Federal Reserve – Page 29 – Digital Finance Analytics (DFA) Blog

US Regulators Say Wells Fargo Has More To Do

The Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Board on Tuesday announced that Bank of America, Bank of New York Mellon, JP Morgan Chase, and State Street adequately remediated deficiencies in their 2015 resolution plans. The agencies also announced that Wells Fargo did not adequately remedy all of its deficiencies and will be subject to restrictions on certain activities until the deficiencies are remedied.

Resolution plans, required by the Dodd-Frank Act and commonly known as living wills, must describe the company’s strategy for rapid and orderly resolution under bankruptcy in the event of material financial distress or failure of the company.

In April 2016, the agencies jointly determined that each of the 2015 resolution plans of the five institutions was not credible or would not facilitate an orderly resolution under the U.S. Bankruptcy Code, the statutory standard established in the Dodd-Frank Act. The agencies issued joint notices of deficiencies to the five firms detailing the deficiencies in their plans and the actions the firms must take to address them. Each firm was required to remedy its deficiencies by October 1, 2016, or risk being subject to more stringent prudential requirements or to restrictions on activities, growth, or operations. The review and the findings announced today relate only to the joint deficiencies identified in April 2016.

The agencies jointly determined that Wells Fargo did not adequately remedy two of the firm’s three deficiencies, specifically in the categories of “legal entity rationalization” and “shared services.” The agencies also jointly determined that the firm did adequately remedy its deficiency in the “governance” category. In light of the nature of the deficiencies and the resolvability risks posed by Wells Fargo’s failure to remedy them, the agencies have jointly determined to impose restrictions on the growth of international and non-bank activities of Wells Fargo and its subsidiaries. In particular, Wells Fargo is prohibited from establishing international bank entities or acquiring any non-bank subsidiary.

The firm is expected to file a revised submission addressing the remaining deficiencies by March 31, 2017. If after reviewing the March submission the agencies jointly determine that the deficiencies have not been adequately remedied, the agencies will limit the size of the firm’s non-bank and broker-dealer assets to levels in place on September 30, 2016. If Wells Fargo has not adequately remedied the deficiencies within two years, the statute provides that the agencies, in consultation with the Financial Stability Oversight Council, may jointly require the firm to divest certain assets or operations to facilitate an orderly resolution of the firm in bankruptcy.

The Federal Reserve Board is releasing the feedback letters issued to each of the five firms. The letters describe the steps the firms have taken to address the deficiencies outlined in the April 2016 letters. The feedback letter issued to Wells Fargo discusses the steps the firm has taken to address its deficiencies and those needed to adequately remedy the two remaining deficiencies.

The determinations made by the agencies today pertain solely to the 2015 plans and not to the 2017 or any other future resolution plans. In addition to requiring that the firms address their deficiencies, in April the agencies also identified institution-specific shortcomings, which are weaknesses identified by both agencies, but are not considered deficiencies.

The agencies in April also provided guidance to be incorporated into the next full plan submission due by July 1, 2017, to the five firms, as well as Goldman Sachs, Morgan Stanley, and Citigroup, and will review those plans under the statutory standard. If the agencies jointly decide that the shortcomings or the guidance are not satisfactorily addressed in a firm’s 2017 plan, the agencies may determine jointly that the plan is not credible or would not facilitate an orderly resolution under the U.S. Bankruptcy Code.

The decisions announced today received unanimous support from the FDIC and Federal Reserve boards.

Feedback letters:
Bank of America (PDF)
Bank of New York Mellon (PDF)
JP Morgan Chase (PDF)
State Street (PDF)
Wells Fargo (PDF)

How the Fed joined the fight against climate change

From The Conversation.

The Federal Reserve’s policy committee is expected to lift its target interest rate a quarter-point – to a range of 0.5 percent to 0.75 percent – at its final meeting of 2016.

The main reasons the Fed has kept rates near zero for eight years have been to restore economic growth and lower unemployment – goals that have been largely achieved. But doing so has had an important, if little noticed – and probably unintended – side effect: It has been promoting efforts to curb global warming.
Solar projects like this one in Pueblo, Colorado, become more attractive when rates are very low. Rick Wilking/Reuters
That is, the ultra-low interest rates have favored sustainable projects like wind farms and corporate solar installations, the kind that are necessary if the world is to transition to a low-carbon future in line with the Paris climate accord. At the same time, they have discouraged unsustainable, high-carbon projects like coal power plants that appear cheap but become unprofitable over time when you factor in the cost of carbon.

Government policy, without help from the Fed, could nudge businesses and consumers to reduce carbon emissions. But, as my research shows, governments walk a fine line when setting carbon policies. They may fail to adequately address climate risks with policies that are too lenient or come too late or they may create systemic instability and financial crises with policies that are too harsh or aggressive.

So one way to reduce these risks is for the business sector to voluntarily and swiftly proceed with the transition to a low-carbon, “green” economy. And thanks to the Fed, the low-interest rate environment is supporting just that.

Opportunity costs

Under the Paris Agreement, more than 190 countries agreed to limit the global temperature increase to below 2 degrees Celsius.

Just last month, the agreement entered into force after countries representing 55 percent of global emissions ratified it.

But the accord doesn’t actually force countries to do anything to live up to their pledges, and many companies have long been resistant to the kinds of policies, like carbon taxes and cap-and-trade systems, that would achieve those aims. Furthermore, U.S. President-elect Donald Trump has vowed to exit the accord.

So how can we reach those goals?

My own research suggests one way to get there is through the widespread adoption of capital budgeting techniques – the process of determining the viability of long-term investments – that take into account the opportunity costs of both financial capital and carbon dioxide.

The opportunity cost of financial capital is simply the rate of return the company could have earned on its next best investment alternative. If a project cannot return at least that, it should not be funded.

On the other hand, atmospheric capital, as measured by carbon dioxide emissions, is not privately owned, making its opportunity cost much harder to measure. This cost includes the benefits we forgo when emitting carbon dioxide into the atmosphere, such as more stable agricultural yields, reduced losses from less violent weather, greater biodiversity, etc. If a project cannot generate a return on carbon that is at least commensurate with the benefits we give up as a result of the project’s carbon emissions, the project should be rejected.

Estimates of the social cost of carbon for the next 35 years have been produced by the U.S. Interagency Working Group on Social Cost of Carbon and other organizations, such as Stanford University. Estimates from these two sources range from approximately US$37 to about $220 per ton of carbon dioxide, while many companies report internal carbon prices at or below the lower end of this range.

Historically, companies creating these costs haven’t borne the brunt of it, but that is changing as countries, states, provinces and cities are imposing or planning to impose various carbon pricing mechanisms. Examples include China, the European Union, California, Canada and U.S. states in the Northeast and Middle Atlantic region.

