Tag: Federal Reserve

Monetary Policy, Financial Stability, and the Zero Lower Bound

Fed Vice Chairman Stanley Fischer spoke about three related issues associated with the zero lower bound (ZLB) on nominal interest rates and the nexus between monetary policy and financial stability: first, whether we are moving toward a permanently lower long-run equilibrium real interest rate; second, what steps can be taken to mitigate the constraints imposed by the ZLB on the short-term interest rate; and, third, whether and how central banks should incorporate financial stability considerations in the conduct of monetary policy. The experience of the past several years in the United States and many other countries has taught us that conducting monetary policy effectively at the ZLB is challenging, to say the least. And while unconventional policy tools such as forward guidance and asset purchases have been extremely helpful, there are many uncertainties associated with the use of such tools.

Are We Moving Toward a World With a Permanently Lower Long-Run Equilibrium Real Interest Rate?
We start with a key question of the day: Are we moving toward a world with a permanently lower long-run equilibrium real interest rate? The equilibrium real interest rate–more conveniently known as r*–is the level of the short-term real rate that is consistent with full utilization of resources. It is often measured as the hypothetical real rate that would prevail in the long-run once all of the shocks affecting the economy die down. In terms of the Federal Reserve’s approach to monetary policy, it is the real interest rate at which the economy would settle at full employment and with inflation at 2 percent–provided the economy is not at the ZLB.

Recent interest in estimates of r* has been strengthened by the secular stagnation hypothesis, forcefully put forward by Larry Summers in a number of papers, in which the value of r* plays a central role. Research that was motivated in part by attempts that began some time ago to specify the constant term in standard versions of the Taylor rule has shown a declining trend in estimates of r*. That finding has become more firmly established since the start of the Great Recession and the global financial crisis.

A variety of models and statistical approaches suggest that the current level of short-run r* may be close to zero. Moreover, the level of short-run r* seems likely to rise only gradually to a longer-run level that is still quite low by historical standards. For example, the median long-run real federal funds rate reported in the Federal Reserve’s Summary of Economic Projections prepared in connection with the December 2015 meeting of the Federal Open Market Committee has been revised down about 1/2 percentage point over the past three years to a level of 1-1/2 percent. As shown in the figure below, a decline in the value of r* seems consistent with the decline in the level of longer-term real rates observed in the United States and other countries.

fischer20160103aWhat determines r*? Fundamentally, the balance of saving and investment demands does so. A very clear systematic exposition of the theory of r* is presented in a 2015 paper from the Council of Economic Advisers. Several trends have been cited as possible factors contributing to a decline in the long-run equilibrium real rate. One a priori likely factor is persistent weakness in aggregate demand. Among the many reasons for that, as Larry Summers has noted, is that the amount of physical capital that the revolutionary IT firms with high stock market valuations have needed is remarkably small. The slowdown of productivity growth, which has been a prominent and deeply concerning feature of the past four years, is another factor reducing r*. Others have pointed to demographic trends resulting in there being a larger share of the population in age cohorts with high saving rates.7 Some have also pointed to high saving rates in many emerging market countries, coupled with a lack of suitable domestic investment opportunities in those countries, as putting downward pressure on rates in advanced economies–the global savings glut hypothesis advanced by Ben Bernanke and others at the Fed about a decade ago.

Whatever the cause, other things being equal, a lower level of the long-run equilibrium real rate suggests that the frequency and duration of future episodes in which monetary policy is constrained by the ZLB will be higher than in the past. Prior to the crisis, some research suggested that such episodes were likely to be relatively infrequent and generally short lived.  The past several years certainly require us to reconsider that basic assumption.

Moreover, the experience of the past several years in the United States and many other countries has taught us that conducting monetary policy effectively at the ZLB is challenging, to say the least. And while unconventional policy tools such as forward guidance and asset purchases have been extremely helpful, there are many uncertainties associated with the use of such tools.

I would note in passing that one possible concern about our unconventional policies has eased recently, as the Federal Reserve’s normalization tools proved effective in raising the federal funds rate following our December meeting. Of course, issues may yet arise during normalization that could call for adjustments to our tools, and we stand ready to do that.

The answer to the question “Will r* remain at today’s low levels permanently?” is that we do not know. Many of the factors that determine r*, particularly productivity growth, are extremely difficult to forecast. At present, it looks likely that r* will remain low for the policy-relevant future, but there have in the past been both long swings and short-term changes in what can be thought of as equilibrium real rates Eventually, history will give the answer.

But it is critical to emphasize that history’s answer will depend also on future policies, monetary and other, notably including fiscal policy.

Fed Warns On Commercial Real Estate Lending

US Banks are increasing their exposure to commercial real estate and increased competitive pressures are contributing significantly to historically low capitalization rates and rising property values.  Influenced in part by the continuing strong demand for such credit and the reassuring trends in asset-quality metrics many institutions’ CRE concentration levels have been rising.

A CRE loan refers to a loan where the use of funds is to acquire, develop, construct, improve, or refinance real property and where the primary source of repayment is the sale of the real property or the revenues from third-party rent or lease payments. CRE loans do not include ordinary business loans and lines of credit in which real estate is taken as collateral. Financial institutions with concentrations in owner-occupied CRE loans also should implement appropriate risk management processes.

Between 2011 and 2015, multi-family loans at insured depository institutions increased 45 percent and comprised 17 percent of all CRE loans held by financial institutions, and prices for multi-family properties rose to record levels while capitalization rates fell to record lows. At the same time, other indicators of CRE market conditions (such as vacancy and absorption rates) and portfolio asset quality indicators (such as non-performing loan and charge-off rates) do not currently indicate weaknesses in the quality of CRE portfolios.

During 2016, supervisors from the banking agencies will continue to pay special attention to potential risks associated with CRE lending.

