Federal Reserve & Interest Rates

Frederic S. Miskin, member of the Federal Reserve Board of Governors gave a speech Friday discussing the financial instability of our nation and the reasoning behind actions that the Federal Reserve has taken both historically and recently.

Miskin explained e responsibility of the Federal Reserve in response to financial instability. He says, “The interest of the Federal Reserve in financial stability does not arise out of a concern for the functioning of financial markets as such or out of a desire to aid distressed investors or institutions. Rather, the Federal Reserve vigorously promotes financial stability because of the intimate connection between a stable financial system and solid macroeconomic performance. The financial system, comprising financial markets and institutions, channels funds to those individuals or firms that have productive investment opportunities.”

According to Governor Mishkin, there are four main ‘shocks’ that can at as ‘catalysts’ in financial instability.

• sharp increases in interest rates
• the deteriorating of corporate and household balance sheets
• weakened financial intermediaries
• problems in the banking sector

“Central banks typically inject liquidity into the system via the banking sector, but the intent is clearly to have the liquidity spread from there…injections of liquidity have the potential to directly address the causes of financial instability and therefore to counteract the pernicious effects of financial instability on broad macroeconomic conditions.”

He went on to discuss financial crisis in the past mentioning issues including the Panic of 1907 and the Stock Market Crash of 1987. He cited methods and examples of the efforts of the Federal Reserve to provide liquidity to the financial system.

While discussing the financial instability that currently faces our nation, Governor Mishkin stated, “Although the provision of liquidity is undoubtedly a useful tool, it is not without potential costs.” He went on to explain that this type of action might create and incentive for banks to increase the amount of investment risks that they are willing to take on. If similar actions are improperly handled, it can lead to further financial instability. The Federal Deposit Insurance Corporation Improvement Act of 1991 limits the lending ability of the Federal Reserve to troubled banks to keep that kind of moral hazard from occurring.

With all of that said, there is still a 50/50 chance that there will be another rate cut this week. The FOMC meets at the end of this month and investors and economists are still wondering what the Federal Reserve will do next. Is this speech a foreshadowing of another drop in rates as a move of the Reserve to increase financial stability? Or is Governor Mishkin saying that further moves to help the troubled markets at this time would cause moral hazard? In just a few more days we shall see if there will be any further moves.