Friday, October 26, 2007

Mishkin on Financial Instability (10/26/07)

Governor Mishkin gave a speech today on "Financial Instability and the Federal Reserve as a Liquidity Provider." In it, he reviews the history of financial panics with only passing reference to current credit market problems. He makes no mention of current economic conditions or monetary policy.

He does, however, refers for a second time to a paper he wrote ten years ago on "The Causes and Propagation of Financial Instability: Lessons for Policymakers" (pdf). He last referred to this paper in a speech on Sept 10th, eight days before the Fed surprised the market with a 50bp cut.

The paper concludes with a review of how the Fed should respond to financial instability:

One problem in deciding whether to engage in the lender-of-last resort role is to recognize that for it to be effective, it has to be implemented quickly. Less intervention is required the faster the lender-of-last-resort role is implemented....

However, the need for the lender-of-last-resort action to be quick does mean that central banks may not be able to wait until all the information is in that tells them a financial crisis is about to occur or is occurring. To wait too long to implement a lender-of last resort policy could be disastrous.
Given that credit markets have not returned to normal since the 50bp cut on Sept 18, my guess is that Mishkin will be arguing for another 50bp cut on Oct 31. I doubt, though, that the rest of the FOMC will go along with him.

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