The Atlanta Fed's 2023 Financial Markets Conference (FMC), Old Challenges in New Clothes: Outfitting Finance, Technology, and Regulation for the Mid-2020s, featured policy panels, academic paper presentations, and keynote speakers who discussed recent developments that have had a significant impact on the financial system. The conference's overarching theme was the idea that many of the issues confronting policy makers are not new but are just appearing in a somewhat different form. This Policy Hub: Macroblog post offers some highlights from the conference keynote speakers, policy panels, and academic paper presentations. More information on all of the sessions is available on the conference agenda page, which has links to the sessions' videos, papers, and presentation notes.

The conference had three keynotes with a headline speaker and a moderated keynote session with two Federal Reserve Bank presidents. These keynote talks addressed issues related to monetary policy and financial stability. The conference started with a keynote speech by Lord Mervyn King (you can see the video here video fileOff-site link), former governor of the Bank of England and former professor at the London School of Economics and New York University. Lord King focused on two topics of crucial importance to central banks: price stability and financial stability. He argued that in both cases central banks had fallen victim to a style of academic research that gives the impression that models can predict the future and, hence, tell us how to set policy. The main problem with this view, according to Lord King, is that the forces affecting the economy are always changing. He viewed this "radical uncertainty" as implying that although estimated models can provide useful insights into how the economy works, they are not literal descriptions of how the economy works. Instead, policymakers must combine key insights from models with an attempt to understand what is going on in the real world.

The next keynote speaker was Securities and Exchange Commission (SEC) chair Gary Gensler (written remarks and video video fileOff-site link), who focused on the SEC's role in helping to protect financial stability and promote markets that are resilient to stress. Gensler used the financial stability lens to frame a variety of SEC's proposals and actions, including those to reform the operation of the Treasury securities market, strengthen clearinghouse governance and use of service providers, require enhanced disclosure by hedge funds, address liquidity issues at money market and open-end bond funds, and enhance cybersecurity practices and reporting. He also expressed concern about whether existing regulatory regimes designed for an earlier era of data analytics would be sufficient for addressing the potential systemic risks associated with deep learning and generative AI.

Monday evening, conference participants saw a fascinating presentation titled "Florida (Un)chained" (paperOff-site link, presentation Adobe PDF file format, and video video fileOff-site link) on the Florida land boom of the 1920s by Charles Calomiris, the Henry Kaufman Professor of Financial Institutions at Columbia Business School. Calomiris observed that southern Florida was devoid of large cities until the 1910s, when the railroad was extended from Jacksonville in the north to Key West in the south. This extension led to a nationwide promotion of Florida as a place to buy and develop land, with 20 million lots put up for sale at a time when the US population was only around 40 million. Calomiris noted that buyers had limited information about what was happening in Florida, with no aggregate data on land sales or prices. In terms of financing this development, deposits flooded into Florida banks. While most banks were relatively conservative, at the core of risk-taking was a group of banks associated with the Manley-Anthony chain and partly owned by developers. Moreover, some key state and federal bank regulators who failed to vigorously enforce prudential rules had a financial interest in the chain banks directly or through the land boom they were financing. Calomiris's oral presentation noted that the boom eventually unwound, but his presentation's slides point to negative press starting in late 1925, railroad problems, and a hurricane in the Miami area as contributory factors.

The last keynote session was a discussion of current monetary policy issues by Atlanta Fed president Raphael Bostic and Chicago Fed president Austan Goolsbee, with the session moderated by New York Times reporter Jeanna Smialek (video video fileOff-site link). The session began with Bostic observing that although inflation had come down, it was still too high and that monetary policy work remained to be done. He also expressed skepticism that inflation will be back to the Fed's target by the end of 2023. Goolsbee generally agreed with that view, but he also noted that as someone coming from outside the Fed, he thought central bankers have a "central banking viewpoint" on the determinants of inflation. He stated that we know there was also a supply-side component from the fact that the increase in inflation was worldwide and that US inflation surged when the unemployment rate was above 6 percent. Later in the discussion, Smialek brought up Lord King's claim that the current inflation arose in part because central bankers relied too heavily on models. In response, President Bostic argued that this view mischaracterizes what they do. He agreed that models are just an approximation of reality, but he lets reality inform where he takes that approximation. He observed that the Atlanta Fed obtains a lot of input from real people in real time, such as through the Bank's Regional Economic Information Network.