The regualtors have  jointly issued a statement to remind financial institutions of existing regulatory guidance on prudent risk management practices for commercial real estate (CRE) lending activity through economic cycles. They say that historical evidence demonstrates that financial institutions with weak risk management and high CRE credit concentrations are exposed to a greater risk of loss and failure. In general, financial institutions that succeeded during difficult economic cycles took the following actions, which are consistent with supervisory expectations:

  1. established adequate and appropriate loan policies, underwriting standards, credit risk management practices, and concentration limits that were approved by the board or a designated committee; lending strategies, such as plans to increase lending in a particular market or property type, limits for credit and other asset concentrations, and processes for assessing whether lending strategies and policies continued to be appropriate in light of changing market conditions; and  strategies to ensure capital adequacy and allowance for loan losses that supported an institution’s lending strategy and were consistent with the level and nature of inherent risk in the CRE portfolio.
  2. conducted global cash flow analyses based on reasonable (not speculative) rental rates, sales projections, and operating expenses to ensure the borrower had sufficient repayment capacity to service all loan obligations.
  3. performed market and scenario analyses of their CRE loan portfolio to quantify the potential impact of changing economic conditions on asset quality, earnings, and capital.
  4. provided their boards and management with information to assess whether the lending strategy and policies continued to be appropriate in light of changes in market conditions.
  5. assessed the ongoing ability of the borrower and the project to service all debt as loans converted from interest-only to amortizing payments or during periods of rising interest rates.
  6. implemented procedures to monitor the potential volatility in the supply and demand for lots, retail and office space, and multi-family units during business cycles.
  7. maintained management information systems that provided the board and management with sufficient information to identify, measure, monitor, and manage concentration risk.
  8. implemented processes for reviewing appraisal reports for sufficient information to support an appropriate market value conclusion based on reasonable market rental rates, absorption periods, and expenses.

Fed Lifts Rates For The First Time in Years

Just Announced.

The Federal Reserve raised the Fed funds rate by 25 basis points to 0.25 percent – 0.5 percent, during its FOMC meeting held on December 16th. While the Fed said is “reasonably confident that inflation will rise, over the medium term, to its 2 percent objective” , Fed Governors were also carefully to point that “economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate”. It was the first hike since June 2006 when Ben Bernanke increased the benchmark rate from 5 to 5.25 percent. From 1971 until 2015, Interest Rate in the United States averaged 5.93 percent, reaching an all time high of 20 percent in March of 1980 and a record low of 0.25 percent in December of 2008.

FED-Rate

Information received since the Federal Open Market Committee met in October suggests that economic activity has been expanding at a moderate pace. Household spending and business fixed investment have been increasing at solid rates in recent months, and the housing sector has improved further; however, net exports have been soft. A range of recent labor market indicators, including ongoing job gains and declining unemployment, shows further improvement and confirms that underutilization of labor resources has diminished appreciably since early this year. Inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation remain low; some survey-based measures of longer-term inflation expectations have edged down.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen. Overall, taking into account domestic and international developments, the Committee sees the risks to the outlook for both economic activity and the labor market as balanced. Inflation is expected to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further. The Committee continues to monitor inflation developments closely.

The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective. Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to 1/4 to 1/2 percent. The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.

Banking Regulation – Why focus on culture?

Remarks by Mr Alberto G Musalem, EVP of the Integrated Policy Analysis Group of the Federal Reserve Bank of New York, highlight why cultural reform in financial services is important. He argues: First, cultural problems are the industry’s responsibility to solve. Second, a bank’s implicit norms-especially those reinforced through incentives-must align with the public purpose of banking. Third, the reform of bank culture should aim to restore trust.

The New York Fed has, for the last two years, been part of an international dialogue on the reform of culture in the financial services industry. Why culture? Let’s begin with the following hypothesis: environment drives conduct. What each of us learned from our parents governs some of our behavior, but not nearly as much as any of us who are parents would like to believe. Place ordinary people in a bad environment, and bad things tend to happen. That said, place someone in a good environment, and good things tend to happen. This is just part of being human. We observe and adapt.

Before continuing, I would like to clarify that the views I express today are my own and may not reflect the views of the Federal Reserve Bank of New York or the Federal Reserve System.

Part of any organization’s environment is its culture. Some have labored over a precise definition of the word “culture.” Bill Dudley, the President of the New York Fed, has offered the following description, which works for me: “Culture relates to the implicit norms that guide behavior in the absence of regulations or compliance rules – and sometimes despite those explicit restraints. Culture exists within every firm whether it is recognized or ignored, whether it is nurtured or neglected, and whether it is embraced or disavowed.”1

The New York Fed’s interest in reforming culture is a product of events since the Financial Crisis. Take, for example, the manipulation of LIBOR and foreign exchange rates, much of which was collusive. Each of those episodes involved misconduct affecting wholesale markets on which the real economy relies. Both cases shared an underlying, flawed outlook. Bankers failed to see beyond their immediate financial goals. They ignored the broader social consequences of their decisions on the firm and its customers, as well as on consumers, producers, savers and investors. The same flawed outlook may have contributed to the Financial Crisis.

There are many more examples. One bank was fined for doing business with Sudan despite economic sanctions imposed for engaging in genocide. Another bank manipulated electricity markets in California and Michigan. Other banks helped U.S. citizens evade taxes. I will not review the full litany. Notably, none of these recent episodes had anything to do with capital levels or liquidity ratios. The many post-Crisis reforms to bank balance sheets – including the Dodd-Frank Act and new standards developed by the Basel Committee on Bank Supervision and the Financial Stability Board-provided necessary bulwarks against systemic risks. Capital and liquidity requirements, and the enhanced testing surrounding them, have made banks and the financial system more resilient to stress. But those new laws, regulations, and standards have done little to curb banker misconduct. Each post-Crisis episode demonstrates a narrow cultural focus on short-term gain and disregard of broader social consequences.

Last year the New York Fed challenged the industry to consider many factors that have contributed to recent, widespread misconduct. There are no simple answers and that discussion is continuing. This year, by contrast, our focus has been more on solutions-what’s working, and what is not. In both years, we have offered three messages to the industry.

First, cultural problems are the industry’s responsibility to solve. The official sector can monitor progress and deliver feedback and recommendations. In fact, many individual supervisory findings are often symptoms of deeper cultural issues at a firm. But the banks themselves must actively reform and manage their cultures.

Second, a bank’s implicit norms-especially those reinforced through incentives-must align with the public purpose of banking. Gerald Corrigan, more than three decades ago, presented a theory of banking based on the principle of reciprocity. Banks receive operating benefits unavailable to other industries because they provide important services to the public. For example, financial intermediation is enhanced through deposit insurance and access to the discount window. Public benefits, though, are not a gift. They are part of a quid pro quo. In exchange for receiving valuable operating benefits, a bank’s implicit codes of conduct-that is, its culture-must reflect the public dimension of the services that banks provide.

Third, the reform of bank culture should aim to restore trust. The bedrock of the financial system is trust and the word credit derives from the Latin notion of believing or trusting. We saw seven years ago that the public’s trust is critical in a crisis. The repair of the financial system would not have been possible without public support. If another crisis were to happen tomorrow, would there be that support?