Since the planning horizon for long-term capital budgeting projects like power plants and solar installations often extends out 10 to 20 years or more, that carbon cost is likely to grow quite a bit, and more of it will be billed to the companies doing the polluting, meaning carbon-intensive projects will become increasingly expensive.

While the Fed does not influence the opportunity cost of carbon – and whether companies account for it – it does influence the opportunity cost of financial capital. Specifically, the Fed influences the time value of money by setting interest rates.

Patient investors

The time value of money is the compensation borrowers pay investors for their patience.

If the interest rate is high, people are very impatient and prefer cash flows now, perhaps leading them to prefer to invest in a polluting power plant that pays out right away rather than an expensive windmill farm. If the interest rate is very low, on the other hand, people have easy access to funding and can wait a long time for cash flows that come much later. That makes longer-term, riskier projects like that windmill farm more attractive because their value will grow as governments punish carbon emitters – and investors will be rewarded for their patience.

It is the Fed’s manipulation of the time value of money that affects the choice of high-carbon versus low-carbon projects, especially when an expected rising opportunity cost of carbon is included in the analysis. So with rates hovering at unprecedented lows for nearly a decade, today’s investors can afford to be patient.

Investments in the green economy that initially may seem expensive but pay off over the long term are favorably viewed when rates are low because positive cash flows in the more distant future are barely discounted. That is, their present value equivalents (the current worth of a future sum of money) are almost the same as the future amounts because so little interest would be earned were they invested elsewhere. That means the positive future cash flows are more likely to outweigh the initial costs of green projects.

In fact, there has been a solid 57 percent increase in renewable energy capacity in the U.S. since 2008, while dirtier power sources – though still dominant – have waned.

Coal, for example, made up 21.5 percent of energy production in 2015, down from 34 percent in 2008. Renewables, meanwhile, climbed to 11.5 percent from 10.2 percent in the same period. Actual consumption tells a similar story, with coal-making up 16 percent of all energy consumed in 2015, compared with 22.6 percent in 2008. Consumption of renewable energy climbed to 9.8 percent from 7.3 percent.

The expansion of the renewable energy sector was driven by a number of factors including cost reductions associated with technological improvements as well as policy support in the form of tax breaks, but the low-interest rate environment undoubtedly contributed to the acceleration of the low-carbon transition.

Will the music stop?

The Fed has been able to keep the time value of money at record low levels for so long thanks to persistently low inflation. If inflation begins to accelerate as economic growth increases, the Fed no longer has that ability, and the upcoming rate rise will be just the beginning. That will begin to shift the valuations of high- and low-carbon projects, making the former a bit more attractive, the latter a bit less so.

But a quarter-point increase won’t change valuations much. For now, the low interest rates will continue to favor long-term sustainable projects that will help us reach the Paris targets, while discouraging unsustainable ones that become unprofitable once budgeting analyses consider the likely future implementation of carbon taxes and new emissions regulations.

If we do reach those targets, we would have the Fed and the markets to thank – and not Congress or Trump – for a successful transition to a low-carbon economy.

Author: Carolin Schellhorn, Assistant Professor of Finance, St. Joseph’s University

Fintech – What Are The Risks?

Fed Governor Lael Brainard spoke on “The Opportunities and Challenges of Fintech” and highlighted the tension between the lightning pace of development of new products and services being brought to market–sometimes by firms that are new or have not historically specialized in consumer finance–and the duty to ensure that important risks around financial services and payments are addressed.The key challenge for regulatory agencies is to create the right balance.

Fintech has the potential to transform the way that financial services are delivered and designed as well as the underlying processes of payments, clearing, and settlement. The past few years have seen a proliferation of new digitally enabled financial products and services, in addition to new processes and platforms. Just as smartphones revolutionized the way in which we interact with one another to communicate and share information, fintech may impact nearly every aspect of how we interact with each other financially, from payments and credit to savings and financial planning. In our continuously connected, on-demand world, consumers, businesses, and financial institutions are all eager to find new ways to engage in financial transactions that are more convenient, timely, secure, and efficient.

In many cases, fintech puts financial change at consumers’ fingertips–literally. Today’s consumers, particularly millennials, are accustomed to having a wide range of applications, options, and information immediately accessible to them. Almost every type of consumer transaction–ordering groceries, downloading a movie, buying furniture, or arranging childcare, to name a few–can be done on a mobile device, and there are often multiple different applications that consumers can choose for each of these tasks based on their preferences. It seems inevitable for this kind of convenience, immediacy, and customization to extend to financial services. Indeed, according to the Federal Reserve Board’s most recent survey of mobile financial services, fully two-thirds of consumers between the ages of 18 and 29 having a mobile phone and a bank account use mobile banking.

New fintech platforms are giving consumers and small businesses more real-time control over their finances. Once broad adoption is achieved, it is technologically quite simple to conduct cashless person-to-person fund transfers, enabling, among other things, the splitting of a check after a meal out with friends or the sending of remittances quickly and cheaply to friends or family in other countries. Financial management tools are automating savings decisions based on what consumers can afford, and they are helping consumers set financial goals and providing feedback on expenditures that are inconsistent with those goals. In some cases, fintech applications are automatically transferring spare account balances into savings, based on monthly spending and income patterns, effectively making savings the default choice. Other applications are providing consumers with more real-time access to earnings as they are accrued rather than waiting for their regular payday. This service may be particularly valuable to the nearly 50 percent of adults with extremely limited liquid savings. It is too early to know what the overall impact of these innovations will be, but they offer the potential to empower consumers to better manage cash flow to reduce the need for more expensive credit products to cover short-term cash needs.

One particularly promising aspect of fintech is the potential to expand access to credit and other financial services for consumers and small businesses. By reducing loan processing and underwriting costs, online origination platforms may enable financial services providers to more cost effectively offer smaller-balance loans to households and small businesses than had previously been feasible. In addition, broader analysis of data may allow lenders to better assess the creditworthiness of potential borrowers, facilitating the responsible provision of loans to some individuals and firms that otherwise would not have access to such credit. In recent years, some innovative Community Development Financial Institutions (CDFIs) have developed partnerships with online alternative lenders, with the goal of expanding credit access to underserved small businesses.

The challenge will be to foster socially beneficial innovation that responsibly expands access to credit for underserved consumers and small businesses, and those who otherwise would qualify only for high-cost alternatives. It would be a lost opportunity if, instead of expanding access in a socially beneficial way, some fintech products merely provided a vehicle to market high-cost loans to the underserved, or resulted in the digital equivalent of redlining, exacerbating rather than ameliorating financial access inequities.

