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C. Peter McColough Series on International Economics

Speaker: Charles Plosser, President and CEO, Federal Reserve Bank of Philadelphia
Presider: Alan S. Blinder, Gordon S. Rentschler Memorial Professor of Economics, Princeton University, and Former Vice Chairman, Board of Governors of the Federal Reserve System
October 8, 2008
Council on Foreign Relations

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ALAN S. BLINDER:  Good morning, everybody -- if I could get your attention.  Welcome.  As I think you know, this meeting is part of the C. Peter McColough Series -- or maybe you don't know, so let me tell you that it's part of the C. Peter McColough Series on International Economics, the next one of which is just this afternoon with the finance minister of Iraq.  So if you have enough time you can spend your entire day at the Council on Foreign Relations and it will be an educational one.

Would you please turn off your cell phones?  The council is very strict.  I'm asked to actually ask you to turn off your vibrators.  I know some of you will not be able to do that, but please do that, and the Blackberries, and all of that stuff that interferes with the sound system.  That is the idea.  I've already done that to mine so I'm BlackBerry-less right now at this moment.  And just to remind everybody that the meeting is on the record.  There is press presence and it's on the record.

It is my great privilege to introduce my friend Charles Plosser, who is the president of the Federal Reserve Bank of Philadelphia.  I should say president and CEO.  For those of you who don't know, the reserve banks around the country, the 12 of them, are dot-orgs, not dot-govs.  They are sort of like corporations with boards of directors and CEOs, et cetera, and they run a business.  The Philadelphia Fed does run a business in addition to its president, now Charles Plosser, being a member of the Federal Open Market Committee.

Charlie has a long -- pardon me for saying "long."  It's not as long as mine.  We'll say long has to do with your age -- a long and distinguished career as an academic economist beginning with earning his Ph.D. at the University of Chicago.  Most of his career was spent at the University of Rochester where in recent years before becoming the head of the Philadelphia Fed he was the dean of the Simon School of Business.  Part of his job -- lately a large part of his job -- is being a member of the Federal Open Market Committee, which, if you haven't been in an igloo in Antarctica, you know has been a busy organization of late, and most appropriately the title that he chose -- I just asked him -- last summer, mind you -- here's a man with foresight -- is, "The Limits of Central Banking," a moving target to be sure.

So we are very honored and privileged to have today Charles Plosser.

(Applause.)

CHARLES PLOSSER:  Good morning, and thank you, Alan, for that very nice introduction.  Indeed, the Fed has been a busy place for the last 18 months.  I told somebody at one point -- I said, you know, I joined the Philadelphia Fed in August of 2006, and to be honest with you there hasn't been a dull moment since then, and I suspect there won't be many dull moments going forward for a while either.

But thank you for welcoming me.  I'm glad to be here.  It's a terrific opportunity.  Today I want to discuss the importance of thinking realistically about the capabilities of a central bank.  In particular, as we look forward and beyond the current financial turmoil to the future, what are the Federal Reserve's responsibilities and capabilities with regard to monetary policy and financial stability?  Financial turmoil over the past year has resulted in restructuring in the marketplace and has prompted calls for the Fed to assume expanded responsibilities.  Some envision the Fed becoming the supervisor and regulator of a broad array of financial institutions and markets to ensure financial stability.

Yet before we seek to dramatically expand the Fed's responsibilities, I believe it's important to recognize that there are limits to what a central bank can do, and this has implications for what a central bank should do.  The Fed needs to be accountable for meeting its goals, yet we must take care to set reasonable expectations of what a central bank can in fact achieve.  We must recognize that over-promising can erode the credibility of a central bank's commitment to meet any of its goals, whether it be for monetary policy or financial stability.  And so my comments today will touch on both of these central bank responsibilities.

Let me start with monetary policy.  Now, much of the public discussion of the Federal Reserve's monetary policy seems to assume that the Fed's job is to stabilize the economy against macroeconomic shocks, such as a sharp rise in the price of oil or a sharp drop in the housing market.  The impression one gets is that if the Fed were simply quicker, smarter, or had more regulatory powers, we could always counteract these adverse effects of these shocks and easily achieve policy's dual mandate of keeping the economy growing with full employment and low inflation.  However, I see two problems with this view.  First, if fails to recognize the difference between what the Fed can do in the long run and what it might be able to do in the short run.  Second, it assumes that the Fed has the ability to stabilize the economy against the adverse effects of almost all sorts of macroeconomic shocks.  On both counts this view seriously overstates the true capability of the Fed, or any central bank, in modern market economies.

In truth, the only thing that sound monetary policy can affect in the long run is the rate of inflation.  Changes in monetary policy can and do affect real economic activity such as the unemployment rate or output growth, but it does so only temporarily and with considerable uncertainty as to both the timing and the magnitude of such interventions.

Consider the case when economic activity is slowing or declining.  If we increase the money supply to lower interest rates or to keep them low, we may temporarily boost economic activity because it takes a while for prices to respond to the additional amount of money in circulation.  The temporary boost, however, occurs with the so-called long and variable lag.  Indeed, the real effects of lower interest rates on economic activity may not be felt for as many as nine or 18 months in the future.  Eventually, though, prices will rise, the purchasing power of money will erode, and the boost to economic activity will fade away.  Moreover, the effect on the real economy can be completely offset if inflation expectations rise in reaction to the monetary accommodation.  That is why central bankers place considerable stress on their credibility and commitment to keep inflation low and stable.

