At the Sandridge Lecture of the Virginia Association of Economists and the H. Parker Willis Lecture of Washington and Lee University, Lexington, Virginia

March 27, 2008

Comfort Zones, Shmumfort Zones

It's a genuine pleasure to address the Virginia Association of Economists here at Washington and Lee University on an important issue in monetary policy. Some of you may be wondering about the meaning of my speech title--"Comfort Zones, Shmumfort Zones."  Well, putting the "shm" before a word is a way to cast a bit of skepticism on it. Thus, if your friend tells you that you are "fancy, shmancy," then you might be overdressed for the occasion. And if you exclaim, "Email, shmemail!" then you've just found your inbox overloaded. Of course, there's also a significant distinction between the expressions "shlemiel" and "shlimazel," but that's more-advanced material that I will defer until another speech.

Although this speech has a somewhat humorous title, my remarks will address a serious and important topic, namely, how central banks promote the stability of prices and economic activity and how this policy framework is communicated to the public. More specifically, I will consider whether central banks should describe price stability in terms of a desired range of inflation outcomes--often referred to as a "comfort zone" for inflation--or in terms of a specific numerical value at which the inflation rate is expected to settle down over some reasonable time horizon.

After a brief review of the academic literature regarding the level of inflation that best promotes longer-run economic growth and employment, I will discuss several conceptual issues regarding the pitfalls of comfort zones and the benefits of specifying a point objective for inflation. Finally, I will move from theory to practice and consider the experiences of other major industrial countries.

As usual, my remarks reflect only my own views and are not intended to reflect those of the Federal Open Market Committee (FOMC) or of anyone else associated with the Federal Reserve System.¹

What is the Optimal Level of the Inflation Rate?
Research in monetary economics usually specifies monetary policy objectives in terms of stabilizing both inflation and economic activity.²   Those two goals are related:  Maintaining price stability promotes stronger economic activity in the long run.

What do we mean by price stability?  A widely cited definition is that the inflation rate is sufficiently low so that households and businesses do not need to take inflation into account in making everyday decisions.³  Broadly speaking, I believe this definition of price stability is a reasonable one, and in practice, central banks around the world have chosen average levels of inflation between 0 and 3 percent as consistent with this criterion. However, this range can be narrowed a bit further by considering the implications of economic theory and empirical evidence about the average inflation rate that produces the best economic outcomes. In particular, the literature on the optimal inflation rate not only bolsters the case for low inflation but also highlights the risks of maintaining an excessively low inflation rate.

The Case for Low Inflation
All economists agree that hyperinflations, such as the one in Germany in the 1920s, are particularly damaging due to the resulting distortion of economic incentives and the waste of valuable resources. Even rates of inflation far short of hyperinflation appear detrimental to economic performance, as evidenced by the double-digit inflation rates of the 1970s.  And over the past decade or so, central bankers and academic economists have reached a remarkable degree of consensus about the desirability of low and stable inflation--and as you know, arriving at a consensus is quite rare for economists.

The average rate of inflation distorts the efficient allocation of resources through three main channels. First, because some firms face costs in changing their prices, a rise in the general price level tends to generate undesirable movements in relative prices, thereby leading to an inefficient allocation of resources. This relative price dispersion increases with inflation, and the desirability of minimizing these relative price distortions provides a key rationale for price stability.⁴

Second, inflation is an implicit tax on capital. In an imperfectly indexed tax system, inflation seriously distorts saving and investment because investment income is taxed on the basis of its nominal rather than inflation-adjusted or real value. In those circumstances, price stability may considerably improve the efficiency of the economy.⁵  Third, a higher average inflation rate tends to generate distortions by raising the cost of holding currency and other non-interest-bearing assets.⁶ 

Can Inflation Be Too Low?
While the benefits of low inflation are now widely recognized, somewhat less attention has been given to the pitfalls of maintaining inflation rates very close to zero, so I will now discuss this issue in somewhat greater detail. Specifically, if the average inflation rate is too low, then the economy faces a greater risk that a given adverse shock could distort labor markets, induce debt deflation, or cause monetary policy to become constrained by the zero lower bound on nominal interest rates. These risks imply that undershooting a zero inflation objective is potentially more costly than overshooting that objective by the same amount, and that setting the inflation objective at a rate a bit above zero provides some insurance against these risks.

Downward nominal wage rigidities. Inflation at rates close to zero might create nonnegligible costs to the economy because firms may be relatively reluctant to cut nominal wages.⁷  Sticky nominal wages can prevent labor markets from reaching the optimal equilibrium. However, empirical evidence from Switzerland and Japan indicates that in an environment of deflation or very low inflation, downward nominal wage rigidities become less prevalent.⁸

Debt deflation. Keeping the average inflation rate close to zero increases the likelihood that the economy will experience occasional episodes of deflation. Deflation can be particularly dangerous for an advanced economy, in which debt contracts often have long maturities. As described by Irving Fisher (1933), an episode of deflation can lead to "debt deflation," that is, a substantial rise in the real indebtedness of households and firms, because the nominal values of debt obligations are largely predetermined whereas the nominal values of household income and business revenue are falling together with the general price level.⁹  Indeed, the deterioration of the balance sheets of households and firms can result in financial turmoil that contributes to further deflation and greater macroeconomic instability.

The zero lower bound. With a very low average inflation rate, monetary policy is also more likely to encounter circumstances in which short-term interest rates are constrained by the so-called zero lower bound on nominal interest rates.¹⁰  Specifically, investors will never choose to lend money at a negative nominal interest rate because they always have the option of simply holding cash at a zero interest rate; thus, nominal interest rates cannot fall below zero.

A number of researchers in the Federal Reserve System and elsewhere have analyzed the implications of the zero lower bound in estimated dynamic rational expectations models.¹¹  If the economy faces a large contractionary shock, the optimal monetary policy response is to push the short-term nominal interest rate below the level of expected inflation, thereby reducing real interest rates enough to mitigate the impact of the shock. But if the central bank has an inflation objective very close to zero, the zero lower bound can prevent the full implementation of this policy response, and hence the economy will tend to exhibit greater volatility of economic activity and inflation.

In contrast, given shocks like those seen over the past several decades, an average inflation rate higher than about 1 percent substantially reduces the frequency with which the economy hits the zero lower bound. An inflation objective of about 2 percent implies that monetary policy is rarely constrained by the zero lower bound and thereby minimizes the adverse consequences for macroeconomic stability.

