Fed Plosser on Financial Stability and Unwinding Lending Programs

Speaking on financial regulatory reform to an audience at the University of Chicago Booth School of Business, president of the Federal Reserve Bank of Philadelphia, Charles Plosser said Tuesday that “unwinding the Federal Reserve’s various lending and securities programs is key once financial markets begin to function normally and the economic outlook improves, but that could be tricky.”

Unwinding from these lending and securities programs will not necessarily be easy. Will there be pressure from various interest groups to retain certain assets? Will there be pressure to extend some of these programs by observers who feel terminating the programs might disrupt “fragile” markets or that the economy’s “headwinds” are too strong? Such pressures could threaten the Fed’s independence to control its balance sheet and monetary policy. We will need to have the fortitude to make some difficult decisions about when our policies must be reversed or unwound.

By setting realistic and feasible objectives, pursuing a systematic approach to its lending policies that avoids credit allocation, and communicating its objectives and actions in a clear and transparent manner, the Fed can operate independently of these types of pressures and resist them when they arise. This will help the Fed better ensure both its ability and its credibility to maintain financial stability as well as its monetary policy objectives.

Plosser said the Fed’s balance sheet, which has significantly expanded to more than $2 trillion given the Fed’s multiple programs to help stabilize the financial system, must contract when conditions improve to maintain price stability. Plosser also said “we must avoid “quick fixes” that may have unintended consequences, inadvertently hamper market competition or innovation, or create conditions that provide the foundation of the next crisis.”

Plosser emphasized that is key for the Fed to develop much clearer criteria under which it will lend to banks or nonbank financial institutions, noting that the lack of clarity surrounding the purposes of the lending programs has added “uncertainty and volatility” to the markets. “We need to clarify,” he said, “under what circumstances, if any, the Fed would lend to insolvent institutions, how insolvency would be determined, and what types of limits, if any, would apply to such lending.”

Full speech transcript available here.

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