WASHINGTON Federal Reserve Board Gov. Daniel Tarullo said Tuesday that the central bank should use alternative tools beyond monetary policy to mitigate risks tied to low interest rates.
The governor, who heads bank supervision at the central bank, stopped short of calling for the establishment of a third mandate for the Fed: financial stability. But he stressed the importance of folding those concerns into monetary policy decisions given their impact on price stability and employment.
Instead, he endorsed supervisors developing so-called time-varying policies that would help to address procyclicality, a key contributor to systemic risk.
"I would devote particular attention to policies that can act as the rough equivalent of an increase in interest rates for particular sources of funding," Tarullo said in a speech before the National Association for Business Economics. "Such policies would be more responsive to problems that were building up quickly because of certain kinds of credit, without regard to whether they were being deployed in one or many sectors of the economy."
Tarullo and other regulators have become increasingly concerned that a low interest rate environment could have an adverse effect on the financial system as banks "reach for yield," while also noting certain supervisory tools can be limited in their ability to capture all of the potential risk.
"The worry is that the actual extended period of low interest rates, along with expectations fostered by forward guidance of continued low rates, may be incentivizing financial market actors to take on additional risks to boost margins, thereby contributing to unsustainable increases in asset prices and a consequent buildup of systemic vulnerabilities," Tarullo said.
The Fed has kept its key interest rate to a range of between zero percent and 0.25% since December 2008, and while the central bank has started taking steps in the direction of easing back its stimulus program starting late last year, it has pushed off the possibility of raising rates into the distant future.
Even with some financial stability concerns, Tarullo held fast that the Federal Open Market Committee should maintain its current policy.
"I do not think that at present we are confronted with a situation that would warrant a change in monetary policy we have been pursuing," he said. "But for that very reason, now is a good time to consider these issues more actively."
One tool at U.S. regulators' disposal is a so-called countercyclical buffer under the Basel III rules, which the three banking agencies approved in July, that could help mimic the effect of lifting interest rates.
In theory, the buffer would force banks to raise capital when the system is not under stress, and allow requirements to decrease when there is heightened risk of losses. Under Basel III, the new requirement won't become effective until 2016.
The buffer, which calls for financial institutions to hold up to an additional 2.5% capital, would wind up increasing the cost of funding for credit.
"In this regard, time-varying macroprudential policies can be thought of as addressing cyclical systemic risks via interest rates in a manner somewhat akin to a tightening of monetary policy, which by raising benchmark interest rates affects a similar increase in funding costs," Tarullo said.
But such policies could not be viewed as a substitute for monetary policy, he said.
"They could potentially provide something of a speed bump, while not producing the much broader effect on the economy that a federal funds rate increase would," Tarullo said. "Moreover, time-varying macroprudential policies may also give monetary policymakers more of an opportunity to assess whether the asset inflation is generalized and sustained enough to warrant a change in monetary policy."
The Fed and other bank regulators have tried to address potential risks by issuing guidance on leveraged lending and underwriting standards. The central bank has also created the Large Supervision Coordinating Committee, of LISCC, to incorporate systemic risk considerations when it comes to its monetary policy decisions.
Through its annual stress testing exercise, the Fed has also been working with firms to strengthen their resilience to possible interest rate shocks. Tarullo said the next round of stress test exercises, in March, will provide regulators and markets with more insight into this effort.
But "ad hoc supervisory action" aimed at specific lending or risks, while "a useful tool," has "limitations," Tarullo said.