Second Look at Kohn Speech

‘People can misinterpret almost anything so that it coincides with
views they already hold. They take from art what they already
believe.’ -SKubrick

Went through Kohn’s speech again and still don’t see it the way the markets do. Am I missing something?

Financial Markets and Central Banking

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.1 This list is not comprehensive: I have concentrated on the issues associated with our roles as monetary policy makers and providers of liquidity–and even in that category I cannot address all the issues in the short time allotted.Like every other period of financial turbulence, this one has been marked by considerable uncertainty. Central banks, other authorities, and private-market participants must make decisions based on analyses made with incomplete information and 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 in increasingly integrated global markets, thereby complicating the difficulty of seeing where 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 or to many commentators than they are to decision makers. For example, the extent to which institutions are facing liquidity constraints as opposed to capital constraints,

Yes, he recognizes the difference. Lending is not constrained by capital.

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 the Federal Reserve discusses have the character of “buying insurance” or managing risk–that is, weighing the possibility of especially adverse outcomes.

Inflation risk which they believe hurts long term optimal employment and growth versus systemic risk which they have called ‘market functioning’ risk.This is some kind of unknown catastrophic shutdown of the real economy due to dependence of the real economy on the functioning of the financial sectors. The risk is both nebulous and outside of mainstream models, hence the radically elevated uncertainty that led to the last two cuts as ‘insurance’ against this ‘market functioning’ risk.From the statement after the October 31 meeting, the inflation risk and the market functioning risk were ‘balanced’. This means the elevated market functioning risk was balanced by the elevated inflation risk.

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.

This refers back to the ‘neutrality of money’ theorem which states that in the long run the economy is supply side constrained and monetary policy is neutral for long term grown and employment, provided the fed keeps inflation expectations ‘well contained’. If expectations are allowed to become elevated, they believe the real losses are far higher than any short term real losses due to a slowdown or recession.

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, and managing their portfolios, both when those decisions turn out to be wise and when they turn out to be ill advised.

‘People’ here for the most part means shareholders and owners. That is the source of the ‘market discipline’ that regulates the risk companies and individuals take.

At the same time, however, in my view, when the decisions do 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.

That is his answer to moral hazard. And he believes that price stability is a necessary condition for optimal long term growth and employment, which is the current ‘mainstream’ economic thought as supported by all of the world’s central bankers and major universities.

This is a direct statement as to the importance of not letting inflation expectations elevate.

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.

Continuation of the neutrality of money idea – markets will adjust in the long run to the economy’s optimal output and employment, as above.

Such a strategy would not forestall the correction of asset prices that are out of line with fundamentals or 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 purchased at unsustainable prices and for mortgages made on the assumption that house prices would rise indefinitely.

With this strategy – “central banks’ focusing on the macroeconomic objectives of price stability and maximum employment” – shareholders and owners will take the losses, not the government.

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 exercised poor judgment. But these people are still bearing the costs of their decisions and we should not hold the economy hostage to teach a small segment of the
population a lesson.

This is justifying the previous cuts. He is saying the fed cuts were in line with its macro objectives. This is moving a bit into the ‘reinventing monetary policy’ realm, as above, as the systemic risks they fear are not in their models nor in mainstream considerations.

Additionally, there is no identified ‘channel’ for the rate cuts to alter ‘market functioning’ apart from the ‘psychological’ considerations, while the fed identifies several ‘channels’ that connect rate cuts to higher inflation.

That’s where all the talk of being ‘quick to take the cuts back’ comes from several fed participants.

The design of policies to achieve medium-term macroeconomic stability can affect the incentives for future risk-taking. To minimize moral hazard, central banks should operate as much as possible through general instruments not aimed at individual institutions. Open market operations fit this description,

Correctly affirming open market operations are not ‘bailouts’ but not going as far as to explain how the merely ‘offset operation factors’. Probably not enough time to get all that in.

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.

This reads to me like a prelude to a discount cut and removal of the ‘stigma’ as we recommended last week. The first step is to recognize that it’s operationally in no way a bail out for weak or insolvent banks. Nor does it help them economically in any way but only aids market functioning.

