SEPTEMBER 25, 2009
The Fed's Job Is Only Half Over
The level of asset prices and associated risk premiums will demand careful assessment as we return to normal
By KEVIN M. WARSH
Recent media stories have chronicled in great detail the events of the last couple of years. A pair of conclusions might be fairly drawn from these early drafts of history. One is that the financial-market turmoil of the last year proved to be of significant consequence to the economy. The second is that the Federal Reserve distinguished itself from historical analogues by taking extraordinary actions to address risks to the economy. Commentators, however, tend to disagree as to whether the extraordinary actions undertaken were to the good or the detriment of the U.S. economy in the long-run.
As my fellow members of the Federal Open Market Committee and I stated earlier this week, economic activity has picked up, and conditions in financial markets have improved further. Longer-term inflation expectations are stable, and economic conditions are likely to warrant exceptionally low levels of the federal-funds rate for an extended period.
Nonetheless, the second anniversary of the onset of the financial crisis—about a year from the darkest days of the "panic of 2008"—is no time to declare victory and scarcely the moment to hand out medals. I cannot help but think of the strong but weary athlete who, after a morning swim, embarks upon a grueling cycling contest to a rising din of cheers and a smattering of boos—only to be reminded that he is participating in a triathlon, and that he has a long run still before him.
It is unwise to prejudge the Federal Reserve's policy strategy—or to declare the victor or the vanquished—by the split time, however notable it might be. We are at a critical transition period, of still unknown duration, and we must prepare diligently for an uneven road race ahead. If policy is not implemented with skill and force and some sense of proportionality, the success of the overall endeavor could suffer.
Judgments made by policy makers in the current period are likely to be as consequential as any made in the depths of the panic. That means policy makers should continue to communicate as clearly as possible the guideposts, conditions and means by which extraordinary monetary accommodation will be unwound, including the removal of excess bank reserves.
It also means that policy makers should acknowledge the heightened costs of policy error. The stakes are high, in part, because the policy accommodation that requires timely removal as the economy rebounds is substantial. And our policy judgments will ultimately prove worthy of the accolades, and tender the ultimate rejoinder to our critics, if we rise to meet this heightened responsibility. I am confident we will.
The final recounting of economic history will judge that winning the battle against the panic of 2008 was a necessary but insufficient condition to win the peace and ensure a strong foundation for economic prosperity. That outcome will require that policy makers have equal parts capability, clairvoyance and courage—perhaps the most important of which is courage.
Economic histories in the U.S. and elsewhere are packed with examples in which the monetary authorities, with the overwhelming benefit of hindsight, may have misjudged the communication, timing or force of their exit strategies. In some cases, policy makers may have waited too long to remove easy-money policies. In other cases, policy makers may have acted too abruptly, normalizing policy before the economy was capable of self-sustaining growth.
Errors of each sort are neither uncommon nor unexpected in the normal conduct of monetary policy. And the current period is anything but normal. There are uncertainties regarding the trajectory of the economy recovering from a major financial crisis and a deep recession. Equally, there are uncertainties about the performance of the monetary transmission mechanism and the operation of the Federal Reserve's unconventional policy tools. A nimble, even-handed approach toward our risk-management challenges will prove necessary.
Today, even more than usual, we should maintain considerable humility about optimal policy. Financial market developments bear especially careful watching. They may impart more forward-looking signs of growth and inflation prospects than arithmetic readings of stimulus-induced gross domestic product or lagged composite readings of inflation. For example, the level of asset prices and associated risk premiums, and gauging their trend and durability, will demand careful assessment.
In this environment, market participants and policy makers alike should steer clear of ironclad policy prescriptions. Nonetheless, I would hazard the view that prudent risk management indicates that policy likely will need to begin normalization before it is obvious that it is necessary, possibly with greater force than is customary, and taking proper account of the policies being instituted by other authorities.
"Whatever it takes" is said by some to be the maxim that marked the battle of the last year. But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns. If "whatever it takes" was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Federal Reserve's institutional credibility. The asymmetric application of policy ultimately could cause the innovative policy approaches introduced in the past couple of years to lose their standing as valuable additions in the arsenal of central bankers.
For those of us at the Federal Reserve, the task ahead involves longer days, but, in all likelihood, fewer weekends. While the undertaking is as challenging as any we faced in the preceding period, it is exceptionally well suited to the Federal Reserve's comparative advantages of deliberation, dispassion, and a determination to make judgments based on the long-term interests of the U.S. economy.
Mr. Warsh has been a member of the Federal Reserve Board of Governors since 2006.
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