To improve Fed policy, improve communications

Since May 2021, we have criticized the Federal Reserve’s lagging response to surging inflation. In our view, both policy and communications were inadequate to address the looming challenge. Early this year, we argued that the Fed created a policy crisis by refusing to acknowledge the rise of trend inflation, maintaining a hyper-expansionary policy well after trend inflation reached levels far above their 2% target, and failing to articulate a credible low-inflation policy.

Against this background, we commend the FOMC for its recent efforts. Not only is policy moving quickly in the right direction, but communication improved markedly. In particular, despite the increasing likelihood of a near-term recession, Chair Powell made clear that price stability is necessary for achieving the second part of the Fed’s dual mandate. We suspect that the combination of the Fed’s recent promise to make policy restrictive, along with its improved communications, is playing a key role in anchoring longer-term inflation expectations.

In this post, we focus on central bank communication and its link to policy setting. By far the most important goal of communication is to clarify the authorities’ reaction function: the systematic response of central bank policy to prospective changes in key economy-wide fundamentals—usually inflation and the unemployment rate.

To anticipate our conclusions, we argue for two changes to the FOMC’s quarterly Summary of Economic Projections to better illuminate the Committee reaction function. First, we encourage publication of more detail on individual participants’ responses to link individual projections of inflation, economic growth, and unemployment to the path of the policy rate. Second, we see a role for scenario analysis in which FOMC participants provide their anticipated policy path contingent on one or more adverse supply shocks that present unappealing policy tradeoffs (for example, between the speed of returning inflation to its target and the pace at which the unemployment rate returns to its sustainable level)….

Thoughts on Deposit Insurance

Government guarantees have become the norm in the financial system. According to the latest Federal Reserve Bank of Richmond (2017) estimate, the U.S. government’s safety net covers 60% of private financial liabilities in the United States. Serious underpricing of government guarantees gives intermediaries the incentive to take risk that can threaten the entire financial system: the Great Financial Crisis of 2007-09 is the most obvious case in point.

Deposit insurance is arguably the oldest and most widespread form of government guarantee in finance. In the United States, Congress established the Federal Deposit Insurance Corporation (FDIC) at the depth of the Great Depression in 1933 to help prevent bank runs. Today, more than 140 countries have some type of deposit insurance scheme.

In this post, we briefly review the evolution of FDIC deposit insurance pricing. We highlight evidence that, largely because of Congressional mandates, the federal insurance guarantee was underpriced for many years. It is not until 2011, following the crisis of 2007-09, that the FDIC introduced the current framework for risk-based deposit insurance fees, bringing insurance premia closer to what observers would deem to be actuarially fair.

Going forward, as with any insurance regime, keeping up with the evolution of bank (and broader financial system) risks will require a willingness to update the deposit insurance pricing framework from time to time. That means adjusting pricing to reflect both the range of bank risk-taking at a point in time and—to ensure the sustainability of the deposit insurance fund without taxpayer subsidies—the evolution of aggregate risk….

Improving U.S. Monetary Policy Communications

Tomorrow, June 4, we will present our paper, Improving U.S. Monetary Policy Communications, as part of the Federal Reserve’s review of its monetary policy strategy, tools, and communications practices. This post summarizes our methodology, analysis and recommendations.

——————————————————————————————————-

Since the mid-1990s, the U.S. economy has been reaping the benefits of a credible commitment to price stability, including a communications framework that reinforces that commitment. Over the same period, both the level and uncertainty of inflation have declined (see here). It is against this backdrop that we look for further enhancements in the Federal Open Market Committee’s (FOMC) communications framework.

Bank Capital and Stress Tests: The Foundation of a Thriving Economy

We submitted this statement to the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Financial Services of the U.S. House of Representatives for its hearing on July 17, 2018.

We appreciate the opportunity to submit the following statement on the occasion of the hearing entitled “Examining Capital Regimes for Financial Institutions.” We welcome the Subcommittee’s further examination of the existing regulatory approach for prudentially regulated financial institutions.