The task is further complicated when one realizes that all sorts of shocks simultaneously are buffeting the economy.  Shocks can occur to specific sectors, specific regions.  Some may be large; some may be small.  They may be positive and boost economic growth while others may be detrimental to growth.  If monetary policy responded to one shock in an attempt to offset its possible effects, it may in fact be aggravating the effects of another shock.

This monetary policy's ability to neutralize the impact of shock is really limited.  Successfully implementing such an economic stabilization policy requires predicting the state of the economy more than a year from now with a high degree of accuracy, including anticipating the nature, timing, and likely impact of future shocks.  The truth is is that economists simply do not possess the accuracy or knowledge to make forecasts with such a high degree of accuracy.  Attempts to stabilize the economy would more likely than not then end up providing stimulus when none is needed, or vice versa.  Indeed, aggressive attempts at stabilization can in fact increase volatility in the economy rather than reduce it.

Now, in many cases the effects of shocks to the economy simply have to play out over time so that markets eventually adjust to new equilibrium.  For example, monetary policy cannot keep the price of gasoline or home heating oil at the low levels they were when crude oil was $30 a barrel, and monetary policy cannot reverse the sharp declines in housing prices over the last year.  Monetary policy simply cannot eliminate the need for households and businesses to make the sometimes painful real adjustments when such shocks occur.

Now, this doesn't mean that monetary policy should be unresponsive to changes in economic conditions.  On the contrary.  Indeed, the best strategy is for us to set our policy instrument -- that being the federal funds rate -- consistent with controlling inflation over the intermediate term.  This implies that the targeted federal funds rate will vary with the outlook for the overall economy.  By keeping inflation stable when shocks occur, monetary policy can foster the conditions that enable households and business to make the necessary adjustments to return the economy to a sustainable growth path.  Although depending on the nature of the shock, this new growth path might be higher, lower, or it may be the same as the old growth path, but monetary policy itself does not determine what that sustainable path is.

For example, if an adverse productivity shock results in substantial reduction in the outlook for economic growth, then real or inflation-adjusted interest rates tend to fall.  As long as inflation is an acceptable level, the appropriate monetary policy is to reduce the federal funds rate to facilitate the adjustment to those lower real interest rates.  Failure to do so could result in misallocation of resources, a steadily declining rate of inflation, and perhaps even deflation.  Conversely, when the outlook for the future economic growth is revised upward, real market interest rates will tend to rise.  Provided, again, that inflation is at an acceptable level, we would want to facilitate that adjustment by raising the federal funds rate.  Failure to do so would again result in the misallocation of resources and in this case a steadily rising rate of inflation.

In both cases I view the changes in the Fed's target interest rate is responding to economic conditions in order to keep inflation low and stable.  Monetary policy is not, in that sense, trading off more inflation for less unemployment in order to stabilize the economy against adverse shocks.  Nor is it trading off more employment for less inflation when there's a favorable shock to the economy.  The empirical evidence to support such a tradeoff is tenuous at best, and the empirical support for the view that central banks can favorably exploit such a potential tradeoff is even weaker, in my mind.

Asking monetary policy to attempt to offset these shocks -- the effects of adverse shocks to the economy is unlikely to work very well, and it will surely exact its toll in terms of higher inflation.  This is particularly troublesome since it would undercut the hard-earned credibility that the Fed's commitment had -- the Fed commitment to control inflation.  This loss of credibility could mean more variability in the public's expectations about future inflation.  As we saw in the late 1970s and early 1980s, such an unanchoring of expectations makes it very difficult and extremely costly to the economy to reduce that inflation when it becomes too high.  Thus, in turn we would also -- this in turn would also make it harder to achieve higher and sustainable growth rates, the other part of our dual mandate since high and variable inflation invariably makes adjustments in labor and product markets more costly.

Now, of course, the concern I'm expressing and the reservation I'm expressing are not a new concern.  In his presidential address to the American Economics Association over 40 years ago, Milton Friedman cautioned the economics profession, and I quote:  "We are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks it cannot achieve, and as a result, in danger of preventing it from making the contribution that it is capable of making."  This caution is well worth remembering and it is still relevant today.

Of course Friedman also recognized that some shocks might require response, in particular those that, in his words, quote, "offer a clear and present danger."  In my view, shocks that put the stability of the financial system at significant risk requires a response.  Indeed, over the past year the Federal Reserve has aggressively eased monetary policy and employed innovative liquidity tools to help mitigate the effects of this financial turmoil.  Now, the widespread effects of this financial turmoil have focused attention on the role of central banks in supporting financial stability, and that's what I'll turn to now.

The Fed, as lender of last resort, has undertaken several liquidity measures intended to address extreme financial stress, to forestall contagion, and mitigate systemic risk.  One role of financial intermediaries that they perform is bearing and managing liquidity risk that arises from funding long-term assets with short-term liabilities.  Businesses are able to get funding for their projects that may not pay off until sometime in the future and financial intermediaries are able to meet savers' withdrawals of funds with retained earnings or by selling off liquid assets.  In most cases, this maturity transformation works quite well.