We are also monitoring a growing fintech segment called “regtech” that aims to help banks achieve regulatory compliance more effectively. Regtech firms are designing new tools to assist banks and other financial institutions in addressing regulatory compliance issues ranging from onboarding new customers to consumer protection to payments and governance. Many of the current solutions are focused on Bank Secrecy Act (BSA) regulatory requirements, including know-your-customer (KYC) and suspicious activity reporting requirements. The solutions utilize new technologies and data-analytic techniques that may reduce the costs and time needed for banks to identify and assess customers’ money-laundering and terrorist-financing risks. However, it is too early to tell the degree to which innovative approaches to customer due diligence, such as KYC utilities, will deliver efficiency gains such as those outlined in the recent Bank for International Settlements Committee on Payments and Market Infrastructures report on correspondent banking.

Ensuring Risks Are Managed and Consumers Are Protected

While financial innovation holds promise, it is crucial that financial firms, customers, regulators, and other stakeholders understand and mitigate associated risks. There is a tension between the lightning pace of development of new products and services being brought to market–sometimes by firms that are new or have not historically specialized in consumer finance–and the duty to ensure that important risks around financial services and payments are addressed. Firms need to ensure that they are appropriately controlling and mitigating both risks that are unique to fintech as well as risks that exist independently of new technologies.

For example, some fintech firms are exploring the use of nontraditional data in underwriting and pricing credit products. While nontraditional data may have the potential to help evaluate consumers who lack credit histories, some data may raise consumer protection concerns. Nontraditional data, such as the level of education and social media usage, may not necessarily have a broadly agreed upon or empirically established nexus with creditworthiness and may be correlated with characteristics protected by fair lending laws. To the extent that the use of this type of data could result in unfairly disadvantaging some groups of consumers, it requires careful review to ensure legal compliance. In addition, while consumers generally have some sense of how their financial behavior affects their traditional credit scores, alternative credit scoring methods present new challenges that could raise questions of fairness and transparency. It may not always be readily apparent to consumers, or even to regulators, what specific information is utilized by certain alternative credit scoring systems, how such use impacts a consumer’s ability to secure a loan or its pricing, and what behavioral changes consumers might take to improve their credit access and pricing.

Similarly, fintech innovations that rely on data sharing may create security, privacy, and data-ownership risks, even as they provide increased convenience to consumers. Recent examples of large-scale fraud and cybersecurity breaches have illustrated the significance of possible security risks. As the data sets that financial institutions utilize expand beyond traditional consumer credit histories, data privacy will become a growing concern, as will data ownership and whether or not the consumer has any say over how these data are used and shared or whether he or she can review it for accuracy. The Consumer Financial Protection Bureau recently issued a request for information to better understand the benefits and risks associated with new financial services that rely on access to consumer financial accounts and account-related information.

In addition to the risks I have outlined that are specific to new financial technologies, firms also must control for risks that have always been present, even in brick-and-mortar financial institutions. For example, risks around the BSA and Anti-Money Laundering rules cut across all segments and all portfolios. Similarly, firms must monitor credit and liquidity risks of loans acquired or processed via fintech platforms, especially given that these products have not been tested over an economic cycle.

Furthermore, as a general rule, the introduction of new products or services typically involves heightened risks as a financial institution enters into new areas with which it may not have experience or that may not be consistent with its overall business strategy and risk tolerance. Banks collaborating with fintech firms must control for the risks associated with the associated new products, services, and third-party relationships. When incorporating innovation that is consistent with a bank’s goals and risk tolerance, bankers will need to consider which model of engagement is most appropriate in light of their business model and risk-management infrastructure, manage any outsourced relationships consistent with supervisory expectations, ensure that regulatory compliance considerations are included in the development of new products and services, and have strong fallback plans in place to limit the risks associated with products and partners that may not survive.

With the growing number of partnerships between banks and fintech companies, we often receive questions about the applicability of our vendor risk-management guidance. We are actively reviewing our guidance to determine whether any adjustments or clarifications may become appropriate in the context of these arrangements. We hear concerns from community bankers in particular about their internal capacity to undertake the requisite due diligence and ongoing vendor management on their own, especially with much larger vendors, and questions about whether the interagency service providers supervision program might be relevant in this context. We are thinking about whether changes brought about by fintech and fintech partnerships may warrant consideration of any changes to the interagency supervision program for service providers.

Regulatory Engagement

I believe that the Federal Reserve is well-positioned to help shape this innovation as it develops, and it is important that we be clear about our expectations and mindful of the possible effects of our actions. The policy, regulatory, and supervisory decisions made by the Federal Reserve and other financial regulators can impact the ways in which new financial technologies are developed and implemented, and ultimately how effective they are. It is critical that fintech firms and financial institutions comply with all applicable legal protections and obligations. At the same time, it is important that regulators and supervisors not impose undue burdens on financial innovations that would provide broad social benefits responsibly. An unduly rigid regulatory or supervisory posture could lead to unintended consequences, such as the movement of innovations outside of the regulated banking industry, potentially creating greater risks and less transparency.

The rapid pace of change and the large number of actors–both banks and nonbanks–in fintech raise questions about how to effectively conduct our regulatory and supervisory activities. In one sense, regulators’ approach to fintech should be no different than for conventional financial products or services. The same basic principles regarding fairness and transparency should apply regardless of whether a consumer obtains a product through a brick-and-mortar bank branch or an online portal using a smartphone. Indeed, the same consumer laws and regulations that apply to products offered by banks generally apply to nonbank fintech firms as well, even though their business models may differ. However, the application of laws and regulations that were designed based on traditional financial products and delivery channels may give rise to complex or novel issues when applied to new products or new delivery channels. As a result, we are committed to regularly engage with firms and the technology to develop a shared understanding of these issues as they evolve.

Fundamentally, financial institutions themselves are responsible for providing innovative financial services safely. Financial services firms must pair technological know-how and innovative services with a strong compliance culture and a thorough knowledge of the important legal and compliance guardrails. While “run fast and break things” may be a popular mantra in the technology space, it is ill-suited to an arena that depends on trust and confidence. New entrants need to understand that the financial arena is a carefully regulated space with a compelling rationale underlying the various rules at play, even if these are likely to evolve over time. There is more at stake in the realm of financial services than in some other areas of technological innovation. There are more serious and lasting consequences for a consumer who gets, for instance, an unsustainable loan on his or her smartphone than for a consumer who downloads the wrong movie or listens to a bad podcast. At the same time, regulators may need to revisit processes designed for a brick-and-mortar world when approaching digital finance. To ensure that fintech realizes its positive potential, regulators and firms alike should take a long view, with thoughtful engagement on both sides.

When we look back at times of financial crisis or missteps, we frequently find that a key cause was elevating short-term profitability over long-term sustainability and consumer welfare. It was not long ago that so-called exotic mortgages originally designed for niche borrowers became increasingly marketed to low- and moderate-income borrowers who could not sustain them, ultimately with disastrous results. In addition to the financial consequences for individual consumers, the drive for unsustainable profit can contribute to distrust in the financial system, which is detrimental to the broader economy. It is critical that firms providing financial services consider the long-term social benefit of the products and services they offer. Concerns regarding long-term sustainability are magnified in situations where banks may bear credit or other longer-term operational risks related to products delivered by a fintech firm. One useful question to ask is whether a product’s success depends on consumers making ill-informed choices; if so, or if the product otherwise fails to provide sufficient value to consumers, it is not going to be seen as responsible and may not prove sustainable over time.

