Board of Governors of the Federal Reserve System

December 15, 2023

The Third SNB-FRB-BIS High-Level Conference on Global Risk, Uncertainty, and Volatility: Monetary Policy and Banking Regulation under Elevated Uncertainty

Mohammad R. Jahan-Parvar, Juan M. Londono, Beth Anne Wilson, and Ilknur Zer¹

"Uncertainty—about the state of the economy, the economy's structure, and the inferences that the public will draw from policy actions or economic developments—is a pervasive feature of monetary policy making." - Ben S. Bernanke²

The Swiss National Bank (SNB), the Division of International Finance of the Federal Reserve Board (FRB), and the Bank for International Settlements (BIS) jointly organized the third High-Level Conference on Global Risk, Uncertainty, and Volatility on November 14 and 15 of 2023. The conference brought academics and policymakers together to discuss the many sources of risk and uncertainty under which monetary policymakers and bank regulators operate, recent advances in measuring the multi-faceted nature of uncertainty, and how policymakers respond to these challenges.³

Although, overall, uncertainty is now lower than at the onset of the COVID-19 pandemic, economic uncertainty around the globe remains high by historical standards. Even when most central banks have slowed or paused monetary tightening in the second quarter of 2023, uncertainty about inflation remains highly elevated, as FRB Vice Chair Philip Jefferson highlighted in his remarks at this year's conference. Moreover, as SNB Chairman Thomas Jordan mentioned in his opening remarks, inflation uncertainty is especially relevant at inflection points in monetary policy, when underlying conditions under which central banks must make decisions are highly uncertain. Among these uncertain conditions, one must obviously include rising geopolitical tensions, such as the Russian invasion of Ukraine and the war in Gaza, which loom over the global economy. Uncertainty over the last year also emanated from the banking sector, with the collapse of large financial institutions in the United States and Switzerland and the ever-growing relevance of nonbank financial institutions (NBFIs) posing challenges to banking supervision and regulation across the globe.

With this economic landscape in mind, this year's conference was centered on two main topics, the broader issues of policy making and communication in high-uncertainty scenarios and the challenges posed by uncertainty to the banking system. The format of this year's conference featured policy speeches by Vice Chair Jefferson and Chairman Jordan, two policy panels, the presentation and discussion of seven academic papers, and a keynote talk by Professor Darrel Duffie from Standford University.

The question of what policymakers should do when uncertainty is high was the focal point of SNB Chairman Jordan's and FRB Vice Chair Jefferson's remarks and of both policy panels.⁴ Chairman Jordan argued that, even when monetary policy is now at a different point in the tightening cycle, central banks' risk management approach, which is characterized by the principles of pragmatism, consistency, and determination, should remain the same. Policy participants highlighted the challenges of forward guidance when there are considerable levels of uncertainty in the economy. To be effective, monetary policy should affect expectations, making forward guidance an important communication tool. However, deviations from the guidance may cast doubt on the central bank's credibility and, thus, forward guidance should be viewed more as providing information about a reaction function rather than committing to a pre-set course. More uncertainty requires more flexibility, a data-driven approach, and the adaptation of models to rely on more recent data, without falling into the temptation of reacting to every data surprise. A recurrent topic among policymakers was the challenge of communicating data-dependent policy decisions as the path of monetary policy becomes more uncertain. Policymakers also stressed the need to broaden the set of tools at their disposal. For instance, Vice Chair Jefferson and several other conference participants mentioned that policy decisions under uncertainty should include scenario analysis; policymakers need to exercise judgment to determine whether monetary policy needs to change under the more-likely scenario.

Some of the academic papers presented at the conference focused precisely on the set of tools available to policymakers. Thomas M. Mertens, from the Federal Reserve Bank of San Francisco, and Stefania D`Amico, from the Federal Reserve bank of Chicago, discussed the effects of uncertainty on central bank reserves, which are increasingly viewed as another tool in the monetary policy tool kit. Mr. Mertens presented a framework to investigate the challenges of optimal central bank reserve provisions when the demand for these reserves is nonlinear and uncertain, concluding that central banks need to provide more reserves to the banking system under uncertainty than absent uncertainty. Ms. D`Amico discussed how the transition of central banks' balance sheets to a new steady state can create yet another layer of uncertainty. The authors of this study propose a new measure of Federal Reserve's balance sheet policy uncertainty and find that this uncertainty propagates to key financial and economic variables and its effects differ from those of other forms of policy uncertainty, including monetary and fiscal policy uncertainty.

Two papers centered attention on the transmission of monetary policy through financial markets and how this transmission interacts with uncertainty. Nicolas Caramp, from the University of California, Davis, and his coauthor explore up to what extent changes in the prices of real and financial assets play a relevant role in the transmission of monetary policy to the real economy. The authors develop a theoretical model that accounts for heterogeneity in beliefs across agents. The model generates conditions under which changes in risk premia affect asset prices but have no effect on output and inflation. Moreover, if there are notable levels of risky public debt in the economy, the main transmission channel of monetary policy may be through changes in risk premia. Daniel Ostry, from the Bank of England, and his coauthors look at the possibility that the increase in long-run risk in the U.S. economy might have implications for safe assets. Their aim was to reconcile the high U.S. equity premia relative to other G7 economies, the role of the U.S. dollar as the global currency, and the role of U.S. Treasury bonds as the global safe assets through a risk-based open-economy model. The authors document that an increase in the U.S. perceived permanent risk is associated with a fall in the convenience yield that foreign investors attach to long-maturity U.S. Treasuries. These results imply that the rise of U.S. long-run risk and fall in long-maturity Treasury convenience yields are intertwined.

