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The Federal Reserve should pay more attention to financial stability risks in making monetary policy decisions, Cleveland Fed President Loretta Mester urged Tuesday, suggesting the addition of a financial stability "escape clause" in its forward guidance.
Such a clause, already in use by the Bank of England, would allow policymakers to deviate from their forward guidance if financial vulnerability and risks become sufficiently elevated, she told a Norges Bank conference. That is especially important in a low interest rate world that encourages risk taking behavior as investors search for yield, she said.
"In the U.S. we are still a distance away from developing a clear strategy about the circumstances under which monetary policy would be used to combat financial vulnerabilities, but I believe developing a set of principles to guide these decisions would be a useful addition to our monetary policy deliberations in a low-interest-rate world," Mester said.
The Fed should also consider setting its countercyclical capital buffer above zero in normal times, to make sure banks raise capital in good times, she added. The buffer has never been above zero in the U.S.