The key challenge for regulatory agencies is to create the right balance. Ultimately, regulators should be prepared to appropriately tailor regulatory or supervisory expectations, to the extent possible within our respective authorities, to facilitate fintech innovations that produce benefits for consumers, businesses, and the financial system. At the same time, any contemplated adjustments must also appropriately manage corresponding risks.

US Household Debt Hits $12.4 Trillion

From Zero Hedge.

The latest just released Quarterly Report on Household Debt and Credit from the New York Fed showed a small increase in overall debt in the third quarter of 2016, prompted by gains in non-housing debt, and new all time highs in student loans which hit $1.279 trillion, rising $20 billion in the quarter.11.0% of aggregate student loan debt was 90+ days delinquent or in default at the end of 2016 Q3.

Total household debt rose $63 billion in the quarter to $12.35 trillion, driven by a $32 billion increase in auto loans, which also hit a record high of $1.14 trillion. 3.6% of auto loans were 90 or more days delinquent.

Mortgage balances continued to grow at a sluggish pace since the recession while auto loan balances are growing steadily, and hit a new all time high of $1.14 trillion.

What was most troubling, however, is that delinquencies for auto loans increased in the third quarter, and new subprime auto loan delinquencies have not hit the highest level in 6 years.

The rise in auto loans, a topic closely followed here, has been fueled by high levels of originations across the spectrum of creditworthiness, including subprime loans, which are disproportionately originated by auto finance companies.

Disaggregating delinquency rates by credit score reveals signs of distress for loans issued to subprime borrowers—those with a credit score under 620.

To address the troubling surge in auto loan delinquencies, the NY Fed Liberty Street Economics blog posted an analysis of the latest developments in the sector. This is what it found.

Subprime Auto Debt Grows Despite Rising Delinquencies

The rise in auto loans has been fueled by high levels of originations across the spectrum of creditworthiness, including subprime loans, which are disproportionately originated by auto finance companies. Disaggregating delinquency rates by credit score reveals signs of distress for loans issued to subprime borrowers—those with a credit score under 620. In this post we take a deeper dive into the observed growth in auto loan originations and delinquencies. This analysis and our Quarterly Report are based on the New York Fed’s Consumer Credit Panel, a data set drawn from Equifax credit reports.

Originations of auto loans have continued at a brisk pace over the past few years, with 2016 shaping up to be the strongest of any year in our data, which begin in 1999. The chart below shows total auto loan originations broken out by credit score. The dollar volume of originations has been high for all groups of borrowers this year, with the quarterly levels of originations only just shy of the highs reached in 2005. The overall composition of both originations and outstanding balances has been stable.

As we noted in an earlier blog post, one feature of our data set is that it enables us to infer whether auto loans were made by a bank or credit union, or by an auto finance company. The latter are typically made through a car manufacturer or dealer using Equifax’s lender classification. Although it remains true that banks and credit unions comprise about half of the overall outstanding balance of newly originated loans, the vast majority of subprime loans are originated by auto finance companies. The chart below disaggregates the $1.135 trillion of outstanding auto loans by credit score and lender type, and we see that 75 percent of the outstanding subprime loans were originated by finance companies.Auto

In the chart below, auto loan balances broken out by credit score reveal that balances associated with the most creditworthy borrowers—those with a score above 760 (in gray below)—have steadily increased, even through the Great Recession. Meanwhile, the balances of the subprime borrowers (in light blue below), contracted sharply during the recession and then began growing in 2011, surpassing their pre-recession peak in 2015.

Delinquency Rates

Auto loan delinquency data, reported in our Quarterly Report, show that the overall ninety-plus day delinquency rate for auto loans increased only slightly in 2016 through the end of September to 3.6 percent. But the relatively stable delinquency rate masks diverging performance trends across the two types of lenders. Specifically, a worsening performance among auto loans issued by auto finance companies is masked by improvements in the delinquency rates of auto loans issued by banks and credit unions. The ninety-plus day delinquency rate for auto finance company loans worsened by a full percentage point over the past four quarters, while delinquency rates for bank and credit union auto loans have improved slightly. An even sharper divergence appears in the new flow into delinquency for loans broken out by the borrower’s credit score at origination, shown in the chart below. The worsening in the delinquency rate of subprime auto loans is pronounced, with a notable increase during the past few years.

It’s worth noting that the majority of auto loans are still performing well—it’s the subprime loans that heavily influence the delinquency rates. Consequently, auto finance companies that specialize in subprime lending, as well as some banks with higher subprime exposure are likely to have experienced declining performance in their auto loan portfolios.

Conclusion

The data suggest some notable deterioration in the performance of subprime auto loans. This translates into a large number of households, with roughly six million individuals at least ninety days late on their auto loan payments. Even though the balances of subprime loans are somewhat smaller on average, the increased level of distress associated with subprime loan delinquencies is of significant concern, and likely to have ongoing consequences for affected households.

Is Financial Risk Socially Determined?

From The St. Louis On The Economy Blog.

The authors of the In the Balance—Senior Economic Adviser William Emmons, Senior Analyst Lowell Ricketts and Intern Tasso Pettigrew, all with the St. Louis Fed’s Center for Household Financial Stability—found that eliminating so-called “bad choices” and “bad luck” reduced the likelihood of serious delinquency. With the exception of Hispanic families, this did not get rid of disparities in delinquency risk relative to the lower-risk reference group.

However, this exercise was based on the idea that the young (or less-educated or nonwhite) families’ financial and personal choices, behavior and exposure to luck could conform to those of the old (or better-educated or white) families. The authors suggested that such an approach may not be realistic.

A Lack of Choice?

“We believe a more realistic starting point for assessing the mediating role of financial and personal choices, behavior and luck in determining delinquency risk is a family’s peer group,” the authors wrote. They looked at how an individual family’s circumstances differ from its peer group, hoping to capture the “gravitational” effects of the peer group.

The odds are similar to those that were not adjusted, as seen in the figures below. (For 95 percent confidence intervals, see “Choosing to Fail or Lack of Choice? The Demographics of Loan Delinquency.”)

In particular, they examined how a randomly chosen family fared against the average of its peer group, such as how much debt a young black or Hispanic family with at most a high school diploma has compared to the family’s peer-group norm.

“We assume that the distinctive financial or personal traits associated with a peer group ultimately derive from the structural, systemic or historical circumstances and experiences unique to that demographic group,” the authors wrote.

When assuming that individual families’ choices extend only to deviations from peer-group averages, the authors estimated that:

A family headed by someone under 40 years old is 5.8 times as likely to become seriously delinquent as a family headed by someone 62 years old or more.

