Fed Governor Mishkin gave a speech (on Nov 5, 2007) titled Financial Instability and Monetary Policy at a New York conference. In his speech he explains the role of Fed and explains why Fed cut its policy rates (despite the criticisms).
The broad idea is Fed believed the ensuing financial instability could lead to severe slowdown the economy. He explains what is financial instability and how it effects macroeconomy.
The root cause of financial instability is worsening of information asymmetry in financial markets (explained here). This leads to two kinds of risk:
The first is what I will refer to as valuation risk: The market, realizing the complexity of a security or the opaqueness of its underlying creditworthiness, finds it has trouble assessing the value of the security……
The second type of risk that I consider central to the understanding of financial stability is what I call macroeconomic risk–that is, an increase in the probability that a financial disruption will cause significant deterioration in the real economy. Because economic downturns typically result in even greater uncertainty about asset values, such episodes may involve an adverse feedback loop whereby financial disruptions cause investment and consumer spending to decline, which, in turn, causes economic activity to contract.
Mishkin explains that Fed cannot do anything about the first risk but has to minimise the second risk which could disrupt the entire economy.
He explains Fed’s mandate really well:
Originally, the preamble to the Federal Reserve Act of 1913 stated that the Federal Reserve System was created “to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”
Later, in 1977, the Congress amended the act to introduce macroeconomic objectives explicitly. Accordingly, it stated that “the Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Because long-term interest rates can remain low only in a stable macroeconomic environment, these goals are often referred to as the dual mandate–that is, the Federal Reserve seeks to promote the two coequal objectives of maximum employment and price stability.
As financial instability could increase macro risk, “Fed has a clear interest in promoting the stability of financial markets.”
He then explains how monetary policy can influence financial instability and thereby lower macrorisks:
I noted a moment ago that periods of financial instability are characterized by valuation risk and macroeconomic risk. Monetary policy cannot have much influence on the former, but it can certainly address the latter–macroeconomic risk. By cutting interest rates to offset the negative effects of financial turmoil on aggregate economic activity, monetary policy can reduce the likelihood that a financial disruption might set off an adverse feedback loop.
He defends the rate cuts and says the idea was not to promote excessive risk taking (or increase moral hazard) but lower financial instability by addressing macro risks. The companies are still paying for their poor decisions (Merrill, Citi etc.) he however doesn’t name them) by taking on higher valuation risks.
So that is the broad idea. The analysis and defending Fed’s move is pretty nicely done.
Nonetheless, I still think it is a cover-up job. By retorting to jargons, Mishkin has explained and justified but it doesn’t really help. Valuation risk and macro risk are related concepts and according to me both go in tandem. By addressing macro risks, Fed also helps lower valuation risks. As rates decline, lenders and borrowers gain confidence and activity increases in financial markets. The distressed borrowers renegotiate their loans and this helps lenders free more of their capital leading to more loans and so on.
The thing is rate cuts have helped wall street (Mishkin denies it though) lower their losses. They would have made much bigger losses if Fed did not cut rates and may be we would have seen some complete collapse of some reputed financial firm.
The central message from this crisis is that Central Banks might just have to rethink their roles. They just can’t hang on to the inflation/price stability role most have been advocating.