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Dynamic concept Monetary policy U. S.

Decoupling control and financial stability

For the Fed, there are two mandates – maximizing employment and maintaining price stability. In the aftermath of 2007/2008 financial crisis, promoting financial stability is becoming the third de facto mandate for the Fed.

In the language of System Theory, the Fed is in the supervisory role of a multiple-input-multiple-output (MIMO) control system. In designing a MIMO control system, one of the challenges is the coupling between control inputs and system outputs – one control variable can affect the changes of more than one outputs, and an evolution of one output can affect the dynamics of other outputs.

Monetary policy, the Federal funds rate in particular, is one of the main control inputs. Lowering the funds rate can accelerate economic growth and increase employment; however, low interest rate could increase the chance of inflation, promote risk-taking and affect financial stability. As Fed chair Yellen pointed out, “… monetary policy has powerful effects on risk taking … But such risk-taking can go too far, thereby contributing to the fragility in the financial system” ([1]). The introduction of financial stability increases the difficulty if monetary policy being the only control input.

One of control approaches to MIMO systems is via decoupling – control logic is designed such that one control input only affects one output. For the Fed, decoupling is achieved through finding another control input primary to be used to ensure financial stability, while monetary policy remains to focus on price stability and full employment. The new control input is called macroprudential policy such as supervisions and regulations, as outlined by Fed chair Janet Yellen ([1]). The approach has been formed in responses to the financial crisis and now has reflected in a number of laws and regulations.

The Fed members recently warned of the possibility of excesses in asset markets but concluded that, at least for now, if there is a need to act, it will rely on macroprudential policy tools to reduce systemic risk, and will not raise interest rates. At present weak labor markets remains to be a deep concern ([3]) and therefore maintaining low interest rates is approperiate.

In summary, the introduction of macroprudential policy for financial stability shall provide assurance that interest rates and other monetary policies can stay accommodative in order to further improve employment and promote price stability.

References:

[1] Janet Yellen, Monetary policy and financial stability, Remarks at the 2014 Michael Camdessus Central Banking Lecture International Monetary Fund, Washington, D. C. , July 2, 2014.

[2] Martin Feldstein and Robert Rubin: The Fed’s Systemic-Risk Balancing Act, Wall Street Journal, August 2014.

[3] Janet Yellen, Labor markets dynamics and monetary policy, Speech at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, August 22, 2014.

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