, but I would say what we know now is that the labor markets -- employments continue to expand. This provides an important pillar -- underpinning -- for the economy, because when employment's expanding, incomes are expanding and people can consume out of those incomes. That's, I think, been on the positive side in terms of incoming data. I think on the other side, the spending data have been maybe a little to the soft side. We'll get more data on consumption, I think, Friday. Is that right on the consumer thing? But I would say there's been a noticeable slowing in the growth of consumption from what we know now -- the partial data we have in hand. That doesn't suggest that consumption has stopped growing. It's still expanding, but at a slower pace. It's not entirely unexpected. I think when you looked at the surveys of household attitudes and saw people getting more concerned, when you thought about declines in housing prices -- and certainly the failure of housing prices to go up and some, many of them to decline -- folks are looking at their balance sheets and thinking that their wealth is eroding to a certain extent. Their expected wealth is eroding and they're going to be a little more cautious in spending and I think we're beginning to see that on the consumer side as well. So that was a little soft, but we expected a little softness. I think the housing sector has continued to decline and erode at a very, very rapid rate. And while this was expected, I think it would be nice to see some early signs that it was beginning to stabilize and we haven't seen that yet. We'll get data on sales -- both new and existing home sales -- I think today and tomorrow and it would be -- and those data will also contain information about the inventories of unsold new and existing homes. And I think it would be nice to get a clue that sales were beginning to stabilize and builders were beginning to make some more progress in working down those inventories. As long as the inventories of unsold homes are there -- and the new inventories of homes coming onto the market, particularly in the foreclosure process -- looks high, that's going to put a lot of downward pressure on the housing market. So I think we've seen weak housing data. We expected weak housing data, so it'll be hard to assess, but I don't think we've seen the bottom of that market yet. On the inflation side, I think the core data have come in at a moderate pace -- kind of stable. On the other hand, the dollar has dropped further so import prices will under some upward pressure. And energy prices have gone up. So I don't think -- the sources of risk that the committee saw on inflation at the last meeting haven't gone away. And it's something that no central bank can afford to ignore. I think it's very important people -- that we keep prices roughly stable and people perceive that we are keeping prices stable. We cannot let inflation expectations start to rise. That would be a very bad dynamic. You're right: The one thing I think that's really changed since the last meeting is the deterioration in credit markets and financial markets. I never expected the markets to return to normal functioning very rapidly after the upsets of August and September. I thought this was a process that was going to take some time. Credit's going to have to re- channel to new -- out of the securities markets back into the banks to a certain extent. Instruments are going to have to be restructured so they're more transparent and are better able to be understood. The housing market and the macro economy are going to have to begin to stabilize so people -- that uncertainty goes away before things can get better. But I do think the -- and expected some year-end pressures, but I have to admit -- speaking for myself and certainly not for the committee -- the degree of deteriorating that's happened over the last couple of weeks is not something that I personally anticipated. I think the losses that have been announced that seem entrain and have been announced were greater than people expected. This raised questions about financial institutions, how much capital they had, how vigorous they would be in pursuing new loans. Financial institutions became more cautious. And I think this process is one that we're going to have to take a look at when we meet in a couple weeks. Again, extremely responsive answer to a difficult question Let me ask you: You know, when I was on the FOMC and you were secretary of the FOMC and advising me all along the way, Greenspan evolved this view about the risk-management approach to monetary policy. You know, in the context of where we are today with asymmetric downside growth risks that I would see -- and larger tail risk than we ever like to see -- what it meant to me was that the committee should put in place a path of the funds rate that would lead to unacceptably high inflation if those low probability, high- cost events did not occur. That's what risk management is all about. It seems to me, so far, that this committee doesn't believe in the risk management approach. Do I misinterpret the risk management approach? And do you think that the committee in September, when it seemed to think that 50 basis points was enough, was practicing the risk management approach? I think we have been practicing risk management approach to monetary policy. When we met in September we debated the choice between 25 and 50. We went with the 50, in part because we saw downsize risk and we wanted to take -- make sure our actions got ahead of what was happening and what was coming. So we did the larger -- the larger change. Last time, as the minutes noted, there was a question -- people thought it was a close call between -- you know, you may disagree that it wasn't a close call -- No, no. I think it was -- -- but the perception -- perceptions of the committee at that time, given that there'd been very little evidence of spillover from the housing market at that time -- on October 30th-31st -- to other sectors, given that the financial markets had been improving, particularly after our 50-basis point cut in the middle of September, committee members saw that as a close call. And they chose to take -- we chose to take the 25-basis point reduction in part out of the very risk management way of dealing with monetary policy that you were talking about. So when we have tail risk, you go -- you lean