The second risk is associated with the creation of the special lending facilities:
In the current environment, with the targeted funds rate effectively at zero, it cannot serve as a nominal anchor. On the other hand, quantitative measures — such as the stock of money, reserves, or the monetary base — have a long and venerable tradition in monetary theory and policy. Indeed, many countries have used quantitative targets quite successfully over the years, including Germany and Switzerland. However, these metrics do not assess the distribution of Federal Reserve assets across its lending programs, a focus of credit policy.
Nonetheless, while traditional measures of money may not be the best metrics for policy in this zero interest rate environment, the size of the balance sheet does offer a possible nominal anchor for monitoring the volume of our liquidity provisions. While attention is currently focused on credit policy, ignoring or failing to take into account the consequences of unconstrained growth in our balance sheet could be costly down the road in terms of our ability to ensure price stability or support a credible commitment to that goal.
As I have indicated, some of our new lending facilities were created to replace impaired or poorly functioning private credit markets. We must consider the possibility that our presence in these credit markets will deter private-sector participants from returning to and restoring these markets. To prevent our policies from having these perverse effects, we should consider a gradual increase in the cost of borrowing from these facilities to discourage their use and encourage other participants to return to these markets. This should be an important element of our exit strategy.
Unfortunately, simply terminating the special lending programs is not enough to avoid some knotty problems. The mere act of creating the programs has created moral hazard. To the extent that market participants now feel more comfortable asking for the central bank’s support when they get into trouble, they may be inclined to take on more risk than would otherwise be prudent — thus sowing the seeds for the next crisis. In exiting such programs, it will be important for the Fed to develop clear objectives and boundaries for lending that we can commit to follow in the future. Clarifying the criteria under which we will intervene in markets or extend credit, including defining what constitutes the “unusual and exigent” circumstances that form the legal basis for the Fed’s nontraditional lending, will be essential if we are to mitigate the moral hazard we have created.