A lack of trust-or, more accurately, low trustworthiness-also imposes day-to-day costs.8 For starters, there are fines. Then there are the legal costs in investigating allegations and defending lawsuits. Internal monitoring also becomes more expensive as rules become more extensive. Some might say that the proliferation of rules since the Financial Crisis is inversely proportional to a decline in the industry’s perceived trustworthiness. The choice between rules and standards depends on the trustworthiness of the regulated. A more flexible, standards-based legal regime requires a degree of trustworthiness that, in recent years, banks have not demonstrated.

Those are the measurable costs of low trustworthiness. There may be other, longer-term costs that are more difficult to price. Let me raise just two. If employees perceive a firm as untrustworthy or disloyal, will they choose to work in that firm? And, if they do, how will they behave toward the firm and its stakeholders?

I am encouraged that the industry seems to understand the importance of reforming its culture. Consider for a moment the following data points. In September 2013, shareholders of a major U.S. bank requested that the bank prepare “a full report on what the bank has done to end [its] unethical activities, to rebuild [its] credibility and provide new strong, effective checks and balances within the [b]ank.” That request was forwarded, by the way, by a Catholic nun. The bank responded through its attorneys that the nun’s proposal was “materially false and misleading” and “impermissibly vague and indefinite.” Fast forward to May 2015. The Federal Advisory Council-a panel of bankers that advises the Federal Reserve System-reported that “Regulators and the banking industry have worked extensively to restore financial stability through a series of mechanisms and rules that establish appropriate levels of capital, liquidity, and leverage. . . . As often as not, however, the challenges faced in recent years have been behavioral and cultural; post-crisis episodes such as LIBOR and foreign exchange manipulation provide hard evidence that there remains work to be done.” This is clearly an encouraging difference in perspectives.

The public sector, too, has paid increasing attention to culture. The Group of Thirty, the Basel Committee, the European Systemic Risk Board, and the Financial Stability Board have issued papers on culture, governance, and misconduct risk. The Fair and Effective Markets Review-a joint project of the Bank of England, the Financial Conduct Authority, and Her Majesty’s Treasury-has called for heightened standards for market practice in matters affecting the public good. And in the last year, we have seen emerging approaches to supervision that aim to address culture, conduct, and governance. In particular, the central bank of the Netherlands-De Nederlandsche Bank-has pioneered new techniques for the supervision of corporate governance, especially for assessing the group dynamics of boards and senior management.

Culture also features prominently in criminal enforcement. The U.S. Department of Justice requires its prosecutors to determine “the pervasiveness of wrongdoing” at a corporation before seeking an indictment. According to its prosecutors’ manual, “[T]he most important [factor in making this determination] is the role and conduct of management. Although acts of even low-level employees may result in criminal liability, a corporation is directed by its management and management is responsible for a corporate culture in which criminal conduct is either discouraged or tacitly encouraged.” Individuals, including senior managers, also face criminal liability for their conduct. Recent guidance from the U.S. Department of Justice places greater emphasis on individual culpability. And the recent convictions of two traders for rigging LIBOR, one of whom served as the Global Head of Liquidity and Finance at a major bank, may send a powerful message to bankers about the consequences of their misconduct.

The new acceptance of culture as an important area of focus was evident at a workshop that the Federal Reserve Bank of New York hosted on November 5. Christine Lagarde, Managing Director of the International Monetary Fund, and Stanley Fischer, Vice Chairman of the Board of Governors of the Federal Reserve System, headlined a contingent of over 20 public sector authorities from around the globe. They were joined by the CEOs, senior executives, and board members of global financial institutions. Together, they discussed methods of reforming culture and the continuing challenges in this effort. In my view, the workshop offered a number of useful insights, chiefly:

  • Culture is a soft concept that is hard to measure, and perhaps harder to manage and sustain. But it is as important as capital and liquidity, and should receive continuous and persistent attention.
  • A bank’s culture must be consistent with public expectations and promote behavior that considers the firm’s many stakeholders, including the public. Also, a positive, constructive culture can be an important pillar aligned with the execution of a firm’s business strategy.
  • Culture cannot be set by fiat. Leadership is indispensable, and requires more than a “tone from the top.” Managers of all levels must take action to promote a greater sense of personal responsibility and stewardship among employees. The next generation of financial leaders will reflect the expectations of leaders today.
  • Despite firm-wide statements about values and codes of conduct, banks may have several dissonant sub-cultures. “Silos” or “tribes” as they are sometimes called, appear in most if not all of the episodes I described earlier. By sharing best practices across the industry, firms might identify common warning signs of problems within sub-cultures and behaviors that are incompatible with the firm’s values.
  • Diversity of thought and background are valuable cultural assets because they generate better questions and decisions, contributing to effective challenge. A diversity of views, though, must be complemented by a sense of common purpose. Certain basic principles-fair treatment of customers and employees, for example-cannot be open to debate.

The Federal Reserve Bank of New York recently launched a webpage that collects resources on bank culture. We’ve included the papers by the Group of Thirty and other organizations that I have mentioned, and summaries of our two workshops on culture. I hope you’ll take a look.

To conclude, the Financial Crisis and subsequent scandals revealed deep and continuing flaws in the culture of banking. The responsibility to address these flaws rests with the banks themselves. Many industry leaders have initiated reform programs within their firms. It is important to keep the momentum going. Reform requires relentless and sustained effort: from the top of an institution to its most junior employees, and across all of the institution’s business activities. Reform must include the full scope of an employee’s career, beginning with recruiting and continuing with annual performance management, compensation and promotion decisions. We in the official sector will be looking to the industry to fulfill its end of the bargain-to act consistent with the public well-being, to value long-term stability over short-term gain, and to take account of all stakeholders in making decisions.

Emerging Asia in Transition

Fed Vice Chairman Stanley Fischer spoke on “Emerging Asia in Transition“.  After a long period of rapid economic growth, Asia’s emerging economies appear to have entered a transitional phase. For decades, emerging Asian economies have been among the fastest growing and most dynamic in the world. Supported by an export-oriented development model, annual growth averaged 7-1/2 percent in the three decades leading up to the global financial crisis. Will developments in the global economy permit the continuation of the export-centered growth strategy that underlies the Asian miracle or will we later conclude that this period, the period after the Great Recession and the global financial crisis, marked the beginning of a new phase in the economic history of the modern global economy?