The focus of Professor Darrell Duffie's keynote talk was the resilience and liquidity of the U.S. Treasuries market in episodes of high uncertainty. Professor Duffie mentioned the potential fragilities in the market, especially the deterioration of liquidity and market depth in March 2020 and the more general loss of dealer intermediation capacity since the 2008 Global Financial Crisis (GFC). Professor Duffie discussed remedial measures and policy recommendations to safeguard the liquidity in this market. His policy recommendations included official-sector market-function purchase programs, broader central-clearing mandates, central bank financing facilities, better transaction reporting, lifting exemptions to fair-access regulation of trade platforms, and a revision of the leverage-ratio capital requirement, without lowering system-wide capital.

Turning to the second main topic of this year's conference, panelists and academics highlighted the challenges for monetary policy related to the financial sector. This issue is critical because even though policymakers remain focused on meeting inflation targets, ultimately, financial institutions play a key role as the transmission channel for policy. Banking stresses in some countries over the last year clearly illustrated the relation between the uncertainty about the path of monetary policy rates and vulnerabilities in the banking sector. Moreover, the growth of NBFIs poses its own set of challenges, although policymakers viewed NBFIs as complementary to banks and as suppliers of additional funding to corporates and households. Well-developed NBFIs could strengthen financial stability by decreasing interconnectedness, systemic risk, and maturity mismatch inherent in bank-dominated financing by contributing to intermediation capacity and diversification. However, market-based financing poses its own set of risks, especially liquidity risk stemming from these NBFIs. Overall, policymakers provided a calming narrative on how the lessons learned from the 2008 GFC on regulation and supervision created a more stable and robust banking sector, while highlighting that, going forward, regulatory institutions should continue working on improving resilience with a special focus on NBFIs.

Several academic papers presented at the conference focused on the range of ways that uncertainty and risk can affect the banking sector and the interactions between the financial sector and monetary policy. Kalin Nikolov, from the European Central Bank, and coauthors investigate the issue of banking sector resilience when facing diverse shocks, through choosing the optimal level of bank capital requirements. In their framework, bank insolvency problems arise endogenously from the defaults of bank borrowers. They show that the optimal bank capital requirement would be moderately higher than the requirement suggested by standard bank default models that overlook the possibility of simultaneous borrower and bank defaults. Dmitry Kuvshinov, from Pompeu Fabra University, and coauthors study the stance of monetary policy and how it interacts with financial stability risks. They document the effects of monetary policy decisions on banking crises using data from 17 developed countries since 1870s and show that policy rate hikes increase banking crisis risk only if rates were previously low for too long. Linda Goldberg, from the Federal Reserve Bank of New York, and her coauthors broadly highlight the idea that different sources of uncertainty can change how banks behave, which could have implications for financial stability. They study the effects of trade tensions and uncertainty on U.S. bank lending and conclude that increased trade uncertainty has negative real effects for the economy as it is associated with reduced credit, affecting borrowers broadly, beyond the directly affected ones by trade tensions.

To summarize, risk, uncertainty, and volatility are terms commonly used, often mistakenly as synonyms.⁵ The global economy faces elevated inflation uncertainty, synchronized monetary policy tightening, increased geopolitical and climate risks, and stresses in some banking systems. This third conference brought academic and policymakers together to create a more robust, grounded empirical and theoretical understanding that uncertainty, risk, and volatility come from multiple sources, that it is important to clarify these sources and measure each type of uncertainty correctly. Moreover, the discussions at this year's conference added to our understanding of the channels through which risk and uncertainty are transmitted to the real economy and of how policymakers respond to and communicate about them.

References

Afonso, Gara, Gabriele La Spada, Thomas M. Mertens, and John C. Williams (2023). "The Optimal Supply of Central Bank Reserves under Uncertainty," working paper, Federal Reserve Bank of New York.

Caramp, Nicolas and Dejanir H. Silva (2023). "Monetary Policy and Wealth Effects: The Role of Risk and Heterogeneity," working paper, University of California, Davis.

Cascaldi-Garcia, D., C. Sarisoy, J. M. Londono, J. Rogers, D. Datta, T. Ferreira, O. Grishchenko, M. R. Jahan-Parvar, F. Loria, S. Ma, M. Rodriguez, I. Zer (2023). "What is Certain about Uncertainty," Journal of Economic Literature 61(2): 624-654.

Correa, Ricardo, Julian di Giovanni, Linda Goldberg, and Camelia Minoiu (2023). "Trade Uncertainty and U.S. Bank Lending," working paper, Federal Reserve Bank of New York.

Corsetti, Giancarlo, Simon Lloyd, Emile Marin, and Daniel Ostry (2023). "U.S. Risk and Treasury Convenience," working paper, Bank of England.

D'Amico, Stefania and Corey M. Feldman (2023). "Balance Sheet Policy Uncertainty and its Aggregate Implications," working paper, Federal Reserve Bank of Chicago.

Jiménez, Gabriel, Dmitry Kuvshinov, José-Luis Peydró, and Björn Richter (2023). "Monetary Policy, Inflation, and Crises: Evidence from History and Administrative Data," working paper,

Mendicino, Caterina, Kalin Nikolov, Juan Rubio-Ramirez, Javier Suarez, and Dominik Supera (2023). "Twin Defaults and Bank Capital Requirements," working paper, Bank of Spain.