- Federal Reserve Governor Frederic Mishkin said that U.S. banks can cope with ``stressful'' conditions and that the financial system is in ``good health'' even with the disruptions of the subprime-mortgage market.
``The overall financial system appears to be in good health, and the U.S. banking system is well positioned to withstand stressful market conditions,'' Mishkin wrote in the introduction to his paper presented to an annual conference in Jackson Hole, Wyoming.
The governor's comments echo Fed Chairman Ben S. Bernanke, who told the gathering yesterday that the world banking system is in a ``relatively strong position'' to deal with the effects of the subprime crisis.
Mishkin wrote that policy makers should avoid setting interest rates according to swings in the housing market and respond ``only to the extent that they have foreseeable effects on inflation and employment.'' At the same time, Fed models show the best policy in the case of a deep slump in prices would be to ``react immediately'' by cutting rates, he said.
``The federal funds rate is lowered more aggressively and substantially faster'' in the ``optimal response,'' according to the Fed's economic model, Mishkin said. In reality, policy makers face uncertainty about how housing affects the economy and must use their judgment to ``keep track of how well their policy is working'' and alter course as appropriate, he said.
Housing Theme
Mishkin didn't comment directly on the near-term outlook for the economy or interest rates in his 53-page paper. The conference, organized by the Kansas City Fed bank and the theme of which this year was housing and monetary policy, concludes today.
Bernanke said yesterday the Fed ``will act as needed'' to prevent the credit market rout from undoing the six-year expansion. Investors anticipate that officials will cut their benchmark rate at or before the Sept. 18 policy meeting. The Fed chief is Mishkin's former academic research partner.
Losses on subprime loans have made investors reluctant to finance riskier types of mortgages and slowed the pace of corporate-bond issuance, while liquidity in asset-backed commercial paper has ``deteriorated,'' Mishkin wrote. He noted the Federal Open Market Committee said in its Aug. 17 statement that risks to economic growth had increased ``appreciably.''
In his 53-page paper, Mishkin reiterated his view that central banks shouldn't raise interest rates to prick home-price bubbles. ``We do not have a firm understanding'' of how prices respond to rate changes or are determined in general, he wrote.
Managing Risk
Instead, a central bank can ``encourage financial institutions to have appropriate risk-management practices in place'' as house prices start to climb, he wrote.
The central bank can also reduce the chance of bubbles by enforcing ``prudential supervision,'' Mishkin wrote.
The U.S. central bank is now under fire by lawmakers, who blame policy makers for insufficient action to stem predatory lending practices during the mortgage boom.
Another Jackson Hole paper, presented yesterday, argued that Fed officials are missing the point when they talk about interest rates and asset prices.
Ed Leamer, director of an economic forecasting group at UCLA, said in his paper that central bankers should focus on housing investment because it is the ``most important sector in our economic recessions.''
Mishkin's paper indicates he is focusing on the question of whether the slowdown in U.S. home-price increases or a shift to declines ``has created a substantial risk of financial instability with adverse implications for macroeconomic performance.''
`Prudent' Approach
``Rather than try to pre-emptively deal with the bubble, which I have argued is almost impossible to do, a prudent central bank would be better advised to deal with adverse macroeconomic consequences as they emerge in the wake of any substantial decline in asset prices,'' Mishkin wrote.
The Fed governor stated in a January speech that central banks should take a hands-off approach to rising home prices. Bernanke has taken a similar tack in speeches and papers, dating back to his first appearance at the annual Jackson Hole conference in 1999 and repeated several times since becoming Fed chairman last year.
``Although I generally do not place the housing and mortgage markets close to the epicenter of previous cases of financial instability, I would note that the current situation in the U.S. could prove to be different,'' Mishkin wrote. Recent events show that ``under certain conditions the housing sector can be a source of financial instability.''
Computer Model
In another section of the paper, Mishkin discusses how Fed staff economists integrate housing projections into their computer model of the U.S. economy.
At the same time, he cautioned that central bankers shouldn't ``blindly'' follow recommendations stemming from such models. That's a ``dangerous strategy for monetary policy makers -- judgment is still a necessary element of our decisions,'' Mishkin wrote.
``Monetary policy will continue to be an art, albeit one that makes use of science,'' he said in the paper.
Mishkin, 56, was a Columbia University professor before joining the Fed's Board of Governors a year ago. He has attended and spoken at numerous Jackson Hole conferences, including the first gathering in 1982, when he was 31.
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