Why Comfort Zones?
These considerations provide the foundations for a broad consensus among academic economists and monetary policymakers around the world that the optimal inflation rate is in the range of about 1 to 3 percent; that is, an average inflation rate outside this range would be detrimental to longer-run health of the economy. In light of that consensus, it might seem natural to specify price stability in terms of a range of acceptable outcomes for inflation. Indeed, several present and past FOMC participants have used the term "comfort zone" and specified a 1 to 2 percent range, thereby providing valuable information regarding their views about what levels of inflation are consistent with the Federal Reserve's dual mandate.¹²

The Analytical Case for a Point Objective
Nevertheless, while a "comfort zone" approach may seem appealing, analytical considerations reveal some disadvantages of that approach as well as some significant benefits of specifying and maintaining a point objective for inflation.

The Pitfalls of Comfort Zones
In particular, I would like to highlight three specific pitfalls associated with the "comfort zone" approach.

Confusion about objectives. First, when the price stability objective is formulated in terms of an acceptable range of inflation outcomes, the policy implications may be difficult to interpret. For example, if the comfort zone spans a range from 1 to 2 percent, does that mean that policymakers are equally comfortable with inflation rates of 1.1 percent and 1.9 percent?   Furthermore, confusion about inflation objectives might make it harder for a committee of policymakers to decide on the appropriate course of monetary policy. When one member advocates a more accommodative policy stance than other members, it may not be clear whether that reflects a more negative outlook for the economy or a greater willingness to allow inflation to settle in or near the top of the comfort zone. Thus, the comfort zone approach might lead to greater confusion in policy deliberations and hence produce a less effective decisionmaking process.

Perverse expectations dynamics. Second, framing price stability in terms of a comfort zone could lead to perverse expectations dynamics and thereby generate larger fluctuations in economic activity, especially if policymakers maintain a neutral stance regardless of where the inflation rate falls within the comfort zone.

For instance, a negative shock to aggregate demand that brought inflation near the bottom end of the range might cause long-run expected inflation to fall, which would raise the real interest rate if the nominal interest rate remained unchanged. This rise in the real interest rate would exert a further drag that could exacerbate the adverse impact of the original negative shock on the economy. Similarly, a positive shock to aggregate demand that raised inflation to the upper end of the range might cause a rise in expected inflation and thus a decline in the real interest rate, which would provide further stimulus to the economy. The result would then be more pronounced swings in economic activity.

Nonlinearities and macroeconomic stability. Third, if a central bank places a high degree of emphasis on the boundaries of the comfort zone, then these threshold effects imply nonlinearities in the conduct of monetary policy that are likely to produce less desirable economic outcomes (Orphanides and Wieland, 2000). For example, the stance of policy would remain roughly neutral in response to a shock that leaves inflation just below the upper end of the comfort zone, whereas a slightly larger shock that pushes inflation just above that boundary would cause an abrupt shift to a contractionary policy stance. Such a "stop-start" approach is likely to cause greater uncertainty in financial markets and would also tend to generate greater volatility of the macroeconomy.

The Benefits of Maintaining a Point Objective
In contrast to the various pitfalls associated with comfort zones, there are a number of significant benefits to maintaining a point objective for inflation.

Clarity in communication. First, as I have emphasized in several previous speeches, communication plays a crucial role in the success of monetary policy (Mishkin, 2007b and 2007c). And in this regard, it seems virtually self-evident that communicating about a single numerical value for the inflation objective is more straightforward than communicating about an interval or range of numbers. Of course, regardless of whether the central bank has a point objective or a comfort zone, it is inevitable that the inflation rate will fluctuate in response to various shocks; that's why it is also crucial for policymakers to communicate clearly about the outlook for the macroeconomy and about the central bank's strategy for promoting the stability of prices and economic activity.

Anchoring inflation expectations. An explicit point objective anchors inflation expectations more effectively than a comfort zone. If the comfort zone is considered to be a zone of indifference, then the inflation rate might well exhibit highly persistent fluctuations inside the zone, perhaps even looking like a random walk within that range. In that case, if inflation drifts up to the top of the comfort zone, then the private sector could take the view that inflation might remain at that rate for an extended period of time, especially if policymakers are not taking any action to bring inflation back toward the midpoint of the range. Thus, the comfort zone might then generate somewhat larger fluctuations in longer-run inflation expectations, which would in turn tend to contribute to wider fluctuations in actual inflation. In contrast, with a transparent and credible point objective, longer-run inflation expectations will be firmly anchored at that rate.

The insurance motive. Even if policymakers are relatively indifferent about the level of inflation within a comfort zone, research on the optimal design of monetary policy indicates that they shouldn't be:  The central bank should actively seek to bring inflation back to the midpoint of its comfort zone, thereby minimizing the probability that inflation wanders outside the boundaries of that zone. In effect, the optimal policy strategy takes into account the benefits of insurance, and hence the midpoint of the zone becomes the point objective for inflation (Mishkin and Westelius, 2006).

The Empirical Case for a Point Objective
Now let's turn to the international experience.¹³  As shown in table 1, a number of major industrial economies have adopted explicit inflation objectives  In 1990, the newly independent Reserve Bank of New Zealand became the first central bank to establish such an objective. Many governments have followed in New Zealand's footsteps, and the inflation objectives have been variously expressed in the form of a point, a range with a preferred midpoint, or a comfort zone (that is, a range of indifference).

In some cases, the inflation objective was adopted in part as a way to lock in the benefits of recent disinflation and to prevent the return of adverse inflation outcomes. New Zealand, whose inflation performance in the 1970s and 1980s was the worst among the industrialized economies, is arguably one such example. In other instances, inflation had already been kept low and stable for some time, and the adoption of an explicit inflation objective followed from extensive research and debate on issues such as the benefits of low and stable inflation, the presence of biases in the measurement of inflation, and the importance of central bank communications.

Although the mix of reasons and circumstances that led to the adoption of an explicit inflation objective varies across economies, there is a remarkable degree of similarity in the characteristics of these policy frameworks, from which three broad conclusions can be drawn. First, there is a fairly general consensus among central banks throughout the world that the average inflation rate should be somewhere between about 1 percent and 3 percent. Second, point objectives have proven more effective than ranges in anchoring inflation expectations. Third, when the inflation objective is formulated in terms of a range, the implied degree of nonlinearity in the central bank's policy actions can be alleviated by placing increased emphasis on the midpoint of the range.

