Lorie Logan, president of the Federal Reserve Bank of Dallas, suggested that the Fed should reconsider how it approached increasing interest rates to avoid triggering .
Moderating a May 16 panel discussion at a conference held by the Atlanta Fed, Logan noted that global central banks, in their quest to tame inflation, had over the past two years "raised interest rates at the fastest pace since the 1980s."
"And we've seen repeated financial stresses, including … the recent stresses in some U.S. banks," she added.
The remarks come as rapid interest rate increases combined with bank mismanagement and the failure of regulators, including the Fed, to recognize danger resulted in the closure of multiple banks.
Many banks had bought long-term assets — Treasurys and mortgage-backed securities — when interest rates were low. Under available accounting rules, they classified many of these holdings in the category of held-to-maturity, or HTM. The designation would allow them to recognize the full value of the assets because, over the lifetime of the investments, they would eventually receive the full-face value.
However, on open markets, those value were no longer available as interest rates rose. No one would pay full price when they could purchase a newer bond at yields that has grown with rates. Any seller of older bonds would have to discount them to provide an effective yield equal to what was currently available. The dynamic is the basis of the rule of thumb that yields and bond prices move inversely to one another.
Should a bank experience a high volume of deposit withdrawals and not have enough liquidity to enable them, the institution would then have to either borrow to cover the deposits or sell assets. The latter would be fine, except that if the assets for sale included HTM bonds, their categorization would change to available for sale (AFS), at which point they would be marked to market, suddenly worth far less than the face value.
As bank regulators as well as managers of monetary policy, a question facing the Fed, according to Logan is, "How to design monetary policy strategies that mitigate financial stability risks, but still achieve the appropriate macroeconomic goals."
As Logan currently sits on the Federal Open Market Committee, hers is one of the voices that votes on rate-setting decisions.
"We can think of designing monetary policy strategies to mitigate financial stability side effects," Logan said on the panel. "I don't mean examining how monetary policy strategies can trade off achievements of macroeconomic and financial stability goals, but rather the challenge is to set monetary policy in a way that mitigates financial stability risks but still achieves the macroeconomic goals."
More specifically, the Fed has to consider "how fast rates rise, the level they reach, the time spent at that level, and the factors that determine further increases or decreases." These are the "levers" the organization can "can conceivably be arranged to maintain the restrictiveness of policy while reducing financial stability side effects."
Logan, who said that she was speaking for herself and not the Fed as a whole, advocated for "gradual policy adjustments" because overall financial conditions can make sudden sharp moves that damage the economy.
The risk "can be mitigated by raising interest rates in smaller, less frequent steps while using other dimensions of monetary policy to maintain restrictive financial conditions," Logan said.
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