Emerging Asia has played an outsized role in commodity markets for some time now. Specifically, China, with its investment-heavy growth model, has accounted for a substantial amount of incremental commodity demand over the past two decades. Since 2000, China has accounted for roughly 40 percent of the increase in global demand for oil and 80 percent of the growth in demand for steel. For copper, all of the incremental rise in global demand has come from China, with demand excluding China falling over the period.

The strength of emerging Asian demand growth pushed commodity prices up sharply over most of the past decade, at least temporarily reversing what seemed to be an inexorable decline in both commodity prices and the terms of trade of commodity producers in the preceding two decades. Higher prices were a tremendous boon to commodity producers and supported a decade of strong growth in a number of emerging market economies, as well as commodity sectors in certain advanced economies, including Australia and the United States.

Since mid-2014, commodity prices have plummeted, with oil prices falling almost 60 percent and a broad index of metals prices losing about one-third of its value, dragging down growth in many commodity producers. Although rapid commodity output growth in recent years, which has reflected in part the response of producers to previous price increases, has certainly contributed to the fall in commodity prices, the slowing of demand growth from China and emerging Asia has also been an important factor.

While the path ahead for commodity prices is, as always, uncertain, declining investment rates in emerging Asia, particularly China, present the prospect of a prolonged decline in the growth rate of commodity demand. And prices could remain low for quite some time, which seems particularly true for metals, such as copper and steel, used heavily in construction and investment. However, for oil, the implications of a shift from investment-led growth to a consumption-led model are less certain. On a per capita basis, China’s consumption of oil remains far below that of advanced economies, in line with China’s lower rate of car ownership. Per capita oil consumption tends to increase with wealth, such that further income growth in China has the potential to provide strong support for the oil market in the coming years.

Indeed, more generally, the world stands to benefit from a transition to more consumption-led growth in emerging Asia. Under a successful transition toward more-balanced growth, emerging Asia can be expected to import a broader array of goods and services both from within the region and globally. Whether a country benefits from or is harmed by emerging Asia’s transition is likely to be determined by the flexibility of that country’s economy in adapting to shifts in Asian demand away from commodities and inputs for assembly into the region’s exports and toward services and goods to meet Asian final demand.

To recap, the transition to slower growth in the emerging Asian economies, as well as a shift toward domestic demand and consumption and away from external demand and investment in the region, is likely to have profound implications for the global economy. For one, trade growth is unlikely to resume its rapid pace of recent decades, and the long climb in commodity prices, which has benefited commodity producers, appears to have come to an end.

Can India Recharge Growth in Emerging Asia?
One source of uncertainty in this outlook, as alluded to earlier, is the prospect for India to provide a new growth engine for Asian development. In principle, India has enormous potential to recharge the Asian growth engine. For one, India is relatively unintegrated into global production-sharing networks. For example, machinery and electrical products, which feature heavily in production-sharing and which make up about half of exports in other emerging Asian economies, account for only 15 percent of India’s exports. Foreign direct investment into India is about half the size of similar flows into China as a percentage of GDP, and GDP per capita, at $1,600 in 2014, remains considerably below emerging Asia’s average.

All told, while the export-led growth model that propelled growth in China and other economies in emerging Asia has matured, pushing down growth rates, India remains at a relatively early stage of its development trajectory. Further capital deepening and the potential for further productivity gains suggest that India could maintain rapid economic growth for a number of years. As mentioned previously, India is also a young country, with a relatively low dependency ratio and a growing workforce. By United Nations estimates, India is set to overtake China during the next decade as the world’s most populous nation.

In the 1960s and 1970s, the Indian economy grew at around 3 to 4 percent. In subsequent decades the growth rate averaged close to 6 percent, and in the early years of this century it rose further, as can be seen in Table 1. In 2015, growth in India is expected to be 7-1/4 percent, the fastest among large economies, and the IMF expects growth to pick up from this already rapid pace through the end of the decade. Growth has been supported by an improved macroeconomic policy framework, including a strengthening of the framework for conducting monetary policy, as well as legal and regulatory reform. And the authorities have embarked on an ambitious program to improve the business environment.

That said, significant roadblocks need to be overcome for India to reach its full potential. The economy continues to suffer from a number of infrastructure bottlenecks that will be alleviated only through a pronounced increase in investment rates, a process that would likely be helped by a relaxation of restrictions on foreign direct investment. Likewise, efforts at difficult reform will have to be sustained. There is much hard work ahead if India is to come closer to fulfilling the potential that it so manifestly has.

Concluding Remarks
The performance of the Asian economies–notably those of East Asia, particularly China, Japan, and Korea–especially in the past six or seven decades, is an outstanding, if not unique, episode in the history of the global economy.

What lies ahead? In the relatively near future probably some major central banks will begin gradually moving away from near-zero interest rates. The question here is whether the emerging market countries of Asia–and, indeed, of the world–are sufficiently prepared for these decisions, to the extent that potential capital flows and market adjustments can take place without major macroeconomic consequences. While we continue to scrutinize incoming data, and no final decisions have been made, we have done everything we can to avoid surprising the markets and governments when we move, to the extent that several emerging market (and other) central bankers have, for some time, been telling the Fed to “just do it.”

Further ahead lies the answer to the question of whether developments in the global economy will permit the continuation of the export-centered growth strategy that underlies the Asian miracle or whether we will later conclude that this period, the period after the Great Recession and the global financial crisis, marked the beginning of a new phase in the economic history of the modern global economy.7 Either way, the question of the economic future of India is of major importance not only to the 18 percent of the world’s population that lives in India, but also to the other 82 percent of the global population.

At a more structural level are three recent developments whose potential importance is currently difficult to assess: the setting up of the Asian Infrastructure Investment Bank; the likely inclusion of the Chinese yuan in the Special Drawing Rights basket; and the possible establishment of the TPP, a partnership in which China is not expected to be a founding member.

These are interesting and potentially important developments. Underlying the answer to the questions of what they portend, is the answer to the basic question of whether the economic center of gravity of the world will continue its shift of recent decades toward Asia–in particular, to China or, perhaps, to China and India. This shift would represent a return in some key respects to the global order of two centuries ago and earlier, before the economic rise of the West.

A partial answer to that question is that China is for some time likely to continue to grow faster than the rest of the world and thus to produce an increasing share of global output. Its importance in the global economy is likely to increase, and it is probable that, one way or another, its growth will result in its playing a more decisive role in the international economy and in international economic institutions.

