WASHINGTON (MNI) – The following is the text of Federal
Reserve Vice Chairman Donald Kohn’s remarks late Wednesday
prepared for Davidson College in Davidson, North Carolina:

Homework Assignments for Monetary Policymakers

The events of the past few years have raised many questions for
central bankers. Although prompt and innovative actions by the Federal
Reserve and other central banks helped prevent a severe economic
downturn from turning into something even worse, our experience also
highlighted a number of areas we need to study further to see whether we
can improve the conduct of monetary policy. I’ve titled my presentation
“Homework Assignments” because I don’t think the answers are clear,
though I will venture some tentative thoughts. I have four assignments
on my list; I could easily have more. And others would have yet a
different list. I recognize that the complexity of these questions could
keep us profitably engaged for a whole semester, but let’s see if I can
outline some of the challenges and possible responses in an evening.

The first two assignments concern the policy actions the Federal
Reserve and other central banks took during the financial crisis. A key
part of the Federal Reserves response was to fulfill its traditional
role of providing backup liquidity to sound institutions during times of
financial turmoil. In a break with tradition, we had to provide that
liquidity to nonbank financial institutions as well as to banks. One
assignment is to evaluate the implications of the changing character of
financial markets for the design of the liquidity tools the Federal
Reserve has at its disposal when panic-driven runs on banks and other
key financial intermediaries and markets threaten financial stability
and the economy. In addition to providing liquidity on an unprecedented
scale, we reduced our policy interest rate (the target for the rate on
overnight loans between banks) effectively to zero, and then we
continued to ease financial conditions and cushion the effect of the
financial shock on the economy by making large-scale purchases of
several types of securities. My second assignment involves improving our
understanding of the effects of those purchases and the associated
massive increase in bank reserves.

The third and fourth assignments relate to whether changes to the
conduct of monetary policy in normal times could make financial
instability and its wrenching and costly economic consequences less
likely. Number three involves considering whether central banks should
use their conventional monetary policy tool — adjusting the level of a
short-term interest rate — to try to rein in asset prices that seem to
be moving well away from sustainable values, in addition to seeking to
achieve the macroeconomic objectives of full employment and price
stability. The fourth and final assignment concerns whether central
banks should adjust their inflation targets to reduce the odds of
getting into a situation again where the policy interest rate reaches
zero.1 Changes in Financial Markets and the Federal Reserves Liquidity
Tools Financial markets have evolved substantially in recent decades.
The task of intermediating between investors and borrowers has shifted
over time from banks, which take deposits and make loans, to securities
markets, where borrowers and savers meet more directly, albeit with the
assistance of investment banks that help borrowers issue securities and
then make markets in those securities. An aspect of the shift has been
the growth of securitization, in which loans that might have been on the
books of banks are converted into securities and sold in markets.
Serious deficiencies with these securitizations, the associated
derivative instruments, and the structures that evolved to hold
securitized debt were at the heart of the financial crisis. Among other
things, the structures exposed the banking system to risks that neither
participants in financial markets nor regulators fully appreciated.

The implications of these changes are far reaching, but I want to
concentrate on those that bear on the tools we use to supply liquidity
to the financial system. Every central bank had to adapt its liquidity
facilities to some degree, but the Federal Reserve had to adapt more
than most.

(The views expressed here are my own and not necessarily those of
my colleagues on the Board of Governors or the Federal Open Market
Committee. William Nelson of the Boards staff contributed to these
remarks.)

Before the crisis, the Federal Reserve adjusted the liquidity it
provided to the financial system through daily operations with a
relatively small set of broker-dealers against a very narrow set of
collateral — Treasury debt, agency debt, and agency mortgage-backed
securities. Those transactions had the effect of changing the quantity
of reserve balances that banks hold at Federal Reserve Banks, and that
liquidity was distributed by interbank funding markets through the
banking system in the United States and around the world. In addition,
the Federal Reserve stood ready to lend directly to commercial banks and
other depository institutions at the “discount window.” At their
discretion, banks could borrow overnight at an above-market rate against
a broad range of collateral when they had a need for very short-term
funding. But this structure proved inadequate in the crisis. Interbank
markets stopped functioning as effective means to distribute liquidity,
increasing the importance of direct lending through the discount window.
At the same time, however, banks became extremely reluctant to borrow
from the Federal Reserve for fear that the borrowing would become known
and thus cast doubt on their liquidity condition. Importantly, the
crisis also involved major disruptions of important funding markets for
other institutions. Commercial paper markets no longer served as sources
of funds to lenders or to nonfinancial businesses; investment banks
could not borrow for even a short term on a secured basis when lenders
began to have doubts about some of the underlying collateral; banks
overseas could not reliably exchange their currency in swap markets to
fund their dollar assets beyond the very shortest terms; and investors
pulled out from money market mutual funds. These disruptions posed the
same threats to the availability of credit to households and businesses
as did runs on banks in a more bank-centric financial system.
Intermediaries unable to fund themselves were forced to sell assets,
driving down prices and exacerbating the crisis; they were unwilling to
make markets necessary to allow households and businesses to borrow; and
households and businesses unable to borrow were unable to spend,
deepening the recession.

The Federal Reserve responded by providing funding when it became
unavailable to banks and other intermediaries. We reduced the spread of
the discount rate over the target interbank rate, lengthened the maximum
maturity of loans to banks from overnight to 90 days, and also provided
discount window credit through regular auctions to overcome the
reluctance to borrow. In addition, we created emergency liquidity
facilities to meet the funding needs of key market participants,
including primary securities dealers, money market mutual funds, and
other users of short-term funding markets. We did so while generally
adhering to time-honored central banking principles for countering a
financial panic: Lend freely to solvent institutions at a penalty and
against good collateral. We also lent dollars to other central banks so
that they could help banks in their jurisdictions meet their dollar
funding needs, thus easing pressures on U.S. money markets.

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