Middle-aged families (those with a family head aged 40 to 61 years old) are 4.2 times as likely to become seriously delinquent as old families.

A family headed by someone with at most a high school diploma is 1.8 times as likely to become seriously delinquent as a family headed by someone with postgraduate education.

A family headed by someone with at most a four-year college degree is 1.4 times as likely to become seriously delinquent as a family headed by someone with postgraduate education.

A black family is 2.0 times as likely to become seriously delinquent as a white family.

A Hispanic family is 1.2 times as likely to become seriously delinquent as a white family.

These demographic groups still appear to have a higher delinquency risk than older, better-educated and white families. This suggests that younger, less-educated and nonwhite families may have little choice in the matter.

“The striking differences in delinquency risk across demographic groups cannot be explained simply by referring to differences in risk preferences,” Emmons, Ricketts and Pettigrew wrote. “Instead, we suggest that deeper sources of vulnerability and exposure to financial distress are at work.”

The authors also concluded: “Families with ‘delinquency-prone’ demographic characteristics—being young, less-educated and nonwhite—did not choose and cannot readily change these characteristics, so we should refrain from adding insult to injury by suggesting that they simply have brought financial problems on themselves by making risky choices.”

Each family was assigned to one of 12 peer groups, which were defined by age (young, middle-aged or old), race or ethnicity (white or black/Hispanic) and education (at most a high school diploma or any college up to a graduate/professional degree).

The Problem Of Home Ownership

The proportion of households in Australia who own a property is falling, more a renting, or living with family or friends. We track those who are “property inactive”, and the trend, over time is consistent, and worrying.

It is harder to buy a property today, thanks to high prices, flat incomes and higher credit underwriting standards. Whilst some will go direct to the investment property sector (buying a cheaper place with the help of tax breaks); many are excluded.

This exclusion is not just an Australian phenomenon. The Federal Reserve Bank of St. Louis just ran an interesting session on “Is Homeownership Still the American Dream?” In the US the homeownership rate has been declining for a decade. Is the American Dream slipping away? They presented this chart:

A range of reasons were discussed to explain the fall. Factors included: the Great Recession and foreclosure crisis; tougher to get a mortgage now (but probably too easy before the crash); older, more diverse American population; stagnation of middle-class incomes; delayed marriage and childbearing; student loans and growing attractiveness of renting for some.

Yet, there is very little association between local housing-market conditions experienced during the recent boom-bust cycle and changes in attitudes toward homeownership. The desire to be a homeowner remains remarkably strong across all age, education, racial and ethnic groups. To remain a viable option for all groups, homeownership must become more affordable and sustainable.

They went on to discuss how to address the gap.

Tax benefits are “demand distortions.” Most economists agree that tax preferences for shelter (especially homeownership) push up prices: Benefits are “capitalized” into price or rent. Tax benefits of $150 bn. annually are skewed toward homeowners in high tax brackets via tax deductibility or exclusion. Tax changes likely in 2017—lower rates and higher standard deduction—will reduce tax benefits for homeownership, perhaps slowing or reducing house prices.

There also are “supply distortions” in housing that push up prices/rents. Land-use regulations/restrictive building codes increase construction costs, making housing less plentiful and less affordable. Local governments could reduce these constraints, and housing of all types and tenures would become cheaper.

Tightening Underwriting Standards. Unsuccessful homeownership experiences stem from shocks (job loss, divorce, sickness) that expose unsustainable financing—i.e., too much debt and too little homeowners’ equity (HOE). Reduce the risk of financial distress and losing a home by encouraging or requiring higher HOE and less debt. This would increase the age of first-time homebuyers and reduce homeownership but also reduce the risk of foreclosures.

You can watch the video here. But I think there are some important insights which are applicable to the local scene here. Not least, you cannot avoid the discussion around tax – both negative gearing and capital gains benefits need to be on the table. Supply side initiatives alone will not solve the problem.

To Borrow, or not to Borrow?

From The Federal Bank of St. Louis Blog.

Have you ever wondered whether it makes sense to borrow for college? Or how much debt is worth taking on to get that dream home?

Well, we at the Center for Household Financial Stability did. Accordingly, we organized, along with the Private Debt Project, a research symposium back in June to see if there exist tipping points at which taking on more debt could be too financially risky. After all, if debt doesn’t lead to more income and wealth, what’s the point? Asking these questions is one of the driving forces at the Center because we don’t think enough attention is being paid to the debt side of family balance sheets.

For the symposium, we commissioned several new papers from Fed and non-Fed economists. The papers—along with my summary and reflection—were released last week.

The research findings were both interesting and often counterintuitive. Let me mention just a few.

My colleagues Bill Emmons and Lowell Ricketts looked at loan delinquencies. Reflecting our Center’s ongoing work on the demographics of wealth, they found that younger, less-educated and nonwhite families were more likely to tip into delinquency. No huge surprise there. But then the co-authors posed what I think is a groundbreaking framing question, including for many Fed economists: Are these struggling families at this greater risk because they make riskier financial choices or because of structural, systemic forces that are largely shaping their financial behavior? In other words, is our tipping points question whether more financial education is primarily needed or whether a change in public policy is primarily needed?

Neil Bhutta and Benjamin Keys also discerned some alarming tipping points by looking at the nearly $1 trillion in home equity extractions between the boom years of 2002-2005. Extractors, they found, were more likely to default on their mortgages, even after controlling for credit scores and other risk factors. Even more surprising, extractors were more than twice as likely to become severely delinquent on their mortgage debts and almost 40 percent more likely to become delinquent on other kinds of debt.

We didn’t just look at the numbers but also the psychology of tipping points. Christopher Foote, Lara Loewenstein and Paul Willen found that, leading up to the financial crisis, excessive mortgage borrowing was fueled not by a financial indicator (the amount of income needed for a mortgage) but by a psychological one (the expected increase in future housing prices).

The symposium also opened up new ways to think about tipping points: At what point, for example, is an aspiration given up because of too much debt? And do different generations—say Gen Xers and millennials—think differently about how much debt is good or bad?

Several trends suggest families will be struggling with high debt levels for years to come, and it behooves all of us to think more about when debt goes from being productive to destructive. The financial health of families and our economy may depend on it.

I hope you’ll have a chance to read all of the papers, each one novel and forward-looking.

Additional Resources

Symposium: Tipping Points: Mapping and Understanding the Impact of Debt on Household Financial Well Being and Economic Growth

On the Economy: Mortgage Debt’s Share of Total Debt Keeps Declining

On the Economy: How Consumer Debt Has Evolved in the Nation and the Eighth District

Longer-Term Challenges for the U.S. Economy

Macroeconomic policy does not have to be confined to monetary policy. Certain fiscal policies, particularly those that increase productivity, can increase the potential of the economy say Fed Vice Chairman Stanley Fischer who discussed the Longer-Term Challenges for the U.S. Economy.

