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The following is an interview with Michael Woodford, the John Bates Clark Professor of Political Economy at Columbia University and a member of an 18-member Monetary Policy Advisory Panel for the Federal Reserve Bank of New York. Woodford has no role on the decision-making Federal Open Market Committee. New York Fed President Bill Dudley is among the more dovish members of the FOMC.
There’s been much talk about the Federal Reserve introducing changes to its language, possibly at its next rate-setting meeting on Nov. 3-4. Do you think the Fed will soon stop noting that the federal-funds rate will stay very low for an “extended period”?
Woodford: I could imagine them dropping that language. The problem with this kind of language is that it’s perceived as making a promise about future interest rates independently of what happens in the meantime. Even those policy makers who believe that it’s important to reassure people that the Fed isn’t already planning to raise rates would find that language somewhat problematic. What I think they should try to do is to find a way of talking about what the conditions are under which interest rates would rise, rather than simply pretending that there are no conditions under which rates would go up.
Turning to financial market discipline: Senior Fed officials have openly support the idea of imposing a ratio for “contingent capital,” or a kind of debt that automatically converts into equity if a bank hits rocky times. Do you support this notion, and do you see this happening anytime soon?
Woodford: I think it’s a desirable idea. This time, both the Fed and the Treasury have taken a very active role in bailing out financial institutions. But, at the same time, it’s been unpopular with the public and policy makers are nervous about the precedent it creates. So there’s a lot of desire to have something else. One very sensible proposal is to require financial institutions to have contracts with their investors that already specify in advance how additional equity capital is going to be injected by those investors, under contingencies where it’s necessary. So investors will have to think about that contingency. This will give them more of an incentive to monitor risks in an appropriate way, which is very desirable, of course. If you’re asking will it happen — that’s harder to be sure of. No doubt there’s going to be an argument about any such proposal.
Given the importance of financial stability for the wider economy, do you think financial stability should play a greater or explicit role in the Federal Reserve’s policy strategy?
Woodford: No doubt, the Fed should give greater attention to financial stability than it did in the past. One should try and set up a framework to safeguard financial stability, and it may very well be that — within this framework — central banks should play a key role. But, ideally, one would be scrutinizing the risks developing and adjust capital requirements accordingly, rather than using monetary policy to respond to these risks. You’ve got to realize that pretending you can do everything with one tool means you won’t do any of them too well.
Should the Fed be more reactive — leaning against the wind -toward sharp moves in asset prices, such as house prices and equities? Should the Fed include a broader range of asset prices in its policy strategy?
Woodford: I’m not too sympathetic of that way of putting things. Using monetary policy to prevent certain moves in asset prices wouldn’t be a terribly effective tool. And to the extent that it would be effective, it’d involve important costs for the rest of the economy. It’d be particularly bad for the Fed to be saying “we have a view on where asset prices should be, and we’re going to get them there by using monetary policy.” Instead, the focus of the Fed’s investigation should be on what kind of risks financial institutions get themselves into — not on asset prices as such.
The Fed has downgraded the role of money and credit aggregates in its policy strategy. Given the more recent developments, do you think it’s now time to reconsider, or reverse the move?
Woodford: The issue that deserves more attention is monitoring risks to financial stability and identifying possible systemic risks. Unfortunately, traditional monetary and credit statistics aren’t that closely related to the things you really ought to be measuring. For example, lending by non-bank entities has played an important role in the recent real-estate euphoria. Given the emergence of new kinds of institutions and financing arrangements, you cannot simply revert to the old statistics people used to look at decades ago. There should be more research on understanding which measures are in fact the valuable indicators.
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Puppet, I like the rain. Michael, The world is changing fast, after you adjust to one thing, you should look for another. Start on a footing that might get Adam upset. Wealth is a constant in relationship to its people. A guess: 8*GDP and 50% of that being debt ownership. You can find more and better numbers. Wealth, debt and GDP needs to be measured in dollars. Not the quality of wealth. Search for movements.
Creedence Clearwater Revival: Have You Ever Seen The Rain? http://www.youtube.com/watch?v=Gu2pVPWGYMQ
Real Time Economics offers exclusive news, analysis and commentary on the economy, Federal Reserve policy and economics. The Wall Street Journal's Phil Izzo and Sudeep Reddy are the lead writers, with contributions from other Journal reporters and editors. Send news items, comments and questions to realtimeeconomics@wsj.com. Read more Economics coverage.
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