New Zealand
The monetary policy objective of the Reserve Bank of New Zealand is to "keep future CPI inflation outcomes between 1 and 3 per cent on average over the medium term."  The narrowness of this range may seem surprising, especially given the historical volatility of inflation in New Zealand. After all, New Zealand is a small open economy with a large commodity-producing sector, and as a result the economy is particularly subject to external shocks that can have a relatively large impact on consumer prices. In this context, the use of a narrow comfort zone would increase the odds that inflation would fall outside the band at certain times. Some observers have argued that such outcomes may undermine the public's trust in the central bank's ability to deliver inflation outcomes in line with its stated objective, and hence that the inflation band should be widened.¹⁴  Nevertheless, a wider band would hinder the anchoring of inflation expectations, which is pivotal to the successful pursuit of an explicit inflation objective.

As the previous discussion has illustrated, expressing an inflation objective in terms of a range makes it more difficult for a central bank to anchor inflation expectations, especially in the absence of any explicit emphasis on the midpoint. A related issue is that the boundaries of the range may be seen as "hard edges," that is, inflation outcomes inside the range may be seen as qualitatively different from those outside the range. The nonlinear policy reactions implied by this approach can lead to greater variations in interest rates, exchange rates, and output. The international experience indicates that even when inflation bands with hard edges have been introduced, subsequent changes in the central bank's policy framework and communications have tended to soften the edges of the inflation band.

The experience of New Zealand is particularly instructive in this regard. The Reserve Bank Act requires that price stability be defined in a specific and public contract, negotiated between the Minister of Finance and the Reserve Bank of New Zealand. Under the act, the Governor of the Reserve Bank is personally accountable for keeping inflation in line with the stated objective. (Indeed, the Governor could be fired for failing to do so.)  Since 1990, price stability has been defined in terms of a band for the inflation rate. Over the following decade, the Reserve Bank treated this band as having hard edges, both in its conduct of policy and in its communications with the public; indeed, the boundaries of the inflation band were occasionally referred to as "electric fences" (Sherwin, 1999). However, it became increasingly evident that the Reserve Bank's vigorous attempts to keep inflation within the band tended to generate destabilizing fluctuations in nominal interest rates and undesirable outcomes for the broader macroeconomy.

Given the dissatisfaction with that approach, the Reserve Bank's mandate was refined significantly in 1997, namely, in seeking to keep inflation within the band, the Reserve Bank should avoid "unnecessary instability" in output, interest rates, and the exchange rate (Sherwin, 1999).  This refinement allowed the Reserve Bank to lengthen the time horizon for achieving the inflation goal, thereby reducing the need to respond to transitory price fluctuations and providing greater flexibility in promoting the goal of macroeconomic stability. And since the edges of the inflation band have been softened, the Reserve Bank has placed greater emphasis on the policy actions needed to bring inflation toward the midpoint of the band over the forecast horizon.¹⁵

United Kingdom
The desire to anchor inflation expectations more firmly led the United Kingdom to move from a range to a point objective for inflation. Three weeks after the United Kingdom departed from the European Exchange Rate Mechanism in the fall of 1992, the Chancellor of the Exchequer announced an inflation objective of 1 to 4 percent, which was to be achieved by the middle of 1997. The use of a range for the inflation objective was interpreted by many as a way of limiting the extent of discretionary policy and of acknowledging the extent of imperfect control over inflation (Bernanke and others, 1999, p. 154). The initial target range of 1 to 4 percent was often perceived as a range of indifference, which implied that inflation just outside the range would be viewed as qualitatively different from inflation just inside the range. As a consequence, inflation tended to stay near the upper border of the range.

Dissatisfaction with that outcome motivated the subsequent decision in mid-1997 to move to a framework with an explicit point objective of 2-1/2 percent, with deviations in either direction treated symmetrically. This modification of the policy framework was well received by financial markets and the general public, and surveys of households and professional forecasters indicated that inflation expectations converged fairly quickly to the Bank of England's point objective.¹⁶

The Euro Area and Canada
The importance of anchoring expectations helps explain why other central banks that initially adopted an inflation objective stated in terms of a range--even a narrow one--increasingly emphasized a single value in their communications or have replaced the range with a point objective.  For example, in May 2003 the European Central Bank (ECB) clarified that in implementing its mandate of price stability, monetary policy would be aimed at maintaining inflation "below, but close to, 2 percent in the medium term"  (European Central Bank, 2003). That clarification was welcomed by market participants and likely made it easier for the ECB to anchor inflation expectations.

As a final example, consider the evolution of the monetary policy framework in Canada. In the late 1990s, this framework was well described as a range with relatively hard edges because statements by Bank of Canada officials had consistently indicated that the boundaries of the target zone (which ranged from 1 to 3 percent) were to be taken more seriously than the midpoint (Bernanke and others, 1999). Over the past decade, however, the conduct of monetary policy has evolved in the direction of placing greater emphasis on the midpoint, while the range has been used mainly as a communication device rather than as an objective in itself.

Conclusion
I have argued today that the science of monetary policy provides a strong rationale for framing the inflation goal in terms of a specific point objective rather than as a range or comfort zone.¹⁷  First of all, I've argued inflation should be low but not too low. Second, I've provided a brief review of lessons from economic theory that can inform policymakers in their choice of inflation objectives. Third, I've outlined what we can learn from the practical experiences of other industrial economies; indeed, in recent years, a number of foreign central banks have moved toward emphasizing the midpoint of an inflation range or have provided a specific point objective for inflation.

Finally, you may have noticed that I haven't said much about the United States in this speech. Nevertheless, the issues that I've discussed today have potentially important implications for the ongoing process of refining the Federal Reserve's policy framework and of enhancing our communications. Indeed, as Chairman Bernanke has recently indicated, our communication strategy is "a work in progress," and the Federal Reserve "will continue to look for ways to improve the accountability and public understanding of U.S. monetary policymaking" (Bernanke, 2007).  And I certainly hope that my remarks will be helpful in contributing to the continuation of that process.

Table 1:  Major Industrial Economies with Explicit Inflation Objectives

References
Akerlof, George A., William T. Dickens, and George L. Perry (2000). "Near-Rational Wage and Price Setting and the Long-Run Phillips Curve ," Brookings Papers on Economic Activity, vol. 2000 (no. 1), pp. 1-60.

Bailey, Martin J. (1956). "The Welfare Cost of Inflationary Finance," Journal of Political Economy, vol. 64 (April), pp. 93-110.