However, if depositors and other financial liability holders suddenly demand large withdrawals, the intermediary may be forced to sell long-term assets at prices below their value if they were held to maturity.  The intermediary's illiquidity problem could turn into a solvency problem, eventually leading to the intermediary's failure.  Such failures have the potential to cascade throughout counterparties, ultimately leading to a major breakdown of borrowing and lending in the economy.  In times of crisis, such as the situation we have found ourselves in in the past year, the Fed must act as a lender of last resort to provide the liquidity.

Since the summer of 2007, we have set up various channels through which financial institutions can borrow from the Fed against a wide range of collateral.  This has provided direct liquidity to financial institutions, thereby helping to meet our responsibilities for ensuring financial stability.  I want to stress that the Fed has sought to ensure that solvent institutions facing temporary liquidity problems, remain solvent.  The intention was not -- nor is it -- to prop up insolvent institutions.  Similarly I want to emphasize that although the Fed has played a role in the resolution of what we deem systemically important financial firms, the intention has been to protect the orderly functioning of the money market and thus to stem systemic risk to the broader economy, not to address the solvency issues of individual institutions.  Our preference is always to allow market forces to handle any required restructuring in the financial services industry.  However, in some cases this is not possible when the risks to financial stability are too high.

Regardless of our best intentions we need to recognize that by taking these interventions that we have taken, we create expectations about future interventions and who will have access to the central banks lending.  These expectations, in turn, can create moral hazard by influencing firms' risk management incentives and the types of financial contracts that they write.  This may ultimately increase the probability and severity of future financial crises.  Going forward, just as we should avoid setting unrealistic expectations for monetary policy, we should also avoid encouraging unrealistic expectations about what the Fed can do to combat financial instability.

As I've argued in times of times of financial crises, a central bank should act as the lender of last resort by lending freely at a penalty rate against good collateral, yet recent experience suggests we need to clarify what the Fed can and cannot expect to do in today's much more complex financial environment.  The events of the past year underscore the importance of carefully assessing the current financial regulatory structure.  Regulatory reforms, in my mind, should aim to lower the chances of financial crises in the first place, for example by setting capital liquidity standards that encourage firms to appropriately manage risk.  We should consider market structures, clearing mechanisms and resolution procedures that will reduce the systemic fallout from failures of financial firms.  Indeed, it would be desirable to be in an environment where no firm was too big or too interconnected to fail.

Yet regulatory reforms must recognize that modern financial systems will never be immune from financial problems.  Encouraging that belief that any system of financial regulation and supervision can prevent all types of financial instability would be a mistake.  Instead, our goal should be to lower the probability of financial crises and the costs imposed from any troubled financial institution.  As we move forward with regulatory reforms, we must carefully consider the role the Fed should play and our responsibilities for promoting financial stability.

Now, the Fed has learned much over the past two decades about how to conduct monetary policy more effectively.  I believe the general policies or principles for sound monetary policy are just as applicable to our responsibilities for promoting financial stability and fulfilling our role as lender of last resort.  In conducting monetary policy we have learned that clearly stating our policy objectives, taking a systematic approach to achieving those objectives, and committing to the systematic approach over time, even when it seems expedient to abandon it, can deliver better growth and inflation outcomes.  In addition, as my colleague Alan Blinder has so eloquently said in his excellent book practical central bankers, he stressed that central bankers must also be as transparent as possible and communicate their views on monetary policy clearly to the public to whom we are accountable.

I believe these principles should also apply to our lending policies.  In particular, I believe the central banks should clearly state objectives and set boundaries for its lending that can be credibly -- that it can credibly commit to follow.  Clarifying the criteria on which the central bank will intervene in markets or extend its credit facilities is not only essential, it's critical.  Intervening too often or expanding too broadly to set up institutions that have regular access to the central bank's credit facilities can create moral hazard, distort market mechanisms for allocating credit, and thereby increase the probability and severity of future financial crises.  Thus a too-liberal lending policy would undermine the lending policy's intended effect of financial stability.  Now, of course, announcing the central bank's criteria ex ante does not guarantee that it will act that way in every case, but it does raise the cost of deviating from that criteria.

Experience has also shown that when a central bank can conduct its monetary policy independently of the fiscal authority and political influence it can deliver better outcomes because it can take the longer-term perspective in pursuing its objectives.  This principle of central banking independence is critical for the success of monetary policy.  In setting our lending policies we must avoid taking actions that stray into the realm of credit allocation across sectors of the economy, which in my view is appropriately the purview of the marketplace.  But if governments must intervene, it should be the responsibility of the fiscal authority, not the monetary authority.  Expanding the types of assets on the Fed's balance sheet from Treasury securities to a wide array of assets, including loans to a wider variety of institutions, as we have done over the past year in pursuit of financial stability, does raise concerns in my mind, in part because it increases the number of entities that may seek to influence said policies.  The Fed needs to operate independently from these pressures, and it must resist them when they arise so that its policies benefit society at large over the longer term and not particular constituencies in the short term.

Another consideration in setting the Fed's financial stability and regulatory responsibilities is how they interact with our monetary policy goals.  Expanding the Fed's regulatory responsibilities too broadly increases the chances that there will be short-run conflicts between our monetary policy goals and our supervisory and regulatory goals.  In particular -- it is particularly important that such expansion not undermine that expansion of our regulatory authority, not undermine the credibility of our commitment to price stability.  For example, it would be a mistake for the central bank, in my view, to pursue an inflationary monetary policy in order to temporarily relieve funding pressures on financial institutions.  While financial institutions may seem better off in the short run, higher inflation will hurt them and the rest of the economy in the longer run.