Finally, we need to remind ourselves that geopolitical factors will play a critical role in the unfolding of that process.

Improving Culture and Conduct in the Financial Services Industry

Banking regulators are turning their attention to the core values, culture and conduct of financial sector firms, because just lifting capital ratios will not provide adequate safeguards. Therefore the opening remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, at “Reforming Culture and Behavior in the Financial Services Industry: Workshop on Progress and Challenges” are interesting and relevant.

Welcome to the New York Fed and to a discussion of how culture and conduct might be improved within the financial services industry. I am pleased to see all of you here today – there is tremendous breadth of experience and responsibility within this room. We need to take full advantage of this opportunity. I encourage all participants to be candid and on-point, because the task of reforming culture is formidable.

Untrustworthy behavior on the scale that we have witnessed in financial services does not arise in a vacuum. Social science research makes it clear that context largely drives conduct. This is not a new insight. Adam Smith observed centuries ago that, independent of personal sentiment, we often behave according to what we “[see are] the established rules of behavior.” We observe the activity around us, assess the norms of conduct and generally adapt to those norms in our own behaviors.

Banking is not exempt from this universal propensity. Gerry Corrigan noted three decades ago that the “implicit codes of conduct” that govern banker behavior exist apart from “explicit regulations.” He posited that these implicit codes must align with the public good – an obligation that banks owe in exchange for the benefits “uniquely available to [that]particular class of institutions.” This, in Corrigan’s view, was what made banks “special” – the reciprocal benefits and responsibilities that support and constrain an industry essential to public well-being.

Corrigan’s premise is not an antique concept from a bygone era of banking. Then, as now, there are public purposes of banking – including financial intermediation, corporate valuation, facilitating investment opportunities, providing credit and creating market liquidity. These activities underpin the economy and financial stability. Reciprocity – in other words, the expectation of a quid pro quo in the relationship between society and the financial services industry – is the basis of public trust in financial institutions. There is, however, a widespread sense that this principle has been compromised.

Industry responsibility

Two years ago, I noted that recent scandals in banking evidenced “deep-seated cultural and ethical failures.” Many of the industry’s leaders now agree. According to the Federal Advisory Council of the Federal Reserve System, a group composed of senior representatives from the industry, “as often as not […] the challenges faced in recent years have been behavioral and cultural; post-crisis episodes such as LIBOR and foreign exchange manipulation provide hard evidence that there remains work to be done.”

Last year I argued that “the solution [to cultural problems] needs to originate from within the firms, from their leaders.” I view today’s workshop as a progress report on the industry’s efforts. This is an opportunity for us to discuss collectively what is working, what is not, and the next steps that are needed.

We should take care, though, not to confuse cause and effect. The banking scandals that followed the financial crisis are evidence that something fundamental is wrong. I would encourage each of you to consider not just specific examples of misconduct, but the patterns within them that point to underlying causes. I suspect we will see a strong overlap with those factors that contributed to the financial crisis. I think your focus should be less on the search for bad apples and more on how to improve the apple barrels.

Role of the official sector

Dodd-Frank strengthened bank balance sheets, and banks have become more resilient to systemic shocks. This is a positive development. At the same time, it is also important to mitigate the sources of systemic shocks. Dodd-Frank apparently did little to curb misconduct – a possible source of systemic risk. If the people managing capital cushions and liquidity buffers view these tools as sufficient mitigants for the costs of misconduct, or if powerful incentives encourage workarounds of the new regulations, then the connection between post-crisis reforms and greater financial stability becomes threatened.

In the last year, we have seen emerging approaches to supervision that aim to address culture, conduct and governance. These methods are being developed in a number of jurisdictions. I am pleased to welcome representatives of 15 foreign supervisors and other official sector agencies who are joining the many representatives of U.S. supervisory and regulatory agencies here today. The topic of culture and conduct has truly become a global dialogue. We have a lot to learn from each other.

One question on the minds of many in the official sector is, “what is the most effective way to promote reform?” Sharing ideas on leading practices, challenges and the opportunities for industry collaboration is a start – but it is not the end. Financial firms need to act on this information, and the official sector should hold institutions accountable for demonstrating sustained, observable progress.

Overview of agenda

Let me now give a brief overview of today’s agenda. The first panel will present the Group of Thirty’s recent report on banking conduct and culture, which calls for fundamental and sustained change. As you all know, the Group of Thirty is a forum consisting of senior public officials and private sector bankers. Its purpose is to facilitate non-partisan discussion of issues that threaten global economic stability and economic progress. It speaks volumes that the Group has focused its work in recent years on effective governance, the role of supervision, and on conduct and culture.

Each of the four remaining panels will address one aspect of the multidimensional nature of cultural change.

  • In the first panel, we will hear about engagement with employees – especially those who are skeptical of the benefits or practicality of reform.
  • In the second panel, we will discuss accountability – not only in the sense of being “held accountable,” but also in the broader sense of promoting responsibility and stewardship. I am particularly interested in designing incentives – both the carrot and the stick – that yield conduct aligned with the public purposes of banking.
  • The third panel will focus on skill development – particularly on recruiting and training as levers for sustained cultural change.
  • And the last panel will focus on leadership and industry collaboration. A prime element of leadership, within a firm and across the industry, is character – behavior anchored in values consistent with the public’s legitimate expectation of trustworthiness.

Our keynote speaker today is Christine Lagarde, the managing director of the International Monetary Fund. Christine Lagarde has been outspoken in her view that “financial leaders [must] take values as seriously as valuation, culture as seriously as capital.” This makes abundant sense to me – culture and capital each promote financial stability. Thank you for joining us. I am also grateful to Stanley Fischer, the vice chairman of the Board of Governors, who will speak with Christine Lagarde following her remarks.

Federal Reserve Announces Sixth Triennial Study to Examine U.S. Payments Usage

The Federal Reserve today announced plans to conduct its sixth triennial study to determine the current aggregate volume and composition of electronic and check payments in the United States. The study builds upon research begun by the Federal Reserve in 2001 to provide the public and the payments industry with estimates and trend information about the evolving nature of the nation’s payments system. A public report containing initial topline estimates is expected to be published in December 2016.

“Over the 15-year life of the study, the survey instruments have been adapted and updated to keep pace with the dynamic change in the U.S. payments system,” said Mary Kepler, senior vice president of the Federal Reserve Bank of Atlanta and the study’s executive sponsor. “Not surprisingly, the 2016 study will incorporate a number of significant enhancements, including an expansion of fraud-related information and an increase in the number of depository and financial institutions sampled. These improvements will strengthen the value of the trend information and insights to be presented with the study’s findings,” Kepler said.