Bernanke, Ben S. (2002). "Deflation:  Making Sure ‘It' Doesn't Happen Here," speech delivered at the National Economists Club, Washington, November 21.

_________ (2005). "The Economic Outlook," speech delivered at a Finance Committee luncheon of the Executives' Club of Chicago, Chicago, March 8.

_________ (2007). "Federal Reserve Communications," speech delivered at the Cato Institute 25th Annual Monetary Conference, Washington, November 14.

Bernanke, Ben S., Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen (1999). Inflation Targeting:  Lessons from the International Experience. Princeton:  Princeton University Press.

Coenen, Günter, Athanasios Orphanides, and Volker Wieland (2004). "Price Stability and Monetary Policy Effectiveness when Nominal Interest Rates are Bounded at Zero ," Advances in Macroeconomics, Berkeley Electronic Press, vol. 4, article 1.

Eggertsson, Gauti B., and Michael Woodford (2003). "Zero Bound on Interest Rates and Optimal Monetary Policy ," Brookings Papers on Economic Activity, vol. 2003 (no. 1), pp. 139-233.

Eggertsson, Gauti B., and Michael Woodford (2004). "Policy Options in a Liquidity Trap,"  American Economic Review, vol. 94 (May), pp. 76-9.

Estevao, Marcello M., and Beth Anne Wilson (1998). "Nominal Wage Rigidity and Real Wage Cyclicality," Finance and Economics Discussion Series 1998-21. Washington:  Board of Governors of the Federal Reserve System, May.

European Central Bank (2003). Background Studies for the ECB's Evaluation of its Monetary Policy Strategy (1.82 MB PDF) . Frankfurt:  European Central Bank.

Fehr, Ernst, and Lorenz Goette (2005). "Robustness and Real Consequences of Nominal Wage Rigidity ," Journal of Monetary Economics, vol. 52 (May), pp. 779-804.

Feldstein, Martin (1997). "The Costs and Benefits of Going from Low Inflation to Price Stability," in Christina Romer and David Romer, eds., Reducing Inflation: Motivation and Strategy. Chicago:  University of Chicago Press, pp. 123-56.

_________ (1999). "Capital Income Taxes and the Benefits of Price Stability," in Martin S. Feldstein, ed., The Costs and Benefits of Price Stability. Chicago:  University of Chicago Press, pp. 9-40.

Fisher, Irving (1933). "The Debt-Deflation Theory of Great Depressions," Econometrica, vol. 1 (October), pp. 337-57.

Friedman, Milton (1969). The Optimum Quantity of Money and Other Essays. Chicago:  Aldine.

Goodfriend, Marvin, and Robert G. King. (1997). "The New Neoclassical Synthesis and the Role of Monetary Policy," in Ben S. Bernanke and Julio J. Rotemberg, eds., NBER Macroeconomics Annual, vol. 12. Cambridge, Mass.:  MIT Press, pp. 231-83.

Greenspan, Alan (2002). "Chairman's Remarks:  Transparency in Monetary Policy (30 KB PDF)," Federal Reserve Bank of St. Louis, Economic Review, vol. 84 (July/August), pp. 5-6.

Groshen, Erica L., and Mark E. Schweitzer (1999). "Firms' Wage Adjustments:  A Break from the Past (811 KB PDF)," Federal Reserve Bank of St. Louis, Economic Review, vol. 81 (May/June, Labor Markets and Macroeconomics:  Proceedings of the Twenty-Third Annual Economic Policy Conference of the Federal Reserve Bank of St. Louis), pp. 93-112.

Kim, Jinill, and Francisco J. Ruge-Murcia (2007). "How Much Inflation is Necessary to Grease the Wheels?" mimeo, September.

Kuroda, Sachiko, and Isamu Yamamoto (2003). "Are Japanese Nominal Wages Downwardly Rigid? (Part I): Examinations of Nominal Wage Change Distributions ," Monetary and Economics Studies, Bank of Japan, vol. 21 (August).

Kuroda, Sachiko, and Isamu Yamamoto (2003). "Are Japanese Nominal Wages Downwardly Rigid? (Part II): Examinations Using a Friction Model ," Monetary and Economics Studies, Bank of Japan, vol. 21 (August).

Lebow, David E., Raven E. Saks, and Beth Anne Wilson (2003). "Downward Nominal Wage Rigidity:  Evidence from the Employment Cost Index ," Advances in Macroeconomics, Berkeley Electronic Press, vol. 3, article 2.

Mishkin, Frederic S. (2000). "Inflation Targeting in Emerging-Market Countries ," American Economic Review, vol. 90 (May), pp. 105-9.

_________ (2007a). "Monetary Policy and the Dual Mandate," speech delivered at Bridgewater College, Bridgewater, Va., April 10.

_________ (2007b). "Will Monetary Policy Become More of a Science?" Finance and Economics Discussion Series 2007-44. Washington:  Board of Governors of the Federal Reserve System, September.

_________ (2007c). "The Federal Reserve's Enhanced Communication Strategy and the Science of Monetary Policy," speech delivered to the Undergraduate Economics Association, Massachusetts Institute of Technology, Cambridge, Mass., November 29.

_________ (2008). "Does Stabilizing Inflation Contribute to Stabilizing Economic Activity?" speech delivered at East Carolina University's Beta Gamma Sigma Distinguished Lecture Series, Greenville, N.C., February 25.

Mishkin, Frederic S., and Niklas J. Westelius (2006). "Inflation Band Targeting and Optimal Inflation Contracts ," National Bureau of Economic Research Working Paper No. 12384. Cambridge, Mass.:  National Bureau of Economic Research, July. Forthcoming in Journal of Money, Credit and Banking.

Orphanides, Athanasios, and Volker Wieland (2000). "Inflation Zone Targeting ," European Economic Review, vol. 44 (June), pp. 1351-87.

Reifschneider, David, and John C. Williams (2000). "Three Lessons for Monetary Policy in a Low-Inflation Era ," Journal of Money, Credit and Banking, vol. 34 (November, Part 2: Monetary Policy in a Low-Inflation Environment), pp. 936-66.

Sherwin, Murray (1999). "Strategic Choices in Inflation Targeting:  The New Zealand Experience ," Reserve Bank of New Zealand, Reserve Bank Bulletin, vol. 62 (June), pp.73-88.

Stevenson, Richard W. (2002). "The Fed's Evolving Comfort Zone," The New York Times, August 4.