The Federal Reserve’s reduction of the discount rate penalty by 50 basis points in August followed this 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 counter parties and collateral.

As above.

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, created an unsustainable dynamic, which is now reversing.

He recognizes it is indeed reversing.

In that reversal, loss and fear of loss on mortgage credit have impaired the availability of new mortgage loans, which in turn has reduced the demand for housing and put downward pressures on house prices, which have further damped desires to lend. We are following this trajectory closely,

Yes, and for quite a while. Note the word ‘trajectory’ as a downward path was built into the October 31 statement.

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?

looking for ‘spillover.’

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 and tighter credit standards at banks and other lenders would make some types of credit more expensive and discourage some spending, developments that would require offsetting policy actions, other things being 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.

They already have forecast some ‘restraint on demand’.

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.

Right, have things gotten worse since October 31?

In general, nonfinancial businesses have been in very good financial condition; 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. Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses.

There is a possibility of turbulence resulting in further tightening of financial conditions. This is not stated as a certainty.

Heightened concerns about larger losses at financial institutions now reflected in various 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 a well.

Again, ‘could’ be a source of reduced demand. Again not a certainty.

Liquidity Provision and Bank Funding Markets Central banks have been confronting several issues in the provision of liquidity and bank funding. When the turbulence deepened in early August, demands for liquidity and reserves 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 in the dollar-funding markets early in the day have complicated our management of this rate.

Note that this is Euro banks that have been bidding up LIBOR.

And demands for reserves have been more variable and less flexible in an environment of heightened uncertainty, thereby adding to volatility.

This is a weakness in the NY fed’s ‘toolbox’ that he knows about but doesn’t want to directly criticize. Instead he offers remedies.

In addition, the Federal Reserve is limited in its ability to restrict the actual federal funds rate within a narrow band because we cannot, by law, pay interest on reserves for another four years.

Supporting the measure now before congress to allow the fed to pay interest on reserves. This would assist the NY fed in keeping the fed funds rate at the target set by the FOMC.

At the same time, the term 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. 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, and the wider spreads are one development we have factored into our easing actions.

Defending past easings on the notion that even though fed funds are lower, to many the cost of funds is based on LIBOR which hasn’t gone down as much as the fed funds rate.

Moreover, the behavior of these rates is symptomatic of caution among key marketmakers about taking and funding positions, and this is probably impeding the reestablishment of broader market trading liquidity.

The fed funds/LIBOR spread is part of the liquidity problem.

Conditions in term markets have deteriorated some in recent weeks. The deterioration partly reflects portfolio adjustments for the publication of year-end balance sheets. Our announcement on Monday of term open market operations was designed to alleviate some of the concerns about year-end pressures.

Yes, much of the spread is not a year end issue.

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 the 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, caution 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 reduced supplies of term funding, which 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.

That was a few days after we suggested it.

The success of such a program lies not in loans extended but rather in the extent to which the existence of this facility helps reassure market participants. In that regard, I think we had some success, at least for a time.

Yes, kept some of a lid on FF/LIBOR of around 50 bp plus the ‘stigma’ explained below.

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. 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.

A prelude to removing the ‘stigma’ as we also suggested a few days ago.


In response to developments in financial markets, the Federal Reserve has adjusted the stance of monetary policy and the parameters of how we supply liquidity to banks and the financial markets.

In this ‘conclusion’, he turns attention away to *how* they supply liquidity.

These adjustments have been designed to foster price stability and maximum sustainable growth and to restore better functioning of financial markets in support of these 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.

Weigh the balance of risks, and how to address them.

We will need to assess the implications of these developments, along with the 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 the conduct of monetary policy, as Chairman Bernanke has emphasized, we will act as needed to foster both price stability and full employment.

To me, this speech adds up to a discount rate cut and removal of the stigma to foster liquidity and market functioning.

Price stability means no FF cut – the 75 bp ‘insurance’ has already been carried what they see as a high premium as inflation risks have elevated substantially since October 31, and CPI will likely be going through 4% year over year a few days after the meeting.

Full employment also means price stability, as price stability is a necessary condition for max long term employment.

Comments welcome – please send to others for their comments as well.