on the side of doing a little more. I think that's how the committee perceives that it's been operating. When the chairman began his tenure, one of the things he emphasized was that the objective of increased transparency and the goal of the communication strategy was to align market expectations with policy intentions. What that does is lets the markets anticipated future policy and build in today -- in long-term rates and equity prices -- expected future policy. And yet, it's interesting that through most of the last year and a half, there's been this persistent divergence between market expectations and policy intentions. Now, do you think that's a problem? Does it reflect an issue in terms of FOMC communication -- as I would think it does? And if it is a problem, do you have any suggestions as to how it could be rectified? It's a phenomenon -- whether it's a problem or not, I'm not sure. I agree with your characterization that for the last year and a half or more the market has seen lower interest rates and the Federal Reserve -- has been anticipating lower interest rates and the Federal Reserve has delivered. But this is not new. I think when we were tightening in -- beginning in 2004 and 2005, they saw us stopping before we actually started. So there seems to be -- and I don't know why and there are a lot of market people in this room and maybe afterwards they can tell me why -- the market has persistently for several years before the Bernanke era, seen a lower federal funds rate as consistent with our goals than has actually occurred. We need to make the decisions we make -- we are given the responsibility by Congress to promote maximum employment and stable prices and we need to set the federal funds rate, as our judgment, what those -- promote those objectives. The fact that the market sees that differently is an interesting phenomenon. I look at that. When I'm thinking about my own decision, I look at market expectations. And if my going in presumption into the FOMC meeting is different from what the market expects, I ask myself a couple of questions: Why? Do those guys know something I don't know? So it's kind of a check on me. I use it as a check. And the second question I ask is: Suppose we don't do what they expect, what will the market reaction be and now how do I factor that back into my decision? So I think we need to account for those market expectations, but not follow them blindly. I don't think the fact that the markets had different expectations from the Federal Reserve reflects a failure of Federal Reserve communication. I think we are telling you guys more all the time about how we arrive at our decisions -- certainly in October and this new forecast that we're putting out -- what our thinking is. I think Chairman Bernanke does a really clear job of setting out the reasoning for -- in his semiannual testimonies and in the speeches he gives like up here in New York Economics Club -- the setting out how we're viewing the world and why we see things going. And I guess in an ideal world everybody would agree about where things are going and why, and everybody would be on the same page, but that's not what happens. And we can actually get information -- I think we need to keep explaining what we're thinking and why we're thinking it. I don't see any obvious deficiencies in that. The markets disagree. We'll take that onboard and see what information there is in that for us. I don't think it's a deficiency in our communication. I just think people see the world differently. Okay. My last substantive question: Do you believe there was a Greenspan put? That is, that the Fed, while I was serving on the FOMC and you were advising the committee, would come in quickly to protect investors against losses, but sit back when investors were gaining in the markets? And if the answer is you don't believe there was a Greenspan put, why does this committee seem so intent in differentiating itself from the Greenspan Fed? Well , I don't know that -- first of all, you're right. I don't agree there was a Greenspan put. I think the FOMC under Alan Greenspan, as under Paul Volker, as under Ben Bernanke, have kept their eyes on those congressional objectives of high employment and stable prices. I think that's the way we should operate. That's the way we have been operating. I think part of the perception of the Greenspan put -- and we raised interest rates in 1999 when the Stock Market was rising, because we thought that was necessary to keep inflation under control. We raised interest rates in 1994, in 1990 -- in early '95, because we thought that was necessary to keep inflation under control. I think part of the perception of the Greenspan put arises from the fact that asset prices tend to go -- what is the phrase -- up in an escalator and down in an elevator. So if you're looking at the effect of asset prices on the economy and trying to factor that into your policy decisions, naturally the increases in interest rates will look more gradual than the decreases in rates just because of the way asset prices behave. So I don't think there's a Greenspan put. I don't think this committee is acting any different with respect to its ultimate objectives than it did under the previous several chairmen. Okay. Last very short question: Would you like to take a bow on behalf of your communications and on behalf of the FOMC for the quite extraordinary new procedure for reporting information about the FOMC's forecast? No. (Laughter.) You should! You should. It was as much as anybody could have expected and more. think it was a very valuable step. And I hope that people read it and get more information out of it about what the committee is thinking, why it's thinking and where it thinks the economy can go. That was the objective. I think it's also got valuable information about the diversity of views on the committee. And that's important. And about -- one thing that's completely new is about how we're viewing uncertainty and the risk to the forecast. So that was all kind of implied before, but now it's much more explicit. So I think that extending the forecast, looking at the risks and uncertainty in the forecast, adding the totally CP -- oh, total PCE, as well as to the thing -- conveys quite a bit of information. So I'm -- obviously, I was very much in favor of doing this and I'm glad you find it useful and I hope everyone does too.