Frederick Mishkin Discusses the Federal Reserve at the Museum of American Finance

Frederick Mishkin, board member of the Federal Reserve since September 2006, stated at a meeting on Friday that the reason for the market problems that we have been experiencing is because of asymmetric information. Mishkin’s explanation of the market was much of the same information we heard from Randall S Kroszner’s speech about the housing market on the 22nd, another board member of the federal reserve.

Mishkin states that the asymmetric information he is referring to is for example when the borrower is usually much better informed than the lender concerning the potential risks and returns associated with the investment protects to be financed by a loan. Borrowers have been borrowing money with the incentive to invest in high-risk projects in which the borrower does well if the project succeeds, however if it does not the lender bears most of the loss. The obvious problem with his is that lenders may decide that they would rather not make loans at all to remove this risk, leading to suboptimal lending and investment.

When discussing how to avoid and repair the current problems with the mortgage market Mishkin stated “lenders must impose restrictions that penalize borrowers for engaging in certain activities; lenders must also monitor those activities, and they must enforce the restrictions if the borrower violates them.” He also reiterates that the central bank can respond to an episode of financial instability by temporarily providing the liquidity that financial intermediaries are unwilling or unable to supply. The Federal Reserve started doing this when they cut the discount window rates, the rate at which lenders borrow money, on August 10th. The idea behind increasing the liquidity is that it will funnel through the financial markets potentially addressing the causes of financial instability and counteracting the effects of it. Increased liquidity helps restrain rising interest rates which helps prevent a snow balling effect of making the situation worse by rising of rates.

Mishkin also stated that “Although market functioning has certainly not yet returned to normal, and while it is still too early to judge their ultimate success, these actions, along with the policy easing decided at the September (Federal Open Market Committee) meeting, have helped improve conditions in several short-term funding markets.”

To read more about Financial instability and the federal reserve as a liquidity provider head on over to the Federal Reserve’s site.