Notwithstanding a number of shocks over the past year, the U.S. economy is performing reasonably well. Job gains have been robust in recent years, and the unemployment rate has declined to 4.9 percent, likely close to its long-run sustainable level. After running at a subdued pace during the first half of the year, gross domestic product growth has picked up in the most recent data, and inflation has been firming toward the Federal Open Market Committee’s 2 percent target.

Although the economy has moved back to the vicinity of the Committee’s employment and inflation targets–suggesting that the cyclical drag on the economy has been greatly reduced, if not largely eliminated–along some dimensions this has not been a happy recovery. Unease with the economy reflects a number of longer-term challenges, challenges that will require a different set of policy tools than those used to address nearer-term cyclical shortfalls in growth. Prominent among these challenges are low equilibrium interest rates and sluggish productivity growth in the United States and abroad. I will first touch on low interest rates before turning to productivity. The federal funds rate and policy rates in other advanced economies remain very low or even negative. Longer-term rates are also low by historical standards, even taking into account the increase of the past two weeks.

Such low interest rates, together with only tepid growth, suggest that the equilibrium interest rate–that is, the rate that neither boosts nor slows the economy–has fallen. Why does this matter? Importantly, low interest rates make the economy more vulnerable to adverse shocks by constraining the ability of monetary policy to combat recessions using conventional interest rate policy–because the effective lower bound on the interest rate means that monetary policy has less room to reduce the interest rate when that becomes necessary. Also, low equilibrium rates could threaten financial stability by encouraging a reach for yield and compressing net interest margins, although it is important to point out that so far we have not seen evidence that low rates have notably increased financial vulnerabilities in the U.S. financial system. More fundamentally, low equilibrium real rates could signal that the economy’s long-run growth prospects are dim.

Why are interest rates so low? In a speech last month, I identified a number of factors that have worked to boost saving, depress investment, or both. Among the factors holding down interest rates is the sluggishness of foreign economic growth. Another is demographics, with saving being higher as a result of an increase in the average age of the U.S. population. Also, investment recently has been weaker than might otherwise be expected, perhaps reflecting uncertainty about longer-run growth prospects, as well as the decline in investment in the energy sector as a result of the fall in the price of oil. Finally, and most important, weak productivity growth has likely pushed down interest rates both by lowering investment, as firms lower their expectations for the marginal return on investment, and by increasing saving, as consumers lower their expectations for income growth and borrow less and/or save more as a consequence.

Understanding the recent weakness of productivity growth is central to addressing the longer-run challenges confronting the economy. Productivity growth over the past decade has been lackluster by post-World War II standards. Output per hour increased only 1-1/4 percent per year, on average, from 2006 to 2015, compared with its long-run average of 2-1/2 percent from 1949 to 2005. This halving of productivity growth, if it were to persist, would have wide-ranging consequences for living standards, wage growth, and economic policy more broadly. A number of explanations have been offered for the decline in productivity growth, including mismeasurement in the official statistics, depressed capital investment, and a falloff in business dynamism, with reality likely reflecting some combination of all of these factors and more.

We should also consider the possibility that weak demand has played a role in holding back productivity growth, although standard economic textbooks generally trace a path from productivity growth to demand rather than vice versa. Chair Yellen recently spoke on the influence of demand on aggregate supply. In her speech, she reviewed a body of literature that suggests that demand conditions can have persistent effects on supply. In most of the literature, these effects are thought to occur through hysteresis in labor markets. But there are likely also some channels through which low aggregate demand could affect productivity, perhaps by lowering research-and-development spending or decreasing the pace of firm formation and innovation. I believe that the relationship between productivity growth and the strength of aggregate demand is an area where further research is required.

I will conclude by reiterating one aspect of the low interest rate and low productivity growth problems that I have mentioned previously–the fact that, for several years, the Fed has been close to being “the only game in town,” as Mohamed El-Erian described it in his recent book.⁵ But macroeconomic policy does not have to be confined to monetary policy. Certain fiscal policies, particularly those that increase productivity, can increase the potential of the economy and help confront some of our longer-term economic challenges. While there is disagreement about what the most effective policies would be, some combination of improved public infrastructure, better education, more encouragement for private investment, and more effective regulation all likely have a role to play in promoting faster growth of productivity and living standards. By raising equilibrium interest rates, such policies may also reduce the probability that the economy, and the Federal Reserve, will have to contend more than is necessary with the effective lower bound on interest rates.

Watch live: http://www.cfr.org/monetary-policy/conversation-stanley-fischer/p38477 Leaving the Board

Federal Reserve Board orders JPMorgan Chase & Co. to pay $61.9 million civil money penalty

The US Federal Reserve Board on Thursday ordered JPMorgan Chase & Co. to pay a $61.9 million civil money penalty for unsafe and unsound practices related to the firm’s practice of hiring individuals referred by foreign officials and other clients in order to obtain improper business advantages for the firm.

In levying the fine on JPMorgan Chase, the Federal Reserve Board found that the firm’s Asia-Pacific investment bank operated an improper referral hiring program. The firm offered internships, trainings, and other employment opportunities to candidates who were referred by foreign government officials and existing or prospective commercial clients to obtain improper business advantages.

The Federal Reserve found that the firm did not have adequate enterprise-wide controls to ensure that referred candidates were appropriately vetted and hired in accordance with applicable anti-bribery laws and firm policies.

The Federal Reserve’s order requires JP Morgan Chase to enhance the effectiveness of senior management oversight and controls relating to the firm’s referral hiring practices and anti-bribery policies. The Federal Reserve is also requiring the firm to cooperate in its investigation of the individuals involved in the conduct underlying these enforcement actions and is prohibiting the organizations from re-employing or otherwise engaging individuals who were involved in unsafe and unsound conduct.

The Federal Reserve is imposing the fine and requiring the firm to modify its practices concurrently with actions by the U.S. Department of Justice and the Securities and Exchange Commission.

Put Rates UP to Lift Inflation – The Radical Reverse

Conventional wisdom is that to raise inflation, central banks must cut the cash rate – yet this approach is failing. So, is it time for a policy reversal – raise rates? This approach dubbed Neo-Fisherism might seem a radical idea but it could just be the most obvious solution to the low-inflation problem. This from the St. Louis Fed explains.

During the 2007-2009 global financial crisis, many central banks in the world, including the Federal Reserve, cut interest rates and resorted to various unconventional policies in order to fight financial market disruption, high unemployment, and low or negative economic growth. Now, in 2016, these central banks are typically experiencing inflation below their targets, and they seem powerless to correct the problem. Further unconventional monetary policy actions do not seem to help.