Panel: What Opportunities and Risks for Financial Markets Accompany the Growing Role of Nonbank Financial Institutions?
One policy panel (video video fileOff-site link) focused on the risks and opportunities of nonbank financial institutions (NBFIs). The moderator of the panel, Andreas Lehnert, director of the Division of Financial Stability at the Federal Reserve Board of Governors, kicked off the discussion by observing that nonbanks provide about two-thirds of loans to households and businesses in the United States. He also noted that while some nonbanks have well-known fragilities, others have less-well understood linkages to the banking system—for instance, through revolving lines of credit. These deep connections blur the distinction between banks and nonbanks.

The first panelist, Stijn Claessens, head of financial stability policy at the Bank for International Settlements, observed that NBFIs have expanded significantly around the world, especially outside the United States, in part driven by increased demand and in part by tighter regulation of banks after the global financial crisis. Claessens argued that a critical element in assessing the benefits of nonbanks for economic growth is the diversity of financing that they bring. His research shows that across countries the marginal benefit of increased bank financing starts declining at a certain level of development. By contrast, the contribution of equity and nonbank financing to gross domestic product (GDP) growth is still quite positive even at high levels of development. Claessens added that while nonbank financing is more procyclical than bank financing, nonbanks tend to recover from financial crises relatively better. He concluded by noting that a macroprudential view is still missing for nonbanks and that a systemwide perspective needs to be central in the regulatory agenda for the sector.

The next panelist, Meghan Neenan, managing director and North American head of NBFIs at Fitch Ratings, centered her remarks on the fast-growing private credit market (presentation Adobe PDF file format). The size of the market is estimated at some US$ 800 billion, or 3 percent of GDP. Key market participants include alternative investment managers and business development companies (BDCs). Neenan argued the private credit market offers financing to distressed and nondistressed middle-market firms and thus competes head-on with the syndicated lending space. In relation to financial stability ramifications, Neenan remarked that BDCs had low leverage and were resilient to credit line drawdowns during the COVID-19 pandemic. However, the passage of the 2018 Small Business Credit Availability Act allowed these entities to take on more leverage and has perhaps reduced their ability to weather future shocks.

Next, New York University professor Philipp Schnabl focused his discussion (presentation Adobe PDF file format) on bank deposits and interest rates. He emphasized banks' so-called "deposit franchise." One benefit of this franchise is that bank deposit levels tend to remain stable even if banks are not fully passing through increases in market interest rates. The deposit beta is a measure of this pass-through and can be gleaned from historical data. Schnabl showed that the average bank beta has been around 0.4 since the mid-1980s, which means that a 10 basis point increase in the federal funds rate is associated with a 4 basis point increase in the average bank's deposit rate. He went on to highlight three risks in the current environment. First, the deposit hedge only works if deposits stay in the bank. Second, deposit betas may change over time. Third, the deposit channel of monetary policy implies that price-sensitive depositors withdraw funds from banks and move them to higher-yielding accounts. In other words, tighter monetary policy moves deposits out of the banking system. In closing, he said that all these risks have manifested recently.

The last presentation, by Dennis Kelleher, the cofounder, president, and CEO of Better Markets, highlighted the growing risks in the nonbank sector, which he saw as the least transparent and regulated part of the financial system (remarks Adobe PDF file format and presentation Adobe PDF file format). Kelleher said that the "too big to fail" problem remains alive and well despite the regulatory framework put in place by the 2014 Dodd-Frank Act and despite efforts to rein in excessive risk-taking at banks and nonbanks. He argued that systemically significant NBFIs should be identified and regulated similar to banks. Elements of such regulation could include strict capital and liquidity requirements, stress testing with severe adverse scenarios, and resolution plans that enable systemically significant institutions to be resolved in bankruptcy in a way that does not involve government bailouts and support.

Research Session: Nonbank Financial Intermediaries and Financial Stability
The NBFI research session featured a research paper on the role of leverage in the NBFI sector. The paper, presented by Federal Reserve Board of Governors economist Sirio Aramonte (paper Adobe PDF file formatOff-site link, presentation Adobe PDF file format, and video video fileOff-site link), emphasized structural shifts in financial intermediation since the global financial crisis, in particular toward higher leverage in the nonbank sector. Aramonte described a conceptual framework for the main channels of risk propagation in a setting with banks and nonbanks and highlighted the central role of leverage fluctuations through changes in margins. The main takeaway was that that leverage enables greater leverage and breeds financial instability. Aramonte also raised several policy questions, notably that policymakers must strike a delicate balance between providing backstop and "dealer of last resort" arrangements that kick in ex post while at the same time designing regulations that safeguard liquidity provision during good and bad times alike.

