Saturday, September 08, 2007

Fed's Plosser: Financial Disruptions Don't Require Rate Cut

by Calculated Risk on 9/08/2007 08:38:00 PM

"I believe disruptions in financial markets can be addressed using the tools available to the Federal Reserve without necessarily having to make a shift in the overall direction of monetary policy."
Charles I. Plosser. Philly Fed President, Sept 8, 2007
Here is Plosser's speech in Hawaii: Two Pillars of Central Banking: Monetary Policy and Financial Stability (hat tip Ministry of Truth)

On financial stability:
When financial shocks threaten financial stability, a central bank must be prepared to act promptly to forestall any subsequent large adverse effects to the economy or financial system.

However, the term “stability” in this context can be a bit misleading. While an effectively functioning financial system is usually associated with financial stability, it is not appropriate for the Fed to ensure against financial volatility per se, or against individuals or firms taking losses or failing. Policymakers must be careful to allow the marketplace to make necessary corrections in asset prices. To do otherwise would risk misallocating resources and risk-bearing, as well as raise moral hazard problems. This could ultimately increase, rather than reduce, risks to the financial system.

Thus, the Fed does not seek to remove volatility from the financial markets or to determine the price of any particular asset; our goal is to help the financial markets function in an orderly manner. I agree with Chairman Bernanke that we should not seek to protect financial market participants, either individuals or firms, from the consequences of their financial choices. The success of free markets in generating wealth and an efficient allocation of resources depends on individuals and firms having the freedom to be successful and reap the rewards of their efforts. But just as important, those same individuals must also have the freedom to fail. ...

So in the face of a sharp decline in housing and severe problems in the subprime market, the central bank must let markets reassess and re-price risk, which will ultimately lead to the establishment of new levels of prices of housing-related financial assets.
On providing liquidity:
To provide liquidity to facilitate the orderly functioning of financial markets, the Federal Reserve can make temporary adjustments to day-to-day open market operations or to discount window lending. As you know, discount window lending is collateralized lending the Fed provides to depository institutions. Providing liquidity does not necessarily require a more fundamental change in the direction of monetary policy as implemented by a change in the fed funds rate target, although that is also an option if financial sector problems spill over to significantly harm the outlook for the broader economy.

For instance, when liquidity strains appeared in the financial system in mid-August, the Fed injected a larger-than-usual amount of funds into the U.S. banking system through open market operations on several days — $24 billion on Thursday, August 9, and $38 billion on Friday, August 10. ... Operations on August 9 and 10 were larger injections of funds than is typical.

However, these operations were consistent with the objective of the Fed’s Open Market Desk in New York to provide reserves as needed to promote trading in the fed funds market at rates as close as possible to the FOMC’s fed funds rate target of 5.25 percent.

... Most of that liquidity was returned to the Fed on Monday, August 13. With markets calmer, the Fed injected just $2 billion that day — an amount consistent with many typical daily open market operations. ...

Some news stories in August reported the totals for these daily Fed operations by adding them all together, which overstated the total amount of liquidity the Fed was injecting into the financial system at any one time. Actually, many of these repo operations were overnight transactions that reversed the next business day.
All emphasis added.

UPDATE: Mark Thoma notes that the html version of the speech is followed by the usual disclaimer: "The views expressed today are my own and not necessarily those of the Federal Reserve System or the FOMC." Earlier I noted the absence of this typical disclaimer in the PDF version of Plosser's speech.

It is rare for a Fed President to comment so directly on monetary policy. I'd take Plosser's comments as that it is his view that market expectations for a Fed funds rate cut in September are probably too high.