The Long-Run Imperatives of Monetary Policy and Macroprudential Supervision.

• Author: Hoenig, Thomas M.

As central banks have come to dominate financial markets, the debate over their ability to deliver strong, long-run economic growth has become increasingly intense. "Central Banks and Financial Turmoil" is the theme of this conference, and given the dramatic expansion of central bank balance sheets and their influence over economies, it is a topic well worth our attention. I congratulate the conference organizers for their foresight in selecting it.

I will focus my remarks this morning on two areas on which central bank performance is judged: monetary policy and macroprudential supervision. While a host of factors determine an economy's strength, these two policy instruments have come to play a dominant role in our economy, and their role going forward is a major subject of attention. I will suggest that monetary and regulatory policies have for some time been overly focused on short-run effects at the expense of long-run goals, which has unintentionally served to increase uncertainty and economic fragility. Future success requires that policy move deliberately toward a more balanced long-run objective.

Monetary Policy

The dual mandate for U.S. monetary policy, established by Congress, is to "maintain long-run growth of the money 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." (1) In reading this mandate, you might note the emphasis on long-run effects. As a colleague once described it, "central bankers should take care of the long-run so that the short-run can take care of itself."

In a world of discretionary policy, when the moment comes to choose between long-run goals and short-term effects, policymakers experience enormous pressure to choose the more expedient short-run solution, deferring to another time concern with long-run implications.

This tendency can be seen in the long-run trends of short-term interest rates. Figure 1, for example, shows the real fed funds rate from 1960 to August 2016. For comparison, the chart also shows the average real GDP growth rate of near 3 percent for that period. It is noteworthy that the real fed funds rate was below the average real GDP growth rate for nearly 80 percent of the time, and it was negative for over 30 percent of the time. Also noteworthy, the real fed funds rate averaged only 0.9 percent from 1991 to 1995, 0.2 percent from 2001 to 2005, and minus 1 percent or lower from 2008 through 2015. Regardless of what one deems the appropriate U.S. monetary policy to be, it was--except in the early 1980s--decidedly directed toward lower interest rates.

Regulatory Policy and Macroprudential Supervision

Turning to macroprudential supervision, its objective might best be described as that of assuring the integrity of financial institutions, sound markets, and a reliable payments and intermediation framework. Carrying out this mandate involves an extensive program of rules and supervisory oversight designed to achieve long-run financial stability, credit availability, and stable economic growth.

As with monetary policy, authorities have discretion as to how they carry out the supervision mandate, which has led to different degrees of oversight over time. For much of the quarter century prior to 2008, for example, there was a systematic easing of constraints on bank activity and, most notably, an extension of the public safety net to an increasing number of nonbank financial activities conducted by both banks and shadow banks. Commercial banks were given authority to engage in investment banking, trading, and broker-dealer activities, while investment banks and other financial firms were permitted to engage in a host of bank-like activities. (2)

While the safety net was broadened over this period, capital requirements were allowed to weaken, exacerbating the downward effects on stability. (3) Figure 2 shows that, from 2001 through 2008, equity...