The paper's discussion by American University professor Valentina Bruno (presentation Adobe PDF file format) highlighted key features of the analysis––the role of leverage as an amplifier of external shocks and the dual role of prices not only as reflections of fundamentals but also as "imperative to action" by market participants. The paper shows that as these features come together, leverage feeds on leverage and market actions can be very damaging during crises. Bruno alluded to her research on value-at-risk models with leverage constraints and described three recent episodes to illustrate how risks, like viruses, migrate and morph across the financial landscape––the "dash for cash" of spring 2020, the September 2022 United Kingdom pension fund stresses, and the rise of local currency sovereign debt held by U.S. investors.

Panel: How Might Web3 Change the Financial System?
The policy panel "How might Web3 change the financial system?" discussed what Web3 is and what it means for financial services (video video fileOff-site link). Christine Parlour, a University of California Berkeley professor, set the stage by presenting a paper on the economic benefits of Web3 (paper and presentation Adobe PDF file format). She defined Web3 as a combination of blockchains, cryptocurrencies, and tokens that provide decentralized products and services. Decentralized finance is about engaging open-source and open-access protocols, native cryptocurrencies and tokens, and blockchain technology to provide novel ways to trade assets, make collateralized loans, and make payments. Parlour argued that Web3 can improve efficiency and provide new services at lower costs. For instance, a token that allows people to express ownership of illiquid assets such as real estate can be transferred more safely than the current system allows. In another example, she said token-based digital payments can be automated and unlock value because they do not have to go through physical documentation. Similarly, reconciliation of transactions on blockchains is easier and has the added benefit that, without intermediaries, economic power is not concentrated.

Parlour then turned to stablecoins as a key innovation in decentralized finance and contended that stablecoins could be useful for reducing cross-border payments. By eliminating the need for corresponding banking relationships, stablecoins can reduce both the cost of collateral in central clearing mechanisms and the cost of participating in financial markets. She also said that having a blockchain on which all participants can see the transfer of assets improves transparency and reduces informational asymmetries, making the trading and ownership of these assets more cost effective. Parlour concluded by highlighting the challenge facing policymakers to update regulations in the face of recent innovations in financial infrastructures.

The moderator of the panel, Marina Moretti, deputy director of the Monetary and Capital Markets Department at the International Monetary Fund, opened the discussion to the other panelists, asking them to dig deeper into the benefits and use cases of Web3, as well as its potential and actual risks associated with their widespread use. In the remainder of the session, the other panelists reacted to Parlour's presentation by taking contrarian views about Web3.

The second panelist, Steven Diehl, a software engineer and blogger, said that the definition of Web3 is subject to debate, arguing that it was effectively a rebranding of crypto and a gambling product. The core idea of Web3 is to build the financial system on blockchain technology, yet he said the technology is unfit for this purpose because it requires trusting the code more than trusting financial institutions. He asserted that blockchain transfers trust in financial market participants, institutions, and regulators to a small pool of software developers and that such a system would be opaque, unaudited, corruptible, and inefficient. Diehl also proposed that the lack of human interface with the technology and the immutable ledgers from which data cannot be deleted are bad ideas. He concluded that "crypto is essentially a very antihuman technology" and a "new form of predatory investment sold to the public as a way of farming the few assets that people have."

The next panelist, Richard Walker, a partner with Bain & Company, began his comments by noting that technology adoption in banking is very slow and that innovation is critical to reduce the cost of intermediation. While Web3 and blockchain are general-purpose technologies, he mentioned that new uses of these technologies have the potential to transform all aspects of finance. He saw use cases in cross-border payments, bond issuance, syndicated lending, and the repo market, and he argued in favor of collateral (asset) tokenization. Walker said that tokenization/ digitalization of assets would improve the experience of consumers through increased trust, transparency, and immediacy, plus a better use of assets held by households. He compared Web3 today with the internet in its early stages, arguing it has the same potential to unleash a major infrastructure for finance and commerce.

In the last presentation, Hilary J. Allen, a Professor of Law at American University, argued that the claims of Web3 proponents are unachievable because technological decentralization cannot accomplish economic decentralization. She maintained that verifying transactions on a blockchain is inefficient and wasteful and can open the door to bad actors who can take advantage of it. She also expressed the concern that instantaneous settlement in financial markets removes the option of reversing mistakes or fraudulent transactions. According to Allen, Web3 technologies are a form of regulatory arbitrage. Furthermore, financial stability risks such as leverage and runs would likely be exacerbated by asset tokenization.

