Investing.com -- In a speech at the Seventh Annual Women in Macro Conference, Federal Reserve Governor Lisa D. Cook gave an assessment of the stability of the U.S. financial system. Cook discussed the integration of financial stability issues into mainstream macroeconomic research and highlighted the importance of financial stability for the objectives of the Federal Reserve, which include full employment, stable prices, a safe banking system, and an efficient payments system.
Financial stability is defined as the ability of banks, other lenders, and financial markets to provide the financing necessary for households, communities, and businesses to invest, grow, and participate in a well-functioning economy, even in the face of adverse events. Financial instability arises when vulnerabilities such as asset bubbles, excessive leverage, liquidity mismatches, or interconnected exposures build up to a point where they can amplify shocks and threaten the functioning of the broader economy.
Cook applauded advances in incorporating financial stability into macroeconomic models, which have enhanced understanding of financial market functioning and its impact on the economy. She also noted the historical evolution of macroeconomic research and its relationship with financial stability, from the 1800s economic orthodoxy of Say’s law, through the Great Depression, post–World War II era, and up to the Global Financial Crisis.
The Fed Governor pointed out that the Global Financial Crisis highlighted the deep intertwining of the financial system and macroeconomic dynamics, leading to an explosion of research on financial stability and financial frictions. In recent years, macroeconomic research has continued to incorporate important financial stability aspects, such as endogenous leverage and bank runs.
Central banks worldwide routinely monitor the financial system for risks, as financial crises can lead to severe recessions. The Federal Reserve’s work in this area includes a framework for monitoring and assessing vulnerabilities, as outlined in its semiannual Financial Stability Report (FSR). The most recent FSR, released last month, distinguishes between shocks, which are adverse events that are difficult to predict, and vulnerabilities, which are aspects of the financial system that can amplify stress.
In her speech, Cook provided an assessment of the most recent FSR, noting that despite recent financial market volatility, businesses and household finances are generally in solid shape. Most households are able to service their debt, and overall household debt relative to GDP has declined over the past five years. However, there are signs of stress among borrowers with subprime credit scores, including many low- and moderate-income households.
The Fed Governor also discussed valuation pressures in property markets, financial system leverage and funding risks, and the decline in market liquidity. She touched on the volatility in asset prices in April, noting that large asset-price declines can trigger self-reinforcing feedback loops if there is excessive leverage or liquidity mismatches in the system.
Cook concluded her remarks by highlighting several research areas that would be helpful for policymakers, including the development of macroeconomic models that determine financial risk endogenously, the shifting interaction between banks and nonbanks, and efforts to incorporate private credit and private equity into macroeconomic models. She encouraged researchers to take up the challenge of developing new tools and approaches for better characterizing the evolving macro-financial reality.
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