As we consider the financial stability and regulatory responsibilities, we also must be careful not to compromise the Fed's independence.  Nor should we undertake tasks that would undermine our ability to meet our dual mandate of insuring price stability and fostering stable economic growth.

To sum up, the past year has been a challenging time for the U.S. economy and for policymakers.  The Fed has responded to the deteriorating economic outlook and continued stresses in the financial markets with monetary policy and liquidity facilities.  Restructuring is currently occurring in the financial services industry, as we all know, and it's clear that when some normality returns to the markets, which eventually it surely will, some type of regulatory reform will be needed.  Some people may think that expanding the Fed's regulatory and supervisory authority would prevent the types of financial crises that we've been experiencing this year.  Maybe so, yet I've tried to raise some cautionary flags going forward that are beyond -- things that are beyond the limits to what central banks can and should do.

The modern financial system will never be immune to all financial crises.  Setting up expectations that the Fed will surely be unable to fulfill would undermine our ability to achieve our primary monetary policy and financial stability objectives.  Regulatory reform should aim to reduce the probability and economic severity of such future periods of instability but should not be expected to eliminate them entirely.

As legislators continue to consider regulatory reforms, we should avoid giving the Fed new missions or goals that conflict with the one goal that uniquely is the responsibility of the central bank: price stability.  There is no other institution, no other body of government that is charged with this objective, and no other institution can deliver on it.

Thank you very much.

(Applause.)

BLINDER:  (Off mike.)

PLOSSER:  I don't have to sit on -- (inaudible) -- do I?  (Laughs.)

BLINDER:  No.  They remind both of us who we are.

PLOSSER:  These days we forget sometimes.

BLINDER:  Yeah, we do.

PLOSSER:  At our age.  (Laughs.)

BLINDER:  Thank you very much, both for the content and the intellectual and temporal discipline of keeping us right on the clock.  I want to ask you a couple of questions -- and then we're going to open it up to everybody -- germane to what you said, but first, this being the Council on Foreign Relations, I'd like to ask you about what you think about a potential limit to central bank authority or capability, stemming from the global nature of the financial market.  Do you think the fact that we're just one country among many and the Federal Reserve is one central bank among many, is a severe limit on what the Federal Reserve can accomplish or not?

PLOSSER:  Well, I think the Federal Reserve -- if you take the one objective that the Federal Reserve can achieve that no other institution can -- as long as the U.S. functions on a system of flexible exchange rate -- the fact that we operate in a global economy does not limit or restrain our ability to achieve our objectives with regard to inflation being low and stable.  That part of our mandate is not impacted by, in my view, the global nature of the economy.

However, to the extent, whether it be financial stability, given the global nature of financial markets -- their interconnectedness is a word that's been used a lot in the last year -- clearly money moves very fast across national borders, and the nature of financial institutions does lend a complication, if you will, in terms of meeting our goals of financial stability and how global markets are interconnected.  So it does pose some challenges, I think, for that aspect of our mandates.

BLINDER:  Now I'd like to ask you a couple of questions on subjects that you did take up also about limits.  You finished up almost -- the penultimate part of what you were talking about was about regulatory policy and the limits of regulatory policy and the potential for a clash between regulatory policy and other things such as monetary policy.  As you well know, there are some countries in the world -- I won't name names but a lot of people here know who they are -- that have essentially removed the central bank from regulatory policy and say, that's no longer your business; somebody else is doing that.  So that's like a limit of zero.  Your point was there's a limit someplace short of infinity.

BLINDER:  Right.

PLOSSER:  There's a lower bound than zero and some countries have actually gone to the lower bound of zero.  So I'd like to ask you just to expound a bit on what you think the appropriate role for a central bank in the regulatory world, in the United States, is, mindful of the fact -- that you are mindful of that as of today, or as of a few days ago, all the major so-called investment banks in America are banks, the ones that still exist.

PLOSSER:  So to pick up just on your last point, a lot of discussion went on in the press and in the halls of Congress, and even in the Federal Reserve after Bear Sterns in March about, okay, it clearly must be necessary for the Federal Reserve to assume responsibility and regulatory oversight for investment banks.  We focused a great deal -- and many people focused a great deal, well, what would that look like?  How would we do it?  Is that a good thing or a bad thing, and what's the scope of that?  And if you opened up for investment banks, where is the next limit?

Well, as Alan just pointed out, today that's become almost a moot point, okay?  That is to say, with the purchase -- absorption of Bear Sterns and JP Morgan, the purchase of Merrill Lynch into Bank of America, the collapse of Lehman Brothers, the turning into banks of Morgan Stanley and Goldman Sachs, this issue of whether you regulate investment banks is not really relevant anymore in some sense.

So I think what that tells us as we think about regulatory policy going forward, it tell us something about -- that the way to think about the challenges of regulation and financial stability is how the Fed's role fits into that.  We need to think beyond regulating institutions.  We need to think more about what are markets telling us about what we need to regulate?  So the question really becomes not which institutions should come under the Fed's umbrella or the OCC or the OTS or the SEC; what we need to think about if we're going to assign responsibility to the Federal Reserve for oversight, and particularly in terms of financial stability and our role as lender of last resort, we need to think more about what are the market's structures?  What are the instruments that are critical that the Fed, in its role as lender of last resort, needs to know something about?  Which of those markets are important systemically?  Which of those markets, which if fail, put the payment system at risk?