Panel: Mitigating Risks and Preserving Financial Stability in an Appropriately Restrictive Policy Environment
The policy panel on interactions between financial stability and monetary policy focused on the financial stability implications of rising interest rates (video video fileOff-site link). The moderator, Dallas Fed president Lorie Logan, set the stage with three questions. First, how can financial instability be prevented? Second, when should central banks intervene for reasons of financial stability and can they avoid working at cross-purposes with monetary policy? Third, how should central banks design monetary policy strategies that mitigate financial stability risks but still achieve macroeconomic goals? Given that interventions to restore financial stability can have undesired side-effects, she proposed that central banks should conduct a thorough review of the many financial stress episodes that have occurred since the global financial crisis.

Logan argued that it is challenging, yet possible, to set monetary policy in a way that mitigates financial stability risks. She noted that the restrictiveness of monetary policy comes from the entire policy strategy, including the pace of rate hikes, the level they reach, and the time spent at that level. In addition, these levers can be adjusted gradually in a way that maintains the restrictiveness of policy but also mitigates financial stability risks. For instance, when financial conditions deteriorate suddenly and threaten damage to the broader economy, the central bank may raise rates in smaller and less frequent steps while using other dimensions of policy to maintain restrictive financial conditions. Logan used the analogy of a "road trip in foggy weather" to argue that difficult driving conditions may require slowing the car, but a slower pace of tightening should not be construed as a lack of commitment to achieving macroeconomic goals any more than driving slower would suggest you don't want to reach your destination.

The first panelist, Seth Carpenter, managing director and chief global economist at Morgan Stanley, contended that market commentators often highlight a false dichotomy between monetary policy and financial stability. The challenge facing central banks, he said, is one of calibrating monetary policy actions in a way that preserves financial stability. Monetary policy should be conducted, according to him, in way that does not trigger nonlinear tightening of credit conditions. Carpenter also emphasized that the speed of tightening is extremely important and that the difference in real economy outcomes between a gradual and a fast tightening can be much larger than predicted by macroeconomic models. In the current context, a more gradual increase in interest rates would have given more time to banks to restructure their books and would have reduced the possibility of sharp nonlinear dynamics. He also noted this tightening cycle is different than previous ones due to the presence of the Federal Reserve's Reverse Repurchase Facility, which can change the transmission of monetary policy through money markets.

The next panelist, Kathy Jones, managing director and chief fixed income strategist at Schwab Center for Financial Research, reinforced the notion that the rate of change in the monetary policy stance has been a key factor in driving market volatility. She noted that the "accelerated pace of rate hikes" has created uncertainty regarding the path of future monetary policy, exacerbated liquidity issues, and complicated investment decisions by market participants. Jones also maintained that the rapid rise in interest rates has caused deleveraging at banks and other market players. She cautioned that the financial system is very different now compared to the late 1970s and early 1980s and may transmit interest rate rises much more quickly than during the tightening cycle of that time.

The third panelist, New York University professor Viral Acharya, urged that we consider the path dependence of macroeconomic outcomes, as reflected in the Fed's many rounds of quantitative easing and attempts at liftoff since the global financial crisis. He asserted that the success of low-for-long forward guidance should be evaluated in light of this path dependence. Acharya expressed the concern that the Fed may be trying to do "too much" both by way of easing and by way of tightening, which in turn may create unexpected consequences for financial stability. He also argued that monetary policy cannot be conducted without financial stability and that central banks should aim for normal transmission of monetary policy that is not associated with sudden financial fragility. Thinking about the international ramifications of US monetary policy, he emphasized that emerging-market central banks have strengthened their institutional capacity since the global financial crisis. As a result, emerging markets today are better able to respond to the financial cycle caused by the "waxing and waning" of the Fed's balance sheet through an appropriate combination of reserve management and capital controls.

The last panelist, Brad Setser, senior fellow at the Council for Foreign Relations, picked up on President Logan's "road trip in foggy weather" metaphor to argue that the Fed may have felt it was late in starting the tightening cycle. In his view, the speed of tightening increased the riskiness of the cycle. Turning to international spillovers of US monetary policy, Setser argued that tighter monetary policy is a net positive for some countries through a standard exchange rate channel and a shift in demand away from the United States to the rest of the world. However, given the dollar's role as a global currency, higher interest rates imply tighter financial conditions for important parts of the global economy. Setser also emphasized complexities in both the domestic and the international transmission of monetary policy. On the international front, he noted that large global institutions run hedged books, which makes the shape of the yield curve as important as the level of rates. On the domestic front, he noted that institutions respond to higher interest rates not only through the usual transmission channels but also through the loss of value in portfolios (for instance, the implied marked to market on held-to-maturity securities at banks), which can hit capital and dampen risk taking.

