Central Banking After the Financial Crisis

Speaking with, a blog by economists Stephen Cecchetti and Kim Schoenholtz, Donald Kohn discusses how the financial crisis has affected views of the central bank policy tool kit, of financial stability and of what’s needed to preserve the benefits of global finance.

Has the experience of the crisis changed your view of the central bank policy tool kit?

Donald Kohn: My answer is yes, to some extent. It changed my view on asset purchases. Before the crisis I was skeptical that asset purchases, particularly the possibility of U.S. Treasury bond purchases that we were talking about in the U.S. before the crisis, would have much effect. I thought that the Treasury market was extremely liquid and dominated by expectations about future Federal Reserve policy and other things, so that it would take massive purchases to change interest rates.

Maybe what we’ve had is massive purchases, but I do think QE has been effective in a couple of dimensions regardless. One is the portfolio balance dimension, where I was skeptical. The purchases have been large enough to change term premia; to incent people to look for other assets with duration and risk so that the impact spread through the financial system. I also think the purchases, particularly the initial set, were successful in underlining the determination of the Federal Reserve to do whatever it takes to get out of the recession initially and then to stimulate the economy to get back to full employment—importantly including holding interest rates near zero for quite some time.  That has been a signaling aspect of purchases that I believe has been effective.

And finally, because the initial purchases in Fall 2008 and Spring 2009 included mortgage-backed securities at a time when even the government-guaranteed mortgage-backed security market was not very liquid, I think we had an extra bonus from those purchases at that time by promoting liquidity in that particular market.

The other aspect of unconventional monetary policy is forward guidance: what central banks say about future policy rates. This isn’t a tool that originated in the crisis. For example, the Federal Reserve talked about interest rates in 2003, 2004 and 2005, when we were trying to lean against any tendency for the market to over react to the initial tightening coming out of that recession. Some central banks, like the Reserve Bank of New Zealand and the Swedish Riksbank, have published expected interest rate paths for a number of years. But I do think central banks got into much more detail during the crisis. Certainly the Federal Reserve did with a deliberate effort to steer expectations in response to the fact that the federal funds rate was at the zero lower bound.

I always thought that forward guidance and words would be effective in changing expectations. I also thought it was a complicated thing to balance commitment and flexibility; commitment so people believed that the path of interest rates you were telling them about was one that you really thought you were going to follow, other things equal; but flexibility, so that if other things weren’t equal you could change. That has been as complicated and difficult as I thought it would be.

So on the forward guidance, I think it has been effective. My views haven’t changed notably. It’s hard to deal with, but it’s part of the tool kit.

I think the third aspect here is targets. There’s been a lot of discussion about whether, instead of an inflation target, there ought to be a price level or nominal GDP target. Here my view hasn’t changed. I believe that in the case of the United States, the inflation target coupled with the high employment target is better than a price level, or especially a nominal GDP, target. I think it’s worth continuing to think about these things, but right now I would stick to the 2% inflation target that everyone else, including the United States, is using.              

Where should we be looking now for financial stability risks given this experience?

Kohn: The response of the authorities to the crisis has concentrated on banks, especially large banks, and other systemically important financial institutions, including insurance companies, investment banks, etc. I think those financial institutions that have been the target of the authorities’ attention are in much better shape, and I don’t think they constitute a risk to financial stability today. So I don’t think that what nearly brought the system down before, a Lehman Brothers kind of collapse, is currently a risk.

There could be mispriced bonds. People have pointed to junk bonds and dollar-denominated emerging market bonds and asked whether the risk in those bonds has been accurately valued by the market.  With regard to the consequences of a price adjustment, I would contrast the dot-com boom and bust with the housing boom and bust. The difference was the participation of intermediaries. Most price adjustments are fine. There could be quite a bit of volatility in the market as prices adjust. But I don’t see it having the same kind of risk characteristics that the subprime market had in the United States.

I would look at this price risk and volatility in the last couple of months. We’ve seen an increase in volatility and some widening of risk spreads. So, to the extent that we were worried that people were taking risks for which they weren’t being rewarded, and that those risks weren’t being reflected in the market, we ought to be a little less worried today. On the other hand, markets haven’t proven themselves as liquid as we might hope so there might be some liquidity risk out there. So, it’s the markets and the pricing of risks, including liquidity risks, I would be looking at.

Also, I would look at what remains of the shadow banks. In the tri-party RP [repurchase] markets, the money markets funds and other cases, there have been some fixes. But I do think we need to be careful that – as we put more restrictions on banks and other systemically important institutions – if their activity migrates to other places, it doesn’t do so in a way that has systemic risk associated with it. I don’t see that today, but I think it’s something we have to be careful about in the future.

What do we need to do to preserve the benefits of global finance?

Kohn: To start, let me say that I do see considerable benefits from global finance that are worth preserving. The global economy will be more productive if savings can move to the highest return assets. It will be more productive if the global financial system supports international trade, and if businesses can engage in cross-border financial transactions at the least possible cost. I do think it’s important that business find the cheapest possible finance and have the greatest possible opportunities consistent with financial stability to grow and be productive.

One of the problems that came home to us in the crisis was, as [Bank of England Governor] Mervyn King and many others said, these institutions are global in life and national in death. What’s required to preserve a global financial system that distributes savings efficiently is that authorities have confidence in one another. I have to believe that authorities in other countries are making their institutions that are doing business in my country safe. That they are requiring enough capital and liquidity, as well as appropriate risk management practices, so that those institutions don’t constitute a risk to my economy should they get in trouble. So I think making financial institutions safer and enhancing confidence across borders is important.

The other aspect of this is the death part. So, make them safer in life, but also make it possible to resolve them in death. It is important to do this without threatening financial stability and without inducing some authorities to ring fence whatever assets are in their country and grab them first. I do think that the issue of resolution and the resolution of globally active financial institutions is absolutely key.

Now I think progress has been made across both of these issues. Financial institutions are safer, with better capital and liquidity standards across the board. And progress is being made, maybe a little more slowly, on the resolution side of it. But all of this requires international coordination and cooperation. It’s very hard because all these rules are made in nation states. Or, in the case of the euro zone, some of them are made in the nation states and some of them are made in the center. So I think there’s work to be done to preserve global financial stability. But the program is out there; it just needs to be implemented and those understandings need to be enhanced and the confidence of one authority in the other needs to be rebuilt.