Neo-Fisherites argue that the solution to too-low inflation is obvious, and it may have been just as obvious to Irving Fisher, the early 20th century American economist and original Fisherite. The key Neo-Fisherian principle is that central banks can increase inflation by increasing their nominal interest rate targets—an idea that may seem radical at first blush, as central bankers typically believe that cutting interest rates increases inflation.

To see where Neo-Fisherian ideas come from, it helps to understand the roots of the science of modern central banking. Two key developments in central banking since the 1960s were the recognition that: (1) the responsibility for inflation lies with the central bank; and (2) the main instrument for monetary control for the central bank is a short-term (typically overnight) nominal interest rate. These developments were driven largely by monetarist ideas and by the experience with the implementation of those ideas by central banks in the 1970s and 1980s.

Monetarism is best-represented in the work of the economist Milton Friedman, who argued that “inflation is always and everywhere a monetary phenomenon” and that inflation can and should be managed through central bank control of the stock of money in circulation. Friedman reasoned that the best approach to inflation control is the adoption by the central bank of a constant money growth rule: He thought the central bank should choose some monetary aggregate—a measure of the total quantity of currency, accounts with commercial banks and other retail payments instruments (for example, M1)—and conduct monetary policy in such a way that this monetary aggregate grows at a constant rate forever. The higher the central bank’s desired rate of inflation, the higher should be this constant money growth rate.

During the 1970s and 1980s, many central banks, including the Fed, adopted money growth targets as a means for bringing down the relatively high rates of inflation at that time. Monetarist ideas were a key element of the policies adopted by Paul Volcker, chairman of the Fed’s Federal Open Market Committee (FOMC) from 1979 to 1987. He brought the inflation rate down from about 10 percent at the beginning of his term to 3.5 percent at the end through a reduction in the rate of growth in the money supply.

Though monetarist ideas were useful in bringing about a large reduction in the inflation rate, Friedman’s constant-money-growth prescription did not work as an approach to managing inflation on an ongoing basis. Beginning about 1980, the relationship between money growth and inflation became much more unstable, due in part to changes in financial regulation, technological changes in the banking industry and perhaps to monetarist monetary policy itself. This meant that using Friedman’s prescriptions to fine-tune policy to target inflation over the long term would not work.

As a result, most central banks, including the Fed, abandoned money-growth targeting in the 1980s. As an alternative, some central banks adopted explicit inflation targets, which have since become common. For example, the European Central Bank, the Bank of England, the Swedish Riksbank and the Bank of Japan have targets of 2 percent for the inflation rate. The U.S. is somewhat unusual in that Congress has specified a “dual mandate” for the Fed, which, since 2012, the Fed has interpreted as a 2 percent inflation target combined with the pursuit of “maximum employment.”

Conventional Practice

If a central bank is to move inflation toward its inflation target without reference to the growth rate in a measure of money, how is it supposed to proceed? Central banks control inflation indirectly by relying on an intermediate instrument—typically an overnight nominal interest rate. In the U.S., the FOMC sets a target for the overnight federal funds rate (fed funds rate) and sends a directive to the New York Federal Reserve Bank, which has the responsibility of reaching the target through intervention in financial markets.

Conventional central banking practice is to increase the nominal interest rate target when inflation is high relative to the inflation target and to decrease the target when inflation is low. The reasoning behind this practice is that increasing interest rates reduces spending, “cools” the economy and reduces inflation, while reducing interest rates increases spending, “heats up” the economy and increases inflation.

Neo-Fisherism

But what if central banks have inflation control wrong? A well-established empirical regularity, and a key component of essentially all mainstream macroeconomic theories, is the Fisher effect—a positive relationship between the nominal interest rate and inflation. The Fisher relationship, named for Irving Fisher, is readily discernible in the data.

This is a scatter plot of the inflation rate (the four-quarter percentage change in the personal consumption deflator—the Fed’s chosen measure of inflation) vs. the fed funds rate for the period 1954-2015. A positively sloped line would be the best fit to the points in the scatter plot, indicating that inflation tends to rise as the fed funds rate rises.

Many macroeconomists have interpreted the Fisher relation observed as involving causation running from inflation to the nominal interest rate (the usual market quote for the interest rate, not adjusted for inflation). Market interest rates are determined by the behavior of borrowers and lenders in credit markets, and these borrowers and lenders care about real rates of interest. For example, if I take out a car loan for one year at an interest rate of 10 percent, and I expect the inflation rate to be 2 percent over the next year, then I expect the real rate of interest that I will face on the car loan will be 10 percent – 2 percent = 8 percent. Since borrowers and lenders care about real rates of interest, we should expect that as inflation rises, nominal interest rates will rise as well. So, for example, if the typical market interest rate on car loans is 10 percent if the inflation rate is expected to be 2 percent, then we might expect that the market interest rate on car loans would be 12 percent if the inflation rate were expected to be 4 percent. If we apply this idea to all market interest rates, we should anticipate that, generally, higher inflation will cause nominal market interest rates to rise.

But, what if we turn this idea on its head, and we think of the causation running from the nominal interest rate targeted by the central bank to inflation? This, basically, is what Neo-Fisherism is all about. Neo-Fisherism says, consistent with what we see in, that if the central bank wants inflation to go up, it should increase its nominal interest rate target, rather than decrease it, as conventional central banking wisdom would dictate. If the central bank wants inflation to go down, then it should decrease the nominal interest rate target.

But how would this work? To simplify, think of a world in which there is perfect certainty and where everyone knows what future inflation will be. Then, the nominal interest rate R can be expressed as

R = r + π,

where r is the real (inflation-adjusted) rate of interest and π is future inflation. Then, suppose that the central bank increases the nominal interest rate R by raising its nominal interest rate target by 1 percent and uses its tools (intervention in financial markets) to sustain this forever. What happens? Typically, we think of central bank policy as affecting real economic activity—employment, unemployment, gross domestic product, for example—through its effects on the real interest rate r. But, as is widely accepted by macroeconomists, these effects dissipate in the long run. So, after a long period of time, the increase in the nominal interest rate will have no effect on r and will be reflected only in a one-for-one increase in the inflation rate, π. In other words, in the long run, the only effect of the nominal interest rate on inflation comes through the Fisher effect; so, if the nominal interest rate went up by 1 percent, so should the inflation rate—in the long run.

But, in the short run, it is widely accepted by macroeconomists (though there is some disagreement about the exact mechanism) that an increase in R will also increase r, which will have a negative effect on aggregate economic activity—unemployment will go up and gross domestic product will go down. This is what macroeconomists call a non-neutrality of money. But note that, if an increase in R results in an increase in r, the short-run response of inflation to the increase in R must be less than one-for-one.

However, if inflation is to go down when R goes up, the real interest rate r must increase more than one-for-one with an increase in R, that is, the non-neutrality of money in the short run must be very large.

To assess these issues thoroughly, we need a well-specified macroeconomic model. But essentially all mainstream macroeconomic models predict a response of the economy to an increase in the nominal interest rate as depicted below.