And so we need to think about functional regulation as opposed to institutions.  And I think a lot of -- we need to do a lot of thinking about that.  I don't think the answers to that question are at all clear.  There's a lot of research going on these days of people thinking about how to do that, and I think before we rush headlong into rewriting regulatory -- the regulatory structure, we need to think a little more about what it is we were trying to accomplish and make sure we put the things in place that helped to get us there.

BLINDER:  Won't that take you quickly to hedge funds?

PLOSSER:  If you focus on institutions it might.

BLINDER:  No, no, if you focus on markets --

PLOSSER:  But it might focus on -- to the extent hedge funds focus in some one of those markets, it may be not that you want to regulate hedge funds, but you regulate the markets that are critical.

BLINDER:  That they operate in.  Yeah, absolutely.  Thank you.  Another one of the limits you've discussed extensively -- and of course has been on everybody's mind, right up to yesterday until monetary policy grabbed the attention again this morning, is the limits of lending.  To whom can, should the Fed lend, in what amounts, what are the guidelines, et cetera, and you expounded on that at some length, and thank you for doing that.  My question is this:  If you believe that once you cross the Rubicon it's hard to get back again, are there any limits left?

PLOSSER:  Well, I think that's a big challenge that we face.  We have expanded our interventions, expanded our lending in important ways, and I think it's going to be a challenge and it's going to be important, I think, for the Federal Reserve, and in some sense this Treasury, in how we think about this as to how do we roll that back?  What are the limits to that?  How do we contain, as I said in my talk, some of these kinds of interventions that we've engaged in, whether we like it or not, we felt were necessary to protect the payment system?  But they do have consequences and we will need to think hard about how to contain some of the less desirable consequences of those actions and what limits we really want to put on them.  I think that's a big challenge that we face.

That's the reason why it's important we take a step back and think a little more systematically about what it is we're trying to accomplish and what tools do we need to do that?  And I think that's an important and challenging question.

BLINDER:  Thank you.  We're going to open up now to questions from the floor.  I want to say just two things.  The first is that for reasons that are mysterious and only understood in the bowels of the Federal Reserve system, three days after an interest rate decision there's a blackout period.  The right answer to that is it should be three seconds, but in the wisdom of the Fed it's three days, and members of the Open Market Committee are precluded from speaking to that, so please don't ask.  You'll get a very boring answer from Charlie if you ask him about --

PLOSSER:  Or none at all.  (Chuckles.)

BLINDER:  -- this morning's -- or last night's or whenever it was -- interest rate decision, but lots of other topics, as you heard from the talk around the table.  If you raise your hand I'll try to recognize you.  Please wait for the microphone.  There are some very nice people around here with microphones that will come.  If you get the microphone, stand up, say who you are.  And I'm going to enforce this rigorously:  Anybody who starts with, I have three questions, I'm going to ask the microphone to move.  One question, please.  It can be a pithy one, but -- pithy questions are short but come right to the point.  So there's nothing wrong with pithy questions -- those are great -- but no three-part questions, please.  Why don't we start right here in the front?  Then I'll move back.

QUESTIONER:  Hi, my name is Michael Pralle.  I work for J.E. Robert Companies, and my question really is about the limits to the role of the Fed, which you've been discussing, and what's appropriate.  What you described was really a Fed that is involved primarily with monetary policy to manage inflation, and as an observer of what's been going on over the past several weeks, I would say that the Fed's role has been, you know, much more interventionist -- I mean rescuing financial institutions, dealing with the trust and the payments and settlements system, even trying to keep the stock market from going down further.  So is it that the role you described is a role for more normal times and there's a different role during times of crisis or, you know, how do we interpret it because it's very confusing?

PLOSSER:  Well, certainly, as I pointed out at the beginning of my speech, what I was describing for the most part is sort of in more normal times and how do we think about what the role of the Fed should be in a broader environment?  But most of my discussion about what happens when you have financial crises and financial troubles where systemic risk becomes a factor, where there are financial risks to the payment system and to the financial system.  Clearly the Fed's role as lender of last resort is designed and intended to respond and interact with the financial markets in a way to deliver the lender of last resort function in that role.

And so much of what we've been trying to do over the past year has been trying to use those powers that we have as lender of last resort, as a provider of liquidity to parts of the economy, to use those in both novel, creative, and innovative ways to be able to meet the challenges of the financial turmoil we've been facing.  But I think my message in part is that we need to be a little careful as we think about the longer run and restructure the regulatory environment, which inevitably is going to arise and be discussed, to take a step back and think in the broader perspectives about what it is central banks really are capable doing, where their expertise and powers reside, and be careful not to assign it responsibility that it really can't do.

BLINDER:  Next.  All the way in the back.  Right there.  Is that you, George?

QUESTIONER:  George Soros.

BLINDER:  Yes.

QUESTIONER:  I have to apologize.  I came in late so I didn't hear all of it, but --

BLINDER:  Yeah, your name tag was up here, George.