Wolman, Alexander L. (2005). "Real Implications of the Zero Bound on Nominal Interest Rates ," Journal of Money, Credit and Banking, vol. 37 (April), pp. 273-96.

Woodford, Michael (2003). Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton:  Princeton University Press.

Yellen, Janet L. (2006). "Enhancing Fed Credibility," speech delivered at the Annual Washington Policy Conference, sponsored by the National Association for Business Economics, Washington, March 13.

Footnotes

1. I'd like to thank Etienne Gagnon, Steven Kamin, Linda Kole, Andrew Levin, and David Lopez-Salido for helpful comments and assistance with this speech. Return to text

2. Indeed, this specification of monetary policy objectives is exactly what is suggested by the dual mandate that the Congress has given to the Federal Reserve to promote both price stability and maximum employment (Mishkin, 2007a, 2008). Return to text

3. For example, former Federal Reserve Chairman Alan Greenspan (2002) stated that "price stability is best thought of as an environment in which inflation is so low and stable over time that it does not materially enter into the decisions of households and firms." Return to text

4. Over the past couple of decades, an extensive literature has analyzed the benefits of low average inflation in a so-called New Keynesian framework. These studies generally start from a neoclassical model and incorporate two key features:  monopolistic competition and costly price adjustment. Refer, for instance, to Goodfriend and King (1997) and Woodford (2003). Return to text

5. Interestingly, the larger the burden coming from the interaction of inflation and the capital income tax, the more government tax revenues will fall when inflation is reduced. Feldstein (1997, 1999) provides a quantitative assessment of the benefits of price stability based on the interaction of inflation and the tax system, showing that a lower average inflation rate stimulates investment by reducing the effective tax on capital income. Return to text

6. Because real money balances bear no interest, the opportunity cost of holding them is the nominal rate of interest. Higher inflation then leads to higher nominal interest rates, and hence lowers real balances, which causes a welfare loss because the social cost of producing real balances has remained substantially unaffected. In the absence of other frictions in the economy, inflation is viewed in this class of models as a tax on real balances (Bailey, 1956; Friedman 1969). However, the costs from higher holdings of real money balances has arguably become much less relevant as our economy has become more financially sophisticated. Households hold only modest amounts of cash, so these "shoe leather" costs are likely to be fairly trivial. Return to text

7. Akerlof, Dickens, and Perry (2000). The main idea can be described as follows:  During periods of low productivity growth and no inflation, firms that need to cut their relative wages can do so only by cutting money wages. In the presence of downward nominal wage rigidities, firms will keep relative wages too high and employment too low. Hence, very low rates of inflation might prevent real wages from adjusting downward in response to declining labor demand in certain industries or regions, thereby leading to increased unemployment and hindering the re-allocation of labor from declining sectors to expanding sectors. Research by staff at the Federal Reserve Board has found evidence that downward nominal wage rigidities exist in the United States (Estevao and Wilson, 1998; Lebow, Saks, and Wilson, 2003). However, the evidence for the mechanism through which low inflation raises the natural rate of unemployment is not at all clear cut. Inflation not only can "grease" the labor market and thus allow downward shifts in real wages in response to a decline in demand along, but it can also put friction in the system ("sand") by increasing the noise in relative real wages (Groshen and Schweitzer, 1999). The noise reduces the information content of nominal wages and hence the efficiency of the process by which workers are allocated across occupations and industries. Return to text

8. See Kuroda and Yamamoto (2003) for analysis of the Japanese experience, Fehr and Goette (2005) for analysis of the Swiss experience, and Kim and Ruge-Murcia (2007) for macroeconometric analysis of the implications of downward nominal wage rigidity for the United States. Return to text

9. The fact that the deflation is anticipated does not completely rule out a negative effect on balance sheets:   If the debt is sufficiently long-lived, there still is some redistribution from debtors to creditors. Return to text

10. Although these considerations are important for the design of monetary policy, a central bank can make use of other policy tools if the policy rate does become constrained by the zero lower bound (Bernanke, 2002). Return to text

11. See Reifschneider and Williams (2000), Eggertsson and Woodford (2003, 2004), Coenen, Orphanides, and Wieland (2004), Wolman (2005), and the citations therein. Return to text

12. The term "comfort zone" appeared in the headline of a September 2002 New York Times interview with former Federal Reserve Governor Laurence Meyer (Stevenson, 2002) and has subsequently been used by Federal Reserve officials on numerous occasions, including prominent speeches by Bernanke (2005) and Yellen (2006). Return to text

13. This section focuses on the major industrial economies. Mishkin (2000) considers the experiences of a number of emerging market economies that have adopted explicit inflation objectives. Return to text

14. Bernanke and others (1999) countered this line of reasoning by noting that "missing an entire range may be perceived by the public as more serious failure of policy than missing a point, or even a narrow band, (which happens almost inevitably), leading to a possible loss of credibility." Return to text

15. Since the early 1990s, the Reserve Bank of Australia's objective has been to keep the average inflation rate within a range of 2 percent to 3 percent; thus, when the edges of New Zealand's official inflation band were softened, the Reserve Bank of New Zealand described the move as a transition in the direction of an Australian-style "thick point" (Sherwin, 1999). Return to text

16. From 1992 through 2003, the Bank of England's inflation objective was defined in terms of the retail price index excluding mortgage interest (RPIX). In October 2003, the U.K. government announced that the official inflation objective would henceforth be defined in terms of the consumer price index (CPI) and that the target would be set at 2 percent, a choice reflecting the fact that the recent average for CPI inflation had been about 1/2 percentage point lower than that of RPIX inflation. Return to text

17. Further discussion regarding the scientific approach to monetary policy is in Mishkin (2007b). Return to text

Release Date: March 27, 2008

For immediate release

The Federal Reserve Board on Thursday announced that public meetings will be held next month in Los Angeles, California, and Chicago, Illinois, on the notice by Bank of America Corporation to acquire Countrywide Financial Corporation. 

The purpose of these meetings is to collect information relating to factors the Board is required to consider under the Bank Holding Company Act.  These factors are whether the acquiring bank holding company's performance of the activities can reasonably be expected to produce benefits to the public (such as greater convenience, increased competition, and gains in efficiency) that outweigh possible adverse effects (such as undue concentration of resources, decreased or unfair competition, conflicts of interests, and unsound banking practices).   Consideration of these factors includes an evaluation of the financial and managerial resources of the acquiring bank holding company.  In addition, in acting on a notice to acquire a savings association, the Board also reviews the records of performance of the relevant insured depository institutions under the Community Reinvestment Act.