The 2016 Federal Reserve Payments Study consists of three complimentary survey efforts commissioned to estimate the number, dollar value and composition of retail noncash payments in the United States for calendar year 2015. The study will request full-year 2015 payments data for various payment types from respondents to two of the three survey components; the third component involves a random sampling of checks processed in 2015 to determine distribution of party, counterparty and purpose. Results from all three survey components will be used to estimate current trends in the use of payment instruments by U.S. consumers and businesses. Previous studies have revealed significant changes in the U.S. payments system over time, most recently the increasing preference for debit, credit and stored-value cards among consumers and a leveling in growth of other electronic payment types such as the Automated Clearing House network. The Federal Reserve will work with McKinsey & Company and Blueflame Consulting, LLC to conduct this research study.

Additionally, the Federal Reserve plans to supplement its triennial research with two smaller annual research efforts to provide key payments volume and trends estimates in 2017 and 2018. “The industry’s participation and willingness to provide the full scope of the data requested is paramount to our ability to publish the timely and relevant results the industry has come to rely on to help objectively evaluate changes in the nation’s payments landscape,” Kepler said.

More information about Federal Reserve Financial Services can be found at www.frbservices.org. The website also contains links to the five previous Payments Studies.

The Financial Services Policy Committee (FSPC) is responsible for the overall direction of financial services and related support functions for the Federal Reserve Banks, as well as for providing Federal Reserve leadership in dealing with the evolving U.S. payments system. The FSPC is composed of three Reserve Bank presidents and two Reserve Bank first vice presidents.

Latest US Labor Data May Delay Fed Interest Rate Rise

Data from the US Bureau of Labor Statistics for September suggest that the Fed may delay their much anticipated, and continually postponed, interest rate rise. This is a reaction to slowing world trade, China, and financial market uncertainty, as well as as series of downward revisions to earlier months data.

Their September data showed that total nonfarm payroll employment increased by 142,000 in September, and the unemployment rate was unchanged at 5.1 percent. Job gains occurred in health care and information, while mining employment fell. Wage growth was zero.

In September, the unemployment rate held at 5.1 percent, and the number of unemployed persons (7.9 million) changed little. Over the year, the unemployment rate and the number of unemployed persons were down by 0.8 percentage point and 1.3 million, respectively.

The number of persons unemployed for less than 5 weeks increased by 268,000 to 2.4 million in September, partially offsetting a decline in August. The number of long-term unemployed (those jobless for 27 weeks or more) was little changed at 2.1 million in September and accounted for 26.6 percent of the unemployed.

The civilian labor force participation rate declined to 62.4 percent in September; the rate had been 62.6 percent for the prior 3 months. This level of participation has not been seen since the 1970’s. The employment-population ratio edged down to 59.2 percent in September, after showing little movement for the first 8 months of the year.

The number of persons employed part time for economic reasons (sometimes referred to as involuntary part-time workers) declined by 447,000 to 6.0 million in September. These individuals, who would have preferred full-time employment, were working part time because their hours had been cut back or because they were unable to find a full-time job. Over the past 12 months, the number of persons employed part time for economic reasons declined by 1.0 million.

In September, average hourly earnings for all employees on private nonfarm payrolls, at $25.09, changed little (-1 cent), following a 9-cent gain in August. Hourly earnings have risen by 2.2 percent over the year. Average hourly earnings of private-sector production and nonsupervisory employees were unchanged at $21.08 in September.

Macroprudential Policy in the U.S. Economy

Fed Vice Chairman Stanley Fischer spoke at the “Macroprudential Monetary Policy” conference. He remains concerned that the U.S. macroprudential toolkit is not large and is not yet battle tested. The contention that macroprudential measures would be a better approach to managing asset price bubbles than monetary policy, he says, is persuasive, except when there are no relevant macroprudential measures available. It also seems likely that monetary policy should be used for macroprudential purposes with an eye to the tradeoffs between reduced financial imbalances, price stability, and maximum employment.

This afternoon I would like to discuss the challenges to formulating macroprudential policy for the U.S. financial system.

The U.S. financial system is extremely complex. We have one of the largest nonbank sectors as a percentage of the overall financial system among advanced market economies. Since the crisis, changes in the regulation and supervision of the financial sector, most significantly those related to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) and the Basel III process, have addressed many of the weaknesses revealed by the crisis. Nonetheless, challenges to our efforts to preserve financial stability remain.

The Structure, Vulnerabilities, and Regulation of the U.S. Financial System
To set the stage, it is useful to start with a brief overview of the structure of the U.S. financial system. A diverse set of institutions provides credit to households and businesses, and others provide deposit-like services and facilitate transactions across the financial system. As can be seen from panel A of figure 1, banks currently supply about one-third of the credit in the U.S. system. In addition to banks, institutions thought of as long-term investors, such as insurance companies, pension funds, and mutual funds, provide anotherone-third of credit within the system, while the government-sponsored enterprises (GSEs), primarily Fannie Mae and Freddie Mac, supply 20 percent of credit. A final group, which I will refer to as other nonbanks and is often associated with substantial reliance on short-term wholesale funding, consists of broker-dealers, money market mutual funds (MMFs), finance companies, issuers of asset-backed securities, and mortgage real estate investment trusts, which together provide 14 percent of credit.

Fed-Fig-1In the first quarter of this year, U.S. financial firms held credit market debt equal to $38 trillion, or 2.2 times the gross domestic product (GDP) of the United States. As the figure shows, the size of the financial sector relative to GDP grew for nearly 50 years but declined after the financial crisis and has only started increasing again this year.

From the perspective of financial stability, there are two important dimensions along which the categories of institutions in figure 1 differ. First, banks, the GSEs, and most of what I have called other nonbanks tend to be more leveraged than other institutions. Second, some institutions are more reliant on short-term funding and hence vulnerable to runs. For example, MMFs were pressured during the recent crisis, as their deposit-like liabilities–held as assets by highly risk-averse investors and not backstopped by a deposit insurance system–led to a run dynamic after a large fund broke the buck. In addition, nearly half of the liabilities of broker-dealers consists–and consisted then–of short-term wholesale funding, which proved to be unstable in the crisis.