QUESTIONER:  But I did hear you say about exogenous shock, and I wonder whether -- I mean, shouldn't one recognize that this particular financial crisis is really endogenous to the system, that in fact the financial system itself creates bubbles and imbalances?  And if that is the case now, don't we have to consider a more thorough-going, more fundamental revision of what the role of the Federal Reserve is, that it shouldn't perhaps be confined to controlling money supply but also be concerned with preventing asset bubbles and controlling credit as separate from money supply, and maybe even intervene or interfere with the allocation of credit, which you said is definitely outside the scope of the Federal Reserve?

PLOSSER:  Well, I think it's clearly true that this episode that we've experienced over the past year has been both extraordinarily challenging -- it is challenging many of us as we think about sort of what the role of not just the Federal Reserve, but as I was alluding to, regulatory environment and how that shapes the evolution of a financial system.  Some of that's going to be international issues.  Some of that's going to be domestic issues in terms of how markets function.  Markets have a way of moving one step beyond whatever you try to control to find ways around it.

And so we need to think hard exactly about what those consequences are and, yes, we may need to think about not so much what the Federal Reserve or monetary policy can in fact do, but perhaps shape how we go about doing some of the things that we do as the financial structure of the markets exactly evolve.  So I think those are open questions.

BLINDER:  Right here.  You're up.

QUESTIONER:  I think that --

BLINDER:  Could you identify yourself, please?

QUESTIONER:  Yes, I'm Muriel Siebert of Muriel Siebert and Company.  I think there have been two instruments -- it's very hard for regulation to keep up with new technology, and I for one -- I've studied the derivatives market.  There could be $1 quadrillion notional face value outstanding according to a recent study.  I think we should be thinking of studying the dark pools to see how that affects markets.  Have you given any consideration to either of those two items?

PLOSSER:  Well, for the people within the Federal Reserve system and the staff is that we are studying lots of elements of the financial markets these days, some that I suspect five years ago didn't even exist, and trying to get a better understanding of exactly the role played by different financial instruments.  Financial instruments get created very quickly.  There's lots of innovation.  Innovation is typically, for the most part, good, but the danger, it seems to me, is that -- in product markets we have innovation and products all the time.  People create new products, they put them out in the marketplace, and they succeed and sometimes they fail.  When they fail, the inventors or the creators of the new product either withdraw their product from the market, they fail and go away, or they restructure those products in a way that better suits markets' demands in the marketplace, and they put them out again, and perhaps if they meet the marketplace's demands they're more successful.

I think what we've seen in the financial industry is a lot of innovation, a lot of new products, some of which have succeeded, some of which have failed.  The problem is that when financial markets, because of the nature of their interconnectedness, if you will, and so forth, you know, when you have a failure of a product that turned out not to be a very good product, the ramifications of that can be pretty ugly, and I think we need to think hard about that role of innovation, about new products and the roles they play, which takes me back to this sort of functional view of thinking about market structures and what goes on if our role is really to help stabilize and provide some financial stability, not just to financial institutions per se, but for the payment system and the functioning of financial markets.

BLINDER:  I'm going to break in with my Tom Brokaw imitation here for a second.  Follow up.  Do you think the regulatory authorities can and/or should try to push derivative trading into exchanges, clearing houses and things like that and away from OTC exotica?

PLOSSER:  In principle I think the answer to that is yes.  I think one of the things in some of these derivative products and markets, particularly credit default swaps and other things, they trade on one-off bases in many cases.  There is no clearinghouse mechanism, as I mentioned in my talk.  I talked about one of the things that we need to look at is market microstructures and clearinghouses as a mechanism for the private sector to internalize the risks and challenges of some of these more exotic or, as you said, one-off types of securities that are unique.

What does that mean?  That might mean creating clearinghouses, it might mean standardizing products in a way that allow exchanges to work and allow members of that exchange to provide liquidity and therefore responsibility if they fail.  That would be a terrific mechanism.  The New York Fed, Tim Geithner, has been working, and the Fed in general have been working with many of the financial institutions to help create just such a clearinghouse mechanism.  I think that would be one of the things that I think are important in going forward to help standardize products, make them more transparent, and provide market mechanisms, if you will, to protect the system, and clearinghouses are one way of doing that.

BLINDER:  Who's next?  Right here in the center.  A microphone is on the way.

QUESTIONER:  Tim Ferguson with Forbes.  You nodded to the proper responsibilities of fiscal policy.  Is the borrowing level, and ultimately in some sense the solvency of the Treasury, of concern to the Federal Reserve?

PLOSSER:  The solvency of the Treasury is not a particular concern to me.

QUESTIONER:  I was hoping you would answer that.

(Laughter.)

PLOSSER:  Nor are the borrowing levels of the Treasury at this point a particular concern to me.

BLINDER:  Yes, Ben.  Right here in front.

QUESTIONER:  Ben Steel, Council on Foreign Relations.  A follow up on that question.  Many months ago Chairman Bernanke gave congressional testimony and it caused some hilarity when a congresswoman mistook him for the Treasury secretary.  (Laughter.)  Fast-forward to today and perhaps some people could be forgiven for confusing the two.  Their roles seem to have been blurred very significantly.  It's often not clear in the market interventions exactly whose balance sheet is being used, the Treasury's or the Fed's, and whose should be used.  Could you give us some insights into what is going on in terms of who is intervening on whose balance sheets, and what you think should and should not be done?

BLINDER:  An easy question.

