The FSB report10 was released in July and Governor Powell11 has recently described the Federal Reserve’s plans to support the two primary components of the reform of LIBOR. First, we are considering, in cooperation with the LIBOR administrator and other members of the official sector, ways to broaden the definition of LIBOR to more adequately represent current patterns of bank funding and to anchor it more firmly in observable transactions. Second, we believe it is important for market participants to have access to a range of appropriately created and governed reference rates that best suit their particular business needs. For example, some activities such as interest rate derivatives might be better served with a risk-free or near risk-free reference rate, rather than one that embeds a bank credit risk component. I would like to emphasize three points in support of the FSB recommendations and our own efforts. First, the FSB recommendations make clear that there is not one single path for all jurisdictions to achieve the common objective of more robust and resilient reference rates. Rather, each jurisdiction must take into account its own specific institutional, legal and market practices and arrive at its own best solution. In the U.S., I believe it is important to identify alternative reference rates that are grounded in a strong governance framework as laid out in the IOSCO principles and that are supported by market transactions.
The second view is to “lean–against–the–wind”, i.e. that as price stability may not be sufficient for financial stability, central banks should lean against the emergence of financial imbalances by tightening the monetary policy stance over and above the level necessary to bring inflation back to target over a policy horizon that is generally understood to be around two years. The third view is that “financial stability is price stability”. Proponents of this view advocate a more radical change in the objective of monetary policy, arguing that financial stability and price stability are so intertwined that one cannot distinguish between the two.3 Under this view, both standard and non-standard monetary policies are in the first place attempts at stabilizing the financial system, addressing malfunctioning financial markets and smoothing the monetary transmission process. While all these viewpoints recognise the important interplay between financial stability and monetary policy in pursuit of price stability, their relevance ultimately depends on (i) the weight to be attached to the “risk-taking” channel of monetary policy, (ii) the strength of the macroprudential framework and (iii) the policy strategy of the monetary authority, especially as regards its policy horizon. The risk-taking channel Monetary policy contributes to financial stability by smoothing business cycles and anchoring inflation expectations. Monetary policy works through its effects on intertemporal substitution and risk appetite. By lowering risk-free rates, monetary policy increases the attractiveness of investments projects which would not have been profitable under tighter financing conditions.