The pros and cons of a multifaceted financial system
The significant role of nonbanks in the U.S. financial system and the associated complex web of interconnections bring both advantages and challenges relative to the more bank-dependent systems of other advanced economies. A potential advantage of lower bank dependence is the possibility that a contraction in credit supply from banks can be offset by credit supply from other institutions or capital markets, thereby acting as a spare tire for credit supply. Historical evidence suggests that the credit provided by what I termed long-term investors–that is, insurance companies, pension funds, and mutual funds–has tended to offset movements in bank credit relative to GDP, as indicated by the strong negative correlation of credit held by these institutions with bank credit during recessions. In other words, these institutions have acted as a spare tire for the banking sector.

However, complexity also poses challenges. While the financial crisis arguably started in the nonbank sector, it quickly spread to the banking sector because of interconnections that were hard for regulators to detect and greatly underappreciated by investors and risk managers in the private sector.6 For example, when banks provide loans directly to households and businesses, the chain of intermediation is short and simple; in the nonbank sector, intermediation chains are long and often involve a multitude of both banks and other nonbank financial institutions.

Regulatory, supervisory, and financial industry reforms since the crisis
U.S. regulators have undertaken a number of reforms to address weaknesses revealed by the crisis. The most significant set of reforms has focused on the banking sector and, in particular, on regulation and supervision of the largest, most interconnected firms. Changes include significantly higher capital requirements, additional capital charges for global systemically important banks, macro-based stress testing, and requirements that improve the resilience of banks’ liquidity risk profile.

Changes for the nonbank sector have been more limited, but steps have been taken, including the final rule on risk retention in securitization, issued jointly by the Federal Reserve and five other agencies in October of last year, and the new MMF rules issued by the Securities and Exchange Commission (SEC) in July of last year, following a Section 120 recommendation by the Financial Stability Oversight Council (FSOC). More recently, the SEC has also proposed rules to modernize data reporting by investment companies and advisers, as well as to enhance liquidity risk management and disclosure by open-end mutual funds, including exchange-traded funds. Other provisions include the central clearing requirement for standardized over-the-counter derivatives and the designation by the FSOC of four nonbanks as systemically important financial institutions. The industry has also undertaken important changes to bolster the resilience of its practices, including notable improvements to internal risk-management processes.

Some challenges to macroprudential policy
The steps taken since the crisis have almost certainly improved the resilience of the U.S. financial system, but I would like to highlight two significant challenges that remain.

First, new regulations may lead to shifts in the institutional location of particular financial activities, which can potentially offset the expected effects of the regulatory reforms. The most significant changes in regulation have focused on large banks. This focus has been appropriate, as large banks are the most interconnected and complex institutions. Nonetheless, potential shifts of activity away from more regulated to less regulated institutions could lead to new risks.

It is still too early to gauge the degree to which such adaptations to regulatory changes may occur, although there are tentative signs. For example, we have seen notable growth in mortgage originations at independent mortgage companies as reflected in the striking increase in the share of home-purchase originations by independent mortgage companies from 35 percent in 2010 to 47 percent in 2014. This growth coincides with the timing of Basel III, stress testing, and banks’ renewed appreciation of the legal risks in mortgage originations. As another example, there have also been many reports of diminished liquidity in fixed-income markets. Some observers have linked this shift to new regulations that have raised the costs of market making, although the evidence for changes in market liquidity is far from conclusive and a range of factors related to market structure may have contributed to the reporting of such shifts.

Despite limited evidence to date, the possibility of activity relocating in response to regulation is a potential impediment to the effectiveness of macroprudential policy. This is clearly the case when activity moves from a regulated to an unregulated institution. But it may also be relevant even when activity moves from one regulated institution to an institution regulated by a different authority. This scenario can occur in the United States because different regulators are responsible for different institutions, and financial stability traditionally has not been, and in a number of cases is still not, a central component of these regulators’ mandates. To be sure, the situation has improved since the crisis, as the FSOC facilitates interagency dialogue and has a shared responsibility for identifying risks and reporting on these findings and actions taken in its annual report submitted to the Congress. In addition, FSOC members jointly identify systemically important nonbank financial institutions. Despite these improvements, it remains possible that the FSOC members’ different mandates, some of which do not include macroprudential regulation, may hinder coordination. By contrast, in the United Kingdom, fewer member agencies are represented on the Financial Policy Committee at the Bank of England, and each agency has an explicit macroprudential mandate. The committee has a number of tools to carry out this mandate, which currently are sectoral capital requirements, the countercyclical capital buffer, and limits on loan-to-value and debt-to-income ratios for mortgage lending.

A second significant challenge to macroprudential policy remains the relative lack of measures in the U.S. macroeconomic toolkit to address a cyclical buildup of financial stability risks. Since the crisis, frameworks have been or are currently being developed to deploy some countercyclical tools during periods when risks escalate, including the analysis of salient risks in annual stress tests for banks, the Basel III countercyclical capital buffer, and the Financial Stability Board (FSB) proposal for minimum margins on securities financing transactions. But the FSB proposal is far from being implemented, and a number of tools used in other countries are either not available to U.S. regulators or very far from being implemented. For example, several other countries have used tools such as time-varying risk weights and time-varying loan-to-value and debt-to-income caps on mortgages. Indeed, international experience points to the usefulness of these tools, whereas the efficacy of new tools in the United States, such as the countercyclical capital buffer, remains untested.

In considering the difficulties caused by the relative unavailability of macroprudential tools in the United States, we need to recognize that there may well be an interaction between the extent to which the entire financial system can be strengthened and made more robust through structural measures–such as those imposed on the banking system since the Dodd-Frank Act–and the extent to which a country needs to rely more on macroprudential measures. Inter alia, this recognition could provide an ex post rationalization for the United States having imposed stronger capital and other charges than most foreign countries.

Implications for monetary policy
Though I remain concerned that the U.S. macroprudential toolkit is not large and not yet battle tested, that does not imply that I see acute risks to financial stability in the near term. Indeed, banks are well capitalized and have sizable liquidity buffers, the housing market is not overheated, and borrowing by households and businesses has only begun to pick up after years of decline or very slow growth. Further, I believe that the careful monitoring of the financial system now carried out by Fed staff members, particularly those in the Office of Financial Stability Policy and Research, and by the FSOC contributes to the stability of the U.S. financial system–though we have always to remind ourselves that, historically, not even the best intelligence services have succeeded in identifying every significant potential threat accurately and in a timely manner. This is another reminder of the importance of building resilience in the financial system.