In this figure, time is on the horizontal axis, and the central bank acts to increase the nominal interest rate permanently, and in an unanticipated fashion, at time T. This results in an increase in the real interest rate r on impact. Inflation π increases gradually over time, and the real interest rate falls, with the inflation rate increasing by the same amount as the increase in R in the long run. This type of response holds even in mainstream New Keynesian models, which, it is widely believed, predict that a central bank wanting to increase inflation should lower its nominal interest rate target. However, as economist John Cochrane shows, the New Keynesian model implies that if the central bank carries out the policy we have described—a permanent increase of 1 percent in the central bank’s nominal interest rate target—then the inflation rate will increase, even in the short run.

The Low-Inflation Policy Trap

What could go wrong if central bankers do not recognize the importance of the Fisher effect and instead conform to conventional central banking wisdom? Conventional wisdom is embodied in the Taylor rule, first proposed by John Taylor in 1993.5 Taylor’s idea is that optimal central bank behavior can be written down in the form of a rule that includes a positive response of the central bank’s nominal interest rate target to an increase in inflation.

But the Taylor rule does not seem to make sense in terms of what we see. Taylor appears to have thought, in line with conventional central banking wisdom, that increasing the nominal interest rate will make the inflation rate go down, not up. Further, Taylor advocated a specific aggressive response of the nominal interest rate target to the inflation rate, sometimes called the Taylor principle. This principle is that the nominal interest rate should increase more than one-for-one with an increase in the inflation rate.

So, what happens in a world that is Neo-Fisherian (the inflationary process works as above, but central bankers behave as if they live in Taylor’s world? Macroeconomic theory predicts that a Taylor-principle central banker will almost inevitably arrive at the “zero lower bound.” What does that mean?

Until recently, macroeconomists argued that short-term nominal interest rates could not go below zero because, if interest rates were negative, people would prefer to hold cash, which has a nominal interest rate equal to zero. According to this logic, the lower bound on the nominal interest rate is zero. It turns out that, if the central bank follows the Taylor principle, then this implies that the central bank will see inflation falling and will respond to this by reducing the nominal interest rate. Then, because of the Fisher effect, this actually leads to lower inflation, causing further reductions in the nominal interest rate by the central bank and further decreases in inflation, etc. Ultimately, the central bank sets a nominal interest rate of zero, and there are no forces that will increase inflation. Effectively, the central bank becomes stuck in a low-inflation policy trap and cannot get out—unless it becomes Neo-Fisherian.

But maybe this is only theory. Surely, central banks would not get stuck in this fashion in reality, misunderstanding what is going on, right? Unfortunately, not. The primary example is the Bank of Japan. Since 1995, this central bank has seen an average inflation rate of about zero, having kept its nominal interest rate target at levels close to zero over those 21 years. The Bank of Japan has an inflation target of 2 percent and wants inflation to be higher, but seems unable to achieve what it wants.

Over the past several years, membership in the low-inflation-policy-trap club of central banks has been increasing. This club includes the European Central Bank, whose key nominal interest rate is –0.34 percent and inflation rate is –0.22 percent; the Swedish Riksbank, with key nominal interest rate of –0.50 percent and inflation rate of 0.79 percent; the Danish central bank, with key nominal interest rate of –0.23 percent and inflation rate of 0 percent; the Swiss National Bank, with key nominal interest rate of –0.73 percent and inflation rate of –0.35 percent; and the Bank of England, with key nominal interest rate of 0.47 percent and inflation rate of 0.30 percent. Each of these central banks has been missing its inflation target on the low side, in some cases for a considerable period of time.7 The Fed could be included in this group, too, as the fed funds rate was targeted at 0-0.25 percent for about seven years, until Dec. 16, 2015, when the target range was increased to 0.25-0.50 percent. The Fed has missed its 2 percent inflation target on the low side for about four years now.

How a Trapped Central Bank Behaves

Abandoning the Taylor principle and embracing Neo-Fisherism seems a difficult step for central banks. What they typically do on encountering low inflation and low nominal interest rates is engage in unconventional monetary policy. Indeed, unconventional policy has become commonplace enough to become respectably conventional.

Unconventional monetary policy takes three forms in practice. First, central banks can push market nominal interest rates below zero (relaxing the zero lower bound) by paying negative interest on reserves at the central bank—charging a fee on such accounts, as has been done by the Bank of Japan, the Swiss National Bank, the Danish central bank and the Swedish Riksbank. Second, there can be so-called quantitative easing, or QE—the large-scale purchase of long-maturity assets (government debt and private assets, such as mortgage-backed securities) by a central bank. Such programs have been an important element of monetary policy in the U.S., Switzerland and Japan, for example, in the years after the financial crisis (2007-2009). Third, central banks can engage in forward guidance—promises concerning what they will do in the future. Typically, these are promises that interest rates will stay low in the future, in the hope that this will increase inflation. But will any of these unconventional policies actually work to increase the inflation rate? Neo-Fisherism suggests not.

First, given the Fisher effect, a negative nominal interest rate will only make the inflation rate lower, as has happened in Switzerland, where nominal interest rates have been negative for some time and there is deflation—negative inflation. Second, some theory indicates that QE either does not work at all or acts to make inflation lower. This is consistent with what we have seen in Japan, where an extensive QE program in place for two years has not yielded higher inflation. Third, forward guidance, which promises more of the same unconventional policies and continued low interest rates if the low-inflation problem persists, will only prolong the problem.

Conclusion

Among the major central banks in the world, the Fed stands out as the only one that is pursuing a policy of increases in its nominal interest rate target. This policy, referred to as “normalization,” was initiated in December 2015. Normalization, however, is projected to take place slowly and is not motivated explicitly by Neo-Fisherian ideas, though James Bullard, president of the Federal Reserve Bank of St. Louis, has shown interest.

What is the risk associated with Neo-Fisherian denial—a failure to take account of the Fisher relation in formulating monetary policy? Neo-Fisherian denial will tend to produce inflation lower than central banks’ inflation targets and nominal interest rates that are at central banks’ effective lower bounds—the low-inflation policy trap. But what of it? There are no good reasons to think that, for example, 0 percent inflation is worse than 2 percent inflation, as long as inflation remains predictable. But “permazero” damages the hard-won credibility of central banks if they claim to be able to produce 2 percent inflation consistently, yet fail to do so. As well, a central bank stuck in a low-inflation policy trap with a zero nominal interest rate has no tools to use, other than unconventional ones, if a recession unfolds. In such circumstances, a central bank that is concerned with stabilization—in the case of the Fed, concerned with fulfilling its “maximum employment” mandate—cannot cut interest rates. And we know that a central bank stuck in a low-inflation trap and wedded to conventional wisdom resorts to unconventional monetary policies, which are potentially ineffective and still poorly understood.