(Laughter.)

PLOSSER:  Excuse me while a take a drink of water.   The Fed has limited powers, congressional authority, to make fiscal policy decisions in terms of creating a debt for the taxpayer.  That's the way the Federal Reserve Act is written.  It's intended to work that way and it should work that way.  I think in times of financial crises and turmoil, as we've seen, it becomes very important for both the Fed and the Treasury to communicate effectively about who's doing what under what auspices and what's appropriate and what's not appropriate.

One of the important steps, I think, of the recent congressional action on the TARP, as they call it, is that I think what's critical there is that the problem we face in financial markets has grown in a way that the sort of one-off actions and attempts to stabilize and provide liquidity to individual markets has risen to a level and a challenge that those actions, by themselves, may not be sufficient to address the problems.  Now, I think it's important that both Congress and the Treasury understand that if we are to do and deal with this problem in a more systematic way, that it's not -- it needs to go beyond the Fed trying to fix that.  It needs to be a concerted action by the legislators, the administration, and the Treasury secretary.  And I think -- that's why I think that it's important that this step was taken to try to recognize that distinction.

BLINDER:  On the back center there.  The gentleman -- yeah.

QUESTIONER:  Hi.  Arez Clearhan (ph) Partners.  Just to follow up on that question, what limits, if any, do you believe there should be to the degree to which the Fed should extend its own balance sheet to address the liquidity problem in the financial markets?

PLOSSER:  Well, I think it depends on how you think about what that is.  I think we don't want to extend our balance sheet to the point where we try to create -- or as some people have either suggested or worried about -- that we inflate our way out of the problem.  I think that's not the right solution.  We've been doing a lot of interesting things with our balance sheet, trying to address market functioning in various areas to provide liquidity.  I think we will continue to try to do that in areas where we think it's appropriate.  But we will not, nor should we, abandon the discipline of saying -- one of our dual mandates is to provide price stability.  We cannot throw that out the window and expand our balance sheet to the point where we put that objective clearly at risk.  That would be a very costly way to think about the solution.  And it really doesn't solve the problem, when it comes down to it.

BLINDER:  A quick follow up on that, if I may?  Not so very long ago, before things really, really got out of hand, the Fed -- the size of the Fed's balance sheet was around $800 billion or 850 (billion), or something.  Somebody told me just the other day that it's now $1.3 trillion.  Is that right?  And what's on the right-hand side?

PLOSSER:  I don't -- that number -- I haven't looked at it.  (Laughter.)  I mean, they're changing by the day.

(Cross talk.)

BLINDER:  -- your point about blowing up the balance sheet --

PLOSSER:  Right.

BLINDER:  -- exactly that point.

PLOSSER:  Right.  The balance sheet has grown.  One of the ways the balance sheet has grown is through the Treasury's special purpose vehicles where -- those of you who don't understand the Fed's balance sheet very well, and there are times when you look at it and it's hard to figure out what it's saying -- but one of ways that the Fed's balance sheet has grown, aside from some of the loans and discount window, is -- most of you probably know that the Fed is the Treasury's banker.  We provide the checkbook for the U.S. Treasury.  The Treasury, in normal times, carries a balance, if you will, in its checking account.  That balance is made up of Treasury bills, for the most part, and it runs -- that's their checking balance, if you will.

One of the things the Treasury has done in the last several months is to create -- give the Fed some flexibility, if you will, increase its balance sheet by keeping more deposits in its checking account.  That's one way in which the balance sheet has in fact grown.  What that means is it gives the Fed a greater pool, if you will -- in some sense Treasury bills -- when it goes and does its open-market operations to swap for other things in order to offset some of the effects of our lending.  So that's one way in which the balance sheet has grown in a somewhat unusual but not unprecedented way.

BLINDER:  Thank you.  Questions?  We'll go right over here -- this gentleman right here.

QUESTIONER:  I'm Richard Weinhardt (sp).  There's been an enormous amount of discussion over the last 15 years about the globalization and interconnectedness of our financial system, but your remarks so far and the actions not only by the U.S. authorities but by other authorities seem to all have been national with very little apparent coordination. Could you discuss why that is and the wisdom of it?

PLOSSER:  Well, as Alan asked in his first question, it depends on what the objectives are.  I don't think that for the objective of maintaining domestic price stability, that it's anything other than a domestic issue.  Inflation is still created at home.  As long as you're operating in a flexible exchange rate regime, you know, inflation is a choice individual countries make about their own currency.

On the financial side, on the turmoil in regard to financial markets and the lender of last resort function in providing financial stability, the issues become a lot more complex.  You have different regulatory structures in different countries.  You have -- even within the ECB, for example, the regulatory environment for different countries within the ECB are different.  And so various countries face very different challenges, both in terms of what their legislative responsibilities are and their capabilities to deal with some of these things.  So it creates a lot of complexity and difficulty, and in some sense will require some independent action by its very nature.

So I think that's the nature of the beast in some way.  In other ways I think, as happened this morning, there are times when some central banks do cooperate.  Our ability to work with the ECB in particular on the swap lines we've created for them to provide dollar funding in Europe are very active ways in which central banks cooperate with one another to face some of the challenges that they face, with realistic recognition of sort of what the limits that their individual constitutions provide them with.  So it's a challenge, and I think that certainly Chairman Bernanke and the people of the Fed have the phone numbers of every major central bank in the world, and they do talk to one another on a fairly regular basis, and they talk about what actions they're taking and why, and how to coordinate what they're doing, or what the ramifications might be for one country versus the other.  Particularly over the past year that's been a pretty active discussion.

