Bill Dudley (FRB-NY) is a voting member of the FOMC, and flies with the committee’s doves, who believe that monetary policy can and must be used to lower the unemployment rate as long as inflation remains low. In a speech delivered yesterday and posted today, he added a third mandate, namely financial stability:
Financial stability is a necessary prerequisite for an effective monetary policy. There is a critical chain of linkages from monetary policy to banking and onwards to the real economy. Financial stability is a necessary condition for those linkages to operate effectively. Thus, it is a necessary condition for monetary policy to be able to achieve its economic objectives.
He stressed that “the central bank has a major role to play in ensuring financial stability and should evaluate the stance of monetary policy in light of problems in the financial system that may impair the monetary policy transmission mechanism.” More specifically, he said that the central banks must do what it can to avert asset bubbles:
The central bank needs to be willing to respond to limit financial market bubbles from developing in the first place. This includes not just paying attention to asset price bubbles, but also to related excesses in leverage and in short-term funding markets. As I noted in a speech a few years ago, this is difficult to do in practice. After all, bubbles are difficult to identify in real time and the central bank’s policy toolkit to deal with bubbles may be limited. However, this difficulty cannot be an excuse for inaction. Using the bully pulpit, implementing macroprudential measures, or adjusting monetary policy can generate superior results compared to inaction.
As a by-the-way, Dudley admitted that QE may not be as effective as he once thought:
At the zero bound, the central bank is not powerless, and may turn to other monetary policy tools such as forward guidance and large scale asset purchases. But these tools may not be as effective as lowering the short-term rate instrument. In particular, the central bank may not be willing to use these nonconventional tools to the full extent necessary to provide the same degree of stimulus as it would provide if it could set interest rates at negative levels. That might be because of uncertainty about how nonconventional tools will work or because of the potential costs associated with the use of such tools in terms of market functioning and the risks of future financial instability.