The specific dates, times, and locations of the meetings are

• Los Angeles--Monday, April 28, 2008, and Tuesday, April 29, 2008, beginning at 8:30 a.m. PDT, at the Los Angeles Branch of the Federal Reserve Bank of San Francisco, 950 South Grand Avenue, Los Angeles, California.

   

• Chicago--Tuesday, April 22, 2008, beginning at 8:30 a.m. CDT, at the Federal Reserve Bank of Chicago, 230 South LaSalle Street, Chicago, Illinois.

Governor Randall S. Kroszner

At the National Association of Hispanic Real Estate Professionals Legislative Conference 2008, Washington, D.C.

March 27, 2008

Protecting Homeowners and Sustaining Homeownership

The mortgage market has long been a source of strength in the U.S. economy, but it is facing significant challenges, especially in the subprime segment that serves consumers who have shorter or weaker credit records. As of January 2008, the most recent month for which data are available, about 24 percent of subprime adjustable-rate mortgages (ARMs) were ninety or more days delinquent, twice the level one year earlier.¹ Roughly 190,000 foreclosures were started on these mortgages in the fourth quarter, up 11 percent from the previous quarter.² The significance of the problems with subprime loan performance is evident in the unusually high rate of defaults within a few months of loan origination, known as early payment defaults. In January 2008, nearly 9 percent of subprime ARMs originated in the previous six months were already ninety or more days delinquent, twice the rate of the year before and nearly four times the rate two years earlier.³

These problems have many causes, but the role of abusive lending practices is of particular concern. Such practices have led many people into homeownership that they cannot sustain, and have had adverse effects on their neighbors and communities as defaults and foreclosures can lead to declines in the values of surrounding properties. Practices that have hurt consumers have also undermined the confidence of investors and contributed to a virtual shutdown of the subprime market with consequences for other segments of the mortgage market. As a result, it is difficult for many borrowers, especially in the subprime space, to obtain home loans. The implications of diminished access to mortgage credit are of particular concern to the audience today, given that the subprime market was the source of home purchase loans extended to many in the Hispanic community.

These events have highlighted the shared interest of mortgage borrowers, their communities, lenders, and investors in protecting borrowers from abusive practices and preserving their choices. Abusive loans that strip their equity or cause them to lose their homes must not be tolerated. Protecting borrowers with responsible underwriting standards also protects the integrity and proper functioning of the mortgage market by increasing investor confidence. Effective consumer protection produces a complementary benefit for consumers by making more capital available to meet their needs. Similarly, systematic efforts to keep borrowers who may have trouble meeting their loan obligations in their homes on a sustainable basis, by providing more certainty to the market, can have the complementary benefit of ensuring the flow of capital for potential borrowers.

With these principles in mind, I will discuss current initiatives to mitigate foreclosures. Then I will spend most of my time discussing the Board's recent initiative in proposing new regulations that apply to all mortgage lenders, not just federally supervised banks, that are designed to prevent abuse, unfairness, and deception in residential mortgage lending. The expansive scope of this proposal is essential to ensure that consumer protections convey across the mortgage market, regardless of whether a borrower receives a loan from a bank, an independent mortgage company, or through a mortgage broker.

Preventing Unnecessary Foreclosures
Given the high cost of foreclosures to lenders and investors and the disruption and distress that foreclosure can cause to consumers, their families, and their communities, it is in everyone's interest to avoid foreclosures whenever other viable options exist. With large numbers of borrowers facing potential repayment problems, it is in the interest of borrowers and investors alike for the industry to develop prudent loan modification programs and other assistance to help borrowers on a systematic and sustainable basis.

As you know, there are various initiatives underway to help borrowers struggling with their mortgages. NeighborWorks America and the Homeownership Preservation Foundation offer financial counseling services through the Homeowners HOPE hotline. The Hope Now Alliance, a broad-based coalition of government sponsored enterprises, industry trade associations, counseling agencies, and mortgage servicers, is making efforts to find ways to help borrowers through loan modification plans. The Federal Housing Administration has established the FHASecure plan to provide qualified borrowers who are delinquent because of an interest rate reset and who have some equity in the home the opportunity to refinance into an FHA-insured mortgage.

I have been an active proponent of such streamlined systematic approaches to reduce transactions costs and to help mitigate foreclosure risk, and I strongly encourage market participants to adopt and to implement these fast-track modification proposals as quickly as possible. I applaud these efforts but also recognize that much more must be done. Challenges remain, for example, with respect to ongoing constraints on servicing capacity to expedite work outs. Servicers must undertake the investment to overcome the capacity challenges and provide transparent and timely measures of the results.

The Federal Reserve has been working with financial institutions and community groups around the country to address the challenges posed by problem loans. For instance, we have been providing community coalitions, counseling agencies, fellow regulators, and others with detailed analyses identifying neighborhoods at high risk of foreclosures. By understanding those areas with concentrations of subprime mortgages, delinquencies, and foreclosures, community leaders can better target their scarce resources to borrowers in need of counseling and other interventions that may help forestall foreclosure. Communities are also working to find ways to address the challenges that foreclosed homes can present, such as decreased home values and vacant properties that can deteriorate from neglect. Toward this end, the Federal Reserve has recently engaged in a partnership with NeighborWorks America to help identify strategies to help stabilize neighborhoods.

It is essential that organizations with access to at-risk homeowners, particularly those who may have additional challenges, such as language barriers, engage in foreclosure prevention initiatives to help keep families in their homes and stabilize communities. The Federal Reserve has worked to support consumers by providing them with the information they need to understand and shop for banking products, as well as to file a complaint against a bank. Many of these consumer education brochures are available in Spanish.

Importantly, we have just launched a Spanish-language version of the Federal Reserve Consumer Help Center to help better meet the needs of Spanish-speaking consumers. We have seen a dramatic increase in the number of consumers contacting us since we launched this centralized call center and website in November 2007, and now we have the capability to reach even greater numbers by providing information and assistance to Spanish-speaking consumers at 888-851-1920.⁴

The Board's Proposal
I will now focus on the Board's recent proposal for stricter regulations prohibiting abusive and deceptive practices in the mortgage market under authority of the Home Ownership and Equity Protection Act (HOEPA). This proposal is intended to protect consumers and to preserve consumer choice by targeting protections to borrowers who face the most risk. We have also sought to ensure that these standards are clear for lenders to reduce unintended consequences for consumers. Though clear, the standards are intended to be not overly prescriptive, so as to preserve access to responsible credit while amply protecting consumers. Our proposal is also comprehensive, covering most mortgage loans with certain protections and the entire subprime market with certain more specific regulations. While comprehensive, the proposal would focus protections where the risks are greatest and preserve consumers' access to responsible credit.