Panel: How to Conduct Monetary Policy amid Higher Inflation and a Nonbinding Zero (Effective) Lower Bound?
The monetary policy panel addressed the question of how to conduct policy now that inflation rates are higher and interest rates are well above the zero lower bound (video video fileOff-site link). The panel began with a review of the background by its moderator, William English, a professor at Yale University. English observed that central banks responded to the start of the pandemic by aggressively easing policy to address concerns that the recovery coming out of the pandemic would be weak. In the event, the recovery came sooner, faster, and stronger than was anticipated, but it was accompanied by an unwelcome rise in inflation and led to a rapid adjustment to policy in which monetary policy became tighter.

The first panelist, Troy Davig, chief US economist at Symmetry Investments, started with a discussion of recent weaknesses in the financial sector, especially the failure of some large US banks. He argued that these failures were outliers and that few banks are in a similarly weak position. However, he noted that banks were competing for liquidity, especially with money market funds that have been placing a large amount of funds in the Federal Reserve's Reverse Repurchase Facility. He also noted that the US Treasury was likely to issue at least $5 trillion in net new Treasury bills after the debt ceiling is raised. He also predicted that it is likely that the current Federal Reserve tightening of policy will result in a hard landing. If this hard landing comes to pass, he observed that, unlike in other recent recessions, we will not be able to count on fiscal policy to cushion the decline.

Massachusetts Institute of Technology professor Kristin Forbes (presentation Adobe PDF file format) began her discussion with a riff on the conference theme by arguing that what is needed is not new clothes but to apply three old lessons to contemporary monetary policy. First, although forward guidance may be necessary to help stimulate the economy when rates are near the zero lower bound, such guidance can inappropriately constrain monetary policy when inflation increases unexpectedly. Second, she noted that policymakers cannot take for granted that inflation expectations are anchored and that large price shocks can drive expectations away from central bank's goals. Third, policymakers have some ability to decide whether to front-load their policy moves or adopt a more gradualist approach. A comparison of the US frontloading versus the UK's more gradual approach is that the US approach more effectively controlled inflation expectations.

The next panelist, Goldman Sachs chief economist Jan Hatzius (presentation Adobe PDF file format), focused his comments on the potential for US inflation to hit the Fed's 2 percent target while avoiding a hard landing. He said that Goldman's baseline forecast is on the optimistic side that inflation can be brought down without a recession. That said, he noted that Goldman's team expects that the fed funds rate will remain higher than what the market expects. Hatzius made the interesting observation that the current job market has seen the job vacancy rate come down without an increase in unemployment, a development that he called "unprecedented."

John Taylor (presentation Adobe PDF file format), a professor at Stanford University and the author of the famous Taylor Rule for setting monetary policy based on the inflation and unemployment rates, began by observing that the Fed had flip-flopped on the role of monetary policy, and he attributed the current high inflation rates to the failure to follow an appropriate rule. In terms of the current state of policy, he said the current fed funds rate of approximately 5 percent is close to the 6 percent implied by the Taylor rule. That said, Taylor acknowledged that while policy should be based on rules that markets can understand, central banks should have contingency plans for unusual circumstances.

Research Session: Back to the 1980s or Not? The Drivers of Real and Inflation Risks in Treasury Bonds
In a final research session, University of Chicago professor Carolin Pflueger (paper Adobe PDF file formatOff-site link and presentation Adobe PDF file format) presented a paper that uses a New Keynesian model to help better understand the change in the correlation between stock and bond returns between the 1980s and 2000s. Her model suggests that the positive correlation of the two returns that existed in the 1980s are not easy to generate and would arise only if supply shocks are paired with fast, anti-inflationary monetary policy response. In contrast, her analysis suggests that the negative correlation between stock and bond returns in the 2000s arises because markets anticipate a less aggressive Fed response to adverse supply shocks resulting in a "soft(ish) landing."

The discussion of the paper, delivered by Min Wei, senior associate director at the Federal Reserve Board of Governors (presentation Adobe PDF file format), highlighted some strengths of the paper, but as academic discussants often do, she also drew attention to some aspects of the research that could benefit from further analysis. Among these were suggestions to use more asset prices, reassess the importance of the change in the monetary policy rule, and explore other dimensions of the data such as term premiums.

We hope this summary gives you a sense of the important matters raised at the FMC and the questions that participants will be thinking about in the future.