Nonetheless, the limited macroprudential toolkit in the United States leads me to conclude that there may be times when adjustments in monetary policy should be discussed as a means to curb risks to financial stability. The deployment of monetary policy comes with significant costs. A more restrictive monetary policy would, all else being equal, lead to deviations from price stability and full employment. Moreover, financial stability considerations can sometimes point to the need for accommodative monetary policy. For example, the accommodative U.S. monetary policy since 2008 has helped repair the balance sheets of households, nonfinancial firms, and the financial sector.

Given these considerations, how should monetary policy be deployed to foster financial stability? This topic is a matter for further research, some of which will look similar to the analysis in an earlier time of whether and how monetary policy should react to rapidly rising asset prices. That discussion reached the conclusion that monetary policy should be deployed to deal with errant asset prices (assuming, of course, that they could be identified) only to the extent that not doing so would result in a worse outcome for current and future output and inflation.

There are some calculations–for example, by Lars Svensson–that suggest it would hardly ever make sense to deploy monetary policy to deal with potential financial instability. The contention that macroprudential measures would be a better approach is persuasive, except when there are no relevant macroprudential measures available. I believe we need more research into the question. I also struggle in trying to find consistency between the certainty that many have that higher interest rates would have prevented the Global Financial Crisis and the view that the interest rate should not be used to deal with potential financial instabilities. Perhaps that problem can be solved by seeking to distinguish between a situation in which the interest rate is not at its short-run natural rate and one in which asset-pricing problems are sector specific.

Of course, we should not exaggerate. It is one thing to say we have no macroprudential tools and another to say that having more macroprudential measures–particularly in the area of housing finance–could provide major financial stability benefits. It also seems likely that monetary policy should be used for macroprudential purposes with an eye to the tradeoffs between reduced financial imbalances, price stability, and maximum employment. In this regard, a number of recent research papers have begun to frame the issue in terms of such tradeoffs, although this is a new area that deserves further research.

It may also be fruitful for researchers to continue investigating the deployment of new or little-used monetary policy tools. For example, it is arguable that reserve requirements–a traditional monetary policy instrument–can be viewed as a macroprudential tool. In addition, some research has begun to ask important questions about the size and structure of monetary authority liabilities in fostering financial stability.

Conclusion
To sum up: The need for coordination across different regulators with distinct mandates creates challenges to the timely deployment of macroprudential measures in the United States. Further, the toolkit to act countercyclically in the face of building financial stability risks is limited, requires more research on its efficacy, and may need to be enhanced. Given these challenges, we need to consider the potential role of monetary policy in fostering financial stability while recognizing that there is more research to be done in clarifying the potential costs and benefits of doing so when conditions appear so to warrant.

After all of the successful work that has been done to reform the financial system since the Global Financial Crisis, this summary may appear daunting and disappointing. But it is important to highlight these challenges now. Currently, the U.S. financial system appears resilient, reflecting the impressive progress made since the crisis. We need to address these questions now, before new risks emerge.

Fed Still Expecting To Lift Rates

In a wide-ranging speech, at the Philip Gamble Memorial Lecture, Fed Chair Yellen discussed inflation in the US and monetary policy. The net summary is that the more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data.

Consistent with the inflation framework I have outlined, the medians of the projections provided by FOMC participants at our recent meeting show inflation gradually moving back to 2 percent, accompanied by a temporary decline in unemployment slightly below the median estimate of the rate expected to prevail in the longer run. These projections embody two key judgments regarding the projected relationship between real activity and interest rates. First, the real federal funds rate is currently somewhat below the level that would be consistent with real GDP expanding in line with potential, which implies that the unemployment rate is likely to continue to fall in the absence of some tightening. Second, participants implicitly expect that the various headwinds to economic growth that I mentioned earlier will continue to fade, thereby boosting the economy’s underlying strength. Combined, these two judgments imply that the real interest rate consistent with achieving and then maintaining full employment in the medium run should rise gradually over time. This expectation, coupled with inherent lags in the response of real activity and inflation to changes in monetary policy, are the key reasons that most of my colleagues and I anticipate that it will likely be appropriate to raise the target range for the federal funds rate sometime later this year and to continue boosting short-term rates at a gradual pace thereafter as the labor market improves further and inflation moves back to our 2 percent objective.

By itself, the precise timing of the first increase in our target for the federal funds rate should have only minor implications for financial conditions and the general economy. What matters for overall financial conditions is the entire trajectory of short-term interest rates that is anticipated by markets and the public. As I noted, most of my colleagues and I anticipate that economic conditions are likely to warrant raising short-term interest rates at a quite gradual pace over the next few years. It’s important to emphasize, however, that both the timing of the first rate increase and any subsequent adjustments to our federal funds rate target will depend on how developments in the economy influence the Committee’s outlook for progress toward maximum employment and 2 percent inflation.

The economic outlook, of course, is highly uncertain and it is conceivable, for example, that inflation could remain appreciably below our 2 percent target despite the apparent anchoring of inflation expectations. Here, Japan’s recent history may be instructive, survey measures of longer-term expected inflation in that country remained positive and stable even as that country experienced many years of persistent, mild deflation. The explanation for the persistent divergence between actual and expected inflation in Japan is not clear, but I believe that it illustrates a problem faced by all central banks: Economists’ understanding of the dynamics of inflation is far from perfect. Reflecting that limited understanding, the predictions of our models often err, sometimes significantly so. Accordingly, inflation may rise more slowly or rapidly than the Committee currently anticipates; should such a development occur, we would need to adjust the stance of policy in response.

Considerable uncertainties also surround the outlook for economic activity. For example, we cannot be certain about the pace at which the headwinds still restraining the domestic economy will continue to fade. Moreover, net exports have served as a significant drag on growth over the past year and recent global economic and financial developments highlight the risk that a slowdown in foreign growth might restrain U.S. economic activity somewhat further. The Committee is monitoring developments abroad, but we do not currently anticipate that the effects of these recent developments on the U.S. economy will prove to be large enough to have a significant effect on the path for policy. That said, in response to surprises affecting the outlook for economic activity, as with those affecting inflation, the FOMC would need to adjust the stance of policy so that our actions remain consistent with inflation returning to our 2 percent objective over the medium term in the context of maximum employment.

Given the highly uncertain nature of the outlook, one might ask: Why not hold off raising the federal funds rate until the economy has reached full employment and inflation is actually back at 2 percent? The difficulty with this strategy is that monetary policy affects real activity and inflation with a substantial lag. If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. In addition, continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability. For these reasons, the more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data.