Our effort to produce robust, clear, and comprehensive rules was based on a rigorous analysis of available qualitative and quantitative data. We have put this proposal out for public comment until April 8 and eagerly seek suggestions to be able to craft the best possible final rule.

Comprehensive Scope
Let me say more about the comprehensive scope of this proposal. It would apply stricter regulations to higher-priced mortgage loans, which we have defined broadly, and it covers all types of mortgage lenders, unlike guidance that only applies to federally insured banks. We were particularly interested in ensuring that protections remain strong over time as loan products and lending practices change. Our analysis of the data suggested that the troubles in the mortgage market generally arise not from a single practice in isolation, but instead from the complex ways that risk factors and underwriting practices can affect each other, sometimes called "risk layering." Therefore, we have proposed using a loan's annual percentage rate, or APR, to determine whether the loan is covered by stricter regulations.⁵ Because the APR is closely correlated to risk, the proposed protections would cover loans with higher risks rather than single out particular risk factors or underwriting practices.

With the APR thresholds we have proposed, we expect that the new protections would cover the entire subprime mortgage market and the riskier end of the "near prime" market, the latter also known as the "alt-A" market. Covering part of the alt-A market would anticipate possible actions by lenders to avoid restrictions on subprime loans priced near the threshold. It would also address real risks to consumers in the alt-A segment. This segment grew very rapidly, and it layered risks, such as undocumented income, on top of other risks, such as nontraditional loan structures allowing borrowers to defer paying principal and interest. However, we have heard from commenters who have expressed concern that in the current market environment, the proposed trigger could cover the market too broadly, and we will carefully consider the issues they raise and other possible approaches to achieve our objective.

Our public hearings and our analysis identified problems not just in higher-priced loans, but also in the broader mortgage market. Thus, our proposal addresses unfair or deceptive practices for the vast majority of mortgage loans secured by a consumer's primary home. Areas targeted this broadly include broker steering, appraisal coercion, unwarranted servicing fees, and deceptive advertising. I'll touch on broker steering toward the end of my remarks.

Robust Approach to Affordability
Extending credit that borrowers can afford to repay is a fundamental pillar of responsible lending. Across the whole range of higher-priced mortgage loans, our proposal offers three rules that, working in combination, would help ensure that borrowers can afford their payments. First, is a requirement that a lender maintain responsible underwriting practices that genuinely assess borrowers' ability to repay. This general requirement would be complemented by a specific requirement to verify the income and assets of the borrower that are relied upon in making the loan. A third rule would require lenders to escrow property taxes and homeowners insurance to help borrowers meet these obligations.

This robust approach to affordability would help ensure that the subprime market promotes sustainable homeownership. Just as important, it would also help protect consumers from abusive refinancings that strip equity. Clear lending standards have the further advantages of increasing investor confidence in the mortgage market and helping to revive the flow of credit to consumers with shorter or weaker credit records.

Assessment of Repayment Ability
Now I want to discuss the major elements of our proposed regulations for higher-priced loans in a little more depth, starting with the requirement to assess repayment ability. The regulations would prohibit a lender from engaging in a pattern or practice of making higher-priced loans based on the value of the borrower's house rather than on the borrower's ability to repay from income, or from assets other than the house. This prohibition is intentionally broad to capture all risks to loan performance and the different ways that these risks can be layered. Moreover, the proposal avoids prescribing quantitative underwriting requirements. For example, the proposal would prohibit a pattern or practice of disregarding the ratio of applicants' income to their debt, but it does not prescribe a maximum ratio because the appropriate number depends heavily on other risk factors, which vary from loan to loan. At the same time, the proposal does offer specifics. For example, it would create a presumption that a lender had violated the regulations if it engaged in a pattern or practice of failing to underwrite at the fully-indexed rate.⁶

Our proposed regulations would be more robust and comprehensive than the subprime guidance the agencies issued last year. The regulations would apply to all mortgage lenders, including independent mortgage companies. Moreover, the regulations would be legally enforceable by supervisory and enforcement agencies. Just as important, the regulations, unlike the guidance, would be legally enforceable by consumers who could recover statutory and actual damages for violations.

The proposed requirement to assess repayment ability is intended to protect consumers from abusive practices while maintaining their access to responsible credit. We recognize that satisfying both objectives at the same time is a challenge. The proposed rule's potential for consumer actions, coupled with its careful avoidance of prescribing quantitative underwriting thresholds, could raise compliance and litigation risk. In turn, this could raise the cost of credit for higher-risk borrowers or limit the availability of responsible credit. That is why we have proposed prohibiting a "pattern or practice" of disregarding repayment ability rather than attaching a risk of legal liability to every individual loan that does not perform. Some commentators have argued that the pattern or practice requirement creates a higher standard of proof that can make it more difficult and costly for consumers to pursue litigation. We have specifically sought comment on this provision and look forward to perspectives offered by the industry and consumer groups.

Income Verification
When we looked closely at why so many borrowers had mortgages that they struggled to repay so soon after taking out the loan, the prevalence of "stated-income" lending was a clear culprit. Substantial anecdotal evidence indicates that failing to verify income invited fraud. Moreover, when we looked at the loan-level data we saw a clear correlation between "low-doc" or "no-doc" lending and performance problems, particularly early payment defaults.

That is why we have proposed to complement a broad requirement to assess repayment ability with a specific requirement to verify the income or assets a lender relies on to make a credit decision. We recognize that stated-income lending may have a proper place when not layered on top of too many other risks. Therefore, we would target the verification requirement to higher-priced loans, including the higher-priced end of the alt-A market, where the risks of stated-income lending could be layered on top of too many other risks.

The proposal identifies standard documents that would be acceptable, such as W-2 forms. It also allows, however, any third party documents that provide reasonably reliable evidence of income. Some consumers may have access to only nonstandard documents and others, such as self-employed entrepreneurs, may have some difficulty documenting their income. This rule is meant to preserve consumer choice by allowing the market to identify credible nontraditional documentation of consumer income--for example, check-cashing receipts. To help ensure that the proposal preserves access to credit for the full range of consumers, we have sought public comment on this issue.

