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Fed’s Stein Says Monetary Policy Must Consider Risk to Stability

Federal Reserve Governor Jeremy Stein said central banks cannot pretend that their policies have no impact on the stability of the financial system.

“There is no general separation principle for monetary policy and financial stability,” Stein said today in prepared remarks for a speech in New York. He was responding to a paper from Michael Feroli, the chief U.S. economist of JPMorgan Chase & Co., and three co-authors, arguing that the Fed’s eventual policy tightening risked causing financial market turmoil.

Stein’s response to the paper expands a debate on the Federal Open Market Committee over how to incorporate financial stability concerns into its policy framework. The discussion at the Fed, which is mandated by Congress to focus on unemployment and inflation, has arisen since the 2007-2009 financial crisis plunged the economy into the longest and deepest recession since the Great Depression.

“Monetary policy is fundamentally in the business of altering risk premiums such as term premiums and credit spreads,” Stein said. “So monetary policy makers cannot wash their hands of what happens when these spreads revert sharply. If these abrupt reversions also turn out to have nontrivial economic consequences, then they are clearly of potential relevance to policy makers.”

Stein said his remarks aren’t “a comment on the current stance of policy.”

Feroli and his co-authors -- Anil Kashyap of the University of Chicago, Kermit Schoenholtz of New York University’s Stern School of Business and Hyun Song Shin of Princeton University -- had correctly identified institutions without leverage as a potential source of risk to the financial system, Stein said.

“They are absolutely on target in emphasizing that the rapid growth of fixed-income funds -- as well as other, similar vehicles -- bears careful watching,” Stein said. “It would be a mistake to be complacent about this phenomenon simply because such funds are unlevered.”

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