Fed Leaders Downplay Risks from Central Bank Policies

WASHINGTON — Two senior Federal Reserve officials at the heart of U.S. monetary policy decisions weighed in on the effects of historically low interest rates in separate speeches Monday.

Federal Reserve Bank of New York President William Dudley, in a speech before the New York Economic Club, warned that regulators will need to keep a close eye on the impact a spike in interest rates could have on the U.S. economy. In separate remarks to the London School of Economics, Federal Reserve Board Chairman Ben Bernanke suggested that "accommodative" monetary policies are not significantly affecting international exchange rates.

Dudley said steps by supervisors should include monitoring banks' exposure to duration risk — which can build up during periods of low rates — as well as the quality of their risk management and capital planning. Regulators should also be examining areas outside the traditional regulatory scope — often referred to as the "shadow banking" system — for such risks, he added. For example, he said, "ongoing attention" should be placed by supervisors on agency mortgage real estate investment trusts — or REITs — and the risk of outflows from bond mutual funds.

"The regulatory community must continue to take steps to mitigate the vulnerability of the economy to a sharp rise in long-term rates," Dudley said.

He also addressed a number of frequently-aired concerns related to the Fed's exit strategy from its current set of monetary policy actions. Many observers anticipate there could be a slew of negative consequences once the Fed decides to sharply lift the federal funds rate, which has remained at a consistently low level. But Dudley said it is too soon to have that debate.

"It's premature to spend much time focusing on exit when we have not yet secured a sustainable economic recovery," he said. "That's putting the cart before the horse in my opinion."

Their comments came less than a week after officials from the Federal Open Market Committee agreed to keep short-term interest rates near zero, a decision it has maintained since December 2008. The central bank also agreed to continue to buy $40 billion in mortgage-backed securities and $45 billion in Treasuries each month for the foreseeable future to help push long-term interest rates even lower.

Observers of Fed policy often cite three concerns: that a large amount of excess reserve now in the banking system could help drive up inflation, the Fed's policy amounts to a subsidy for banks and that a tightening of its policy — whenever that is — will lower remittances to Treasury.

But Dudley tried to dispute that criticism.

For example, he said, the ability of the Fed to pay interest on excess reserves does not unduly help the financial services industry, but rather it allows officials to "control the credit creation process and prevent an upsurge in inflation."

"IOER is not a subsidy to the banks," he said. "In attracting deposits or other liabilities, competition among banks will ensure that higher interest payments to banks on their reserves will be passed through to bank liability holders."

Instead, he said, beneficiaries will be depositors who have not been able earn extra income on their savings because of the Fed's ultra-low rates.

"When we raise the IOER, it will be my mother and my mother-in-law and others like them, not bankers, who will mainly benefit," said Dudley.

On the other side of the Atlantic, Bernanke addressed a separate challenge facing policymakers: whether current easy monetary policy strategies by central bankers across the globe are creating a competitive depreciation of exchange rates.

"With inflation generally contained, central banks in these countries are providing accommodative monetary policies to support growth," Bernanke said. "Do these policies constitute competitive devaluations?"

Bernanke argued the effects have been limited. "To the contrary, because monetary policy is accommodative in the great majority of advanced industrial economies, one would not expect large and persistent changes in the configuration of exchange rates among these countries," he said.

Bernanke said the Group of Seven central bankers and finance ministers issued a statement in February agreeing, he said, to "refrain from actions focusing on achieving competitive advantage by weakening their currencies."