Escrows for Taxes and Insurance
Another part of our proposal for higher-priced loans--a requirement to escrow taxes and insurance--would also help ensure that borrowers can afford their payments. Escrowing has become standard practice in the prime market, and the case for making it standard in the subprime market, too, appears compelling. Consumers with shorter or weaker credit histories may be less likely to appreciate the sizable burden that taxes and insurance can add to the cost of homeownership, or more vulnerable to being misled by payment quotes that leave out these amounts. Moreover, when we looked at the data, we saw in the unusually high level of early payment defaults possible evidence that the lack of escrows hurt consumers who did not have experience paying property tax and insurance bills.

We have proposed to address the problem with a requirement to escrow taxes and insurance on higher-priced loans, accompanied by a limited allowance for opt-out. We wanted the regulations to prevent irresponsible efforts to encourage borrowers to opt out. So the rule would not permit opt-out at the closing table, but instead would require that twelve months pass before a consumer may opt out. The twelve-month waiting period would also apply if a consumer refinanced into another high-cost loan, reducing the likelihood that consumers would refinance solely to decrease monthly payments by eliminating escrowing of taxes and insurance. In this respect the proposal is intended to preserve consumer choice while protecting consumers from unaffordable mortgage obligations.

Prepayment Penalties
Having discussed the rules that would promote affordability, I want to say a word about our proposed rule on prepayment penalties. These penalties can take a toll on consumers who have riskier loans, and many consumers may not even be aware their loans have a penalty. Accordingly, we have proposed a ban on prepayment penalties in circumstances of a high degree of risk to the consumer, and we are also addressing transparency concerns.

The proposed rule would ban prepayment penalties where they are most likely to prevent a consumer from refinancing a loan that has a particularly burdensome payment. Specifically, a penalty would be prohibited where the borrower's debt-to-income ratio exceeds 50 percent, and a penalty would have to expire before a loan's payment could increase. The rule would also ban prepayment penalties where they are more likely to be part of a "loan flipping" scheme--specifically, where a lender or its affiliate refinances the lender's own loan.

Banning penalties altogether could cause all borrowers, including those who do not prepay, to bear the full cost of investors' prepayment risk, which could raise questions of fairness, and it could reduce consumer choice. We recognize there are differing views on this and look forward to gaining those perspectives through the comment process.

Steering
I have so far discussed the elements of our proposal that would seek to ensure that underwriting practices and loan terms on higher-priced loans do not present unwarranted risks to consumers. There is another potential source of risk to consumers that I want to address that is related to "steering"--the risk that when they use the services of a mortgage broker, they do not appreciate the extent to which the broker's interests may diverge from the consumer's interests because of "yield spread premiums."⁷

The growth of the market for brokerage services has no doubt increased competition in the market for mortgage loans, to the benefit of consumers. Moreover, the yield spread premium, a payment from a lender to a broker based on the loan's interest rate, is sometimes the best way for a consumer to fund the cost of a broker's services. However, when a lender pays a broker for a loan that has a higher rate, that payment can create a conflict of interest between the broker and the consumer. This conflict is problematic if the consumer does not know it exists or assumes, incorrectly, that the broker is obligated to put the consumer's interests first. In such cases, the consumer cannot protect his or her own interests, and competition for loans and for brokerage services does not work effectively.

Therefore, we have proposed to prohibit a lender, for both prime and subprime loans, from paying a broker any more than the consumer had expressly agreed that the broker would receive. This agreement must be executed up-front, before the consumer has submitted an application and become invested in closing the deal. The combination of stricter regulation and better disclosure that we are proposing should help reduce a broker's incentive to steer a consumer to a higher rate, empower consumers to shop and negotiate among brokers, and preserve consumers' option to use the services of a broker.

Better and Earlier Information for Consumers
Lastly, to protect consumers and promote competition, our proposed regulation would prohibit misleading mortgage advertising and require that consumers receive loan-specific disclosures early in the application process, when they can use the information to shop more effectively. We recognize, however, that we face a challenge in ensuring that disclosures for mortgage loans remain effective. We have begun a comprehensive program of rigorous consumer testing of potential improvements to current disclosures.

Conclusion
There are more elements of our comprehensive proposal that I do not have time today to discuss, such as a prohibition against coercing appraisers and restrictions on unwarranted servicing fees. We anticipate vigorous public comment on this proposal, and once we have carefully considered all the input we receive, we will move expeditiously to a final rule. As I noted at the outset, effective consumer protection can help to restore confidence in the mortgage markets and help to preserve the flow of capital to consumers who wish to purchase a home.

It is not too early to emphasize that the effectiveness of the final rule will depend critically on effective enforcement. The Federal Reserve will do its part to ensure compliance among the institutions it supervises. We also have been instrumental in launching a pilot project with other federal and state agencies to conduct consumer compliance reviews of non-depository lenders and other industry participants. I am sure we will be aided in these efforts by a new system for registering and tracking mortgage brokers recently launched by the Conference of State Bank Supervisors.

While we work to build effective consumer protections and enforcement regimes for future consumers, we will also continue our efforts, and encourage the initiatives many others are undertaking, to limit unnecessary foreclosures for consumers who are hurting now.

Footnotes

1. Board staff calculation based on data from First American LoanPerformance. Return to text

2. Board staff calculation based on data from the Mortgage Bankers Association. Return to text

3. Board staff calculation based on data from First American LoanPerformance. Return to text

4. Federal Reserve Consumer Help can be accessed online at www.federalreserveconsumerhelp.gov/index_sp.cfm. Return to text

5. Under the proposal, a "higher-priced mortgage loan" would have an APR that exceeds the yield on comparable Treasury securities by three or more percentage points for first-lien loans, or five or more percentage points for subordinate-lien loans. Return to text

6. On an adjustable-rate mortgage, the fully-indexed rate is the sum of the value of the applicable index as of loan origination and the margin specified in the loan agreement. For example, a typical 2/28 mortgage issued in 2006 might have a fully-indexed rate of 11.37. This assumes that the mortgage was linked to the six-month LIBOR, that LIBOR was at its 2006 average value of 5.37 percent, and that the mortgage had a margin of six percentage points. Return to text

7. A "yield spread premium" is the present dollar value of the difference between the lowest interest rate the wholesale lender would have accepted on a particular transaction and the interest rate the broker actually obtained for the lender. This dollar amount is usually paid to the mortgage broker. It may also be applied to other loan-related costs, but the Board’s proposal concerns only the amount paid to the broker. Return to text