BLINDER:  Who's next?  Right over here, the gentleman with his hand up.

QUESTIONER:  Thank you.  Andy Lance, Gibson Dunn.  Returning to the question of differentiation between the Treasury and the Federal Reserve, the TARP bill that you referred to, that requires Treasury to buy --

PLOSSER:  If anyone doesn't know, the TARP is the Troubled Asset Relief Program, the $700 billion so-called bailout or rescue, whatever you want to call it.  Go ahead.

QUESTIONER:  It requires Treasury to buy assets from institutions that the Fed regulates, and an expanding pool of institutions that the Fed is going to regulate, and those purchases are going to have a significant impact on the capital base remaining, once we see what the proceeds are.  How do you view the process of pricing of these purchases to happen in terms of a balance of regulatory authority between Treasury and the Fed in guiding that pricing process?

PLOSSER:  I'm not sure whether it's appropriate for me to comment very much on that except to say pricing is clearly a key piece of this program, and how that pricing is done is critical.  It will be done by the Treasury.  I think it's fair to say -- legitimate to say that clearly the Fed has a lot of economists on staff.  People have fought hard about auctions and other types of mechanisms.  We certainly are more than willing and provide sort of technical support and help, and have been, in thinking about how to do some of this stuff.  I don't think at the end of the day any of that has been finalized.  People are working both in Treasury and in the Federal Reserve banks very diligently on trying to come up with the right mechanism for doing that.  But at the end of the day, Treasury is going to make the decision in terms of what mechanism they choose to implement.

BLINDER:  Others?  Yes, right there.  This woman right there by the post.

QUESTIONER:  Thank you.  Carol O'Claricon (sp).  We've set up our central bank so that there is regional representation sitting around the table, and so I want to ask you how you think the economy is doing and what view you bring to the table from the point of view of Philadelphia -- the Philadelphia city, the Philadelphia region, and is that significantly different from your experience with representing New York or San Francisco or other parts of the country.

PLOSSER:  Well, clearly the role of the district banks, particularly when it comes to monetary policy, is to bring not only an independent view of not just the economy in their regions but also in independent view of policy -- their research staff, in thinking about appropriate policy.  And part of, if you will, the mosaic that goes in in shaping policy decisions is information about the various regions of the economy.  I represent the 3rd District, which is Philadelphia.  Geographically it's a relatively small district, but economically it's not particularly small.

BLINDER:  It includes Princeton, New Jersey.

PLOSSER:  Includes Princeton, New Jersey.  Alan calls me at least once a week.  (Laughter.)

And each of us, whether it be myself in the 3rd District or Janet Yellen in San Francisco in the 12th District -- the U.S. economy is not uniform.  You know, they have different problems in different parts of the economy, different parts of the country.  Geographically some areas of the country are suffering, in greater economic turmoil than others, particularly from the housing market.  Interestingly enough, the 3rd District, where I'm from, we haven't seen near the housing problems that we see in Las Vegas and Southern California and Florida.  It's just different, okay?  And it's very important when we discuss the economy that each of us bring some perspective about what the economy looks like down in the trenches.  And my role -- one of my roles is to sort of share that view with my colleagues.

And the other thing, I'm interested in listening to what is going on in their districts, and that all becomes part of the picture that gets painted of how the economy is doing.  I think that's a very valuable role because it brings texture, it brings, you know, if you will, "Main Street" to the table in talking about how companies and businesses and the economy is doing in very different districts.  But even within some of the bigger geographical districts it's very unevenly distributed in this episode.

So that's an important part of what we do, an important part of learning how the economy is really doing, more broadly speaking.  You think of the -- you can imagine during the period where commodity prices were rising very rapidly and oil was rising very rapidly and corn was big -- you know, the Midwest was doing just fine for the most part, for example, or is much stronger than Southern California or Las Vegas where you had had the largest run-up in housing prices and the related largest drop as well.  So there is a lot of differences -- geographic differences across the economy, and the challenge is always to put those pieces together to try to get a better understanding of exactly how the economy as a whole is doing because monetary policy, at the end of the day, affects the whole economy, not just individual regions.  And we have to take that into account.

And that's my argument or my discussion in my talking points about, you know, different parts of the country, different regions or different sectors can be hit by shocks that are very difficult to manage, okay, where others are not, and how do you think about national policies to deal in some cases with very different, you know, experiences in different parts of the country or in different sectors.  So it's a very -- but that's an important role and something that we talk a lot about.

BLINDER:  Well, we could go on forever but I know half the people in this room have to get out of the room and change their positions in the derivative -- (audio break) -- (laughter) -- and a bunch of us have to get to the council board meeting.

I'd like to thank the audience for a really stellar bunch of questions, making for a very illuminating session.  I especially would like to thank Charlie Plosser for spending so much time handling so many questions -- (applause) -- with such intelligence and frankness.  Everybody in this room -- and it's a sophisticated audience -- has learned something today, including that the Federal Reserve of Philadelphia is in good hands.  Thank you very much.

PLOSSER:  Thank you.  Thank you, Alan.

.STX

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