We are academic experts in financial regulation with extensive knowledge of the financial industry. Our experience includes working with private sector financial institutions, government agencies and international organizations. In our view, a strong and resilient financial system is an essential foundation of a thriving economy. The welfare of every modern society depends on it. The bedrock of this foundation is that banks’ capital buffers are sufficient to withstand significant stress without recourse to public funds. Furthermore, it is our considered view that the benefits of raising U.S. capital requirements from their current modest levels clearly outweigh the costs.

To explain this conclusion, we start with a definition of bank capital, including a discussion of its importance as a mechanism for self-insurance. We then turn to capital regulation and a discussion of stress testing….

Is International Diversification Dead?

At least since Harry Markowitz’s work in the 1950s, diversification has been viewed as the key to an efficient portfolio that minimizes risk for a given expected rate of return. When James Tobin received his Nobel Prize in 1981 – in part for his work on the subject – he summarized portfolio selection theory in the classic fashion: “don’t put all your eggs in one basket.”

Over the years, academicians and market professionals extended this fundamental principle to the global asset universe, highlighting the benefits of going beyond simply holding a broad group of domestic instruments to the idea of international diversification. In the case of equity portfolios, they also observed that people typically hold a smaller share of foreign stocks than simple portfolio selection models prescribe. This gap between actual and model-based optimal allocations of equity portfolios has become known in finance as the equity home bias puzzle.

Making driving safe

The home page for the Google Self-Driving Car Project contains the following:

Imagine if everyone could get around easily and safely, regardless of their ability to drive. […] Aging or visually impaired loved ones wouldn't have to give up their independence. Time spent commuting could be time spent doing what you want to do. Deaths from traffic accidents—over 1.2 million worldwide every year—could be reduced dramatically, especially since 94% of accidents in the U.S. involve human error.

In some walks of life, we can reduce risks by changing human behavior. In the case of automobiles, we train and license people to make them drive more safely. We also fine and incarcerate them when they don't...

China's stock market boom and bust

Ask a well-educated person which country boasts the largest equity market and you’ll usually get the right answer: the United States. Ask which country has the second largest market and you’re likely to get a range of answers: Japan? Britain? Germany?

The answer is China. In terms of annual trading volume, China's equity market has been #2 since 2009. Measured by total market capitalization, it has been #2 for seven of the past nine years....

Why should this matter now? First, because it highlights the extraordinary spread of market-based finance in a country led for more than 65 years by its communist party.... Second, because the growth in Chinese equity markets comes with sizable risks. Recent experience drives home this point....

Financial Innovation and Risk Management

In 2013, Robert Shiller shared the Nobel Prize for Economics with Eugene Fama and Lars Peter Hansen for their research on asset pricing. While Shiller is known as a critic of the efficient markets hypothesis and as a proponent of behavioral finance, less appreciated is his work on advancing financial technology to help societies manage fundamental economic risks.

At a time when the recent crisis has given financial innovation a bad name, Shiller’s contrarian message is that well-designed financial instruments and markets are an enormous boon to social welfare. We agree.

Investing in College

Most Americans want a college education, but it is expensive. On average, a four-year school costs about $25,000 per year, or $100,000 for a degree. That’s roughly half the median house price – a substantial investment. If you have to borrow to finance a college education – just like you borrow to own a house – is it really worth it?

The answer is yes for most people. But the outcome is not free of risk, especially for those students who borrow heavily relative to their future income prospects....

Steve Cecchetti and Kim SchoenholtzSeptember 25, 2014Student loans, Default, Present discounted value, Rate of return, Risk

In Search of Better Credit Assessments

July 21, 2014 was the fourth birthday of the Dodd–Frank Act (DFA). It is maturing faster than a human, but slower than a dog. Of the nearly 400 rules that DFA requires regulators to write, just over half have been completed. At the end of August, the SEC finished another one – regarding credit rating agencies (CRAs). The result makes us wonder what took so long...

Steve Cecchetti and Kim SchoenholtzSeptember 18, 2014SEC, Credit ratings, Dodd-Frank, MBS, Risk, Conflict of interest, Incentives

Commentary

Money, Banking, and Financial Markets