0 The FED in the Crisis and Beyond: New Policies, Old Principles Donald Kohn, Robert S Kerr Senior Fellow The Brookings Institution The Hutchins Center on Fiscal & Monetary Policy Assistance from Willem Daniel
What was the Fed looking at?... 1
2 Policymaking under true Knightian uncertainty React with force: whatever it takes. Required unprecedented response. But deeply rooted in central bank history and practice.
3 Lending to the financial sector The financial system is inherently fragile. It is built on:» Borrowing short and lending long.» Leverage.» Confidence.
4 When confidence leaves the financial sector... Bad things happen...» Runs on banks.» Fire Sales of assets.
5 Wall Street Death Spiral The viability of banks is questioned. Which lead to runs on banks and fire sales. Which lead to banks becoming less viable. Go to step one and repeat...
6 Main Street Death Spiral Financial sector troubles. Which lead to tighter credit. Which leads to reduced spending, higher unemployment, and greater defaults. Go to step one and repeat...
7 Walter Bagehot on Central Bank actions to stop a panic... The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to this man and that man, whenever the security is good. Walter Bagehot, Lombard Street: A Description of the Money Market (1873)
8 Central Bank Playbook In case of a panic:» Lend Freely.» To solvent institutions.» At a penalty rate.» Against sound collateral.
9 Lending to depository and non-depository institutions 1800 Lending by the Federal Reserve 1600 1400 Billions of Dollars 1200 1000 800 600 400 200 0 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Depository Institutions Non-Depository Institutions Central Bank Liquidity Swaps Total Fed Lending Source: Federal Reserve Board, Flow of Funds
10 Changing Financial System Source: Reproduced from Pozsar, Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky. 2013. Shadow Banking, FRBNY Economic Policy Review, December 2013.
11 Central Bank Liquidity Swaps Foreign Banks had...» More dollar assets than liabilities.» And their liabilities were short-term while their dollar assets were long-term mortgages. Efforts to fund dollar assets raised US interest rates. The Fed lends dollars to foreign central banks so central banks can lend dollars to banks.
12 Did it work? Were these bailouts? Did it work?» Yes, eventually. Were these actions bailouts?» For the most part, no. The institutions were clearly sound; the loans were repaid in full.» There were borderline cases when the FED lent to troubled institutions (i.e. for purchase of Bear Sterns, AIG, Citi, BoA).
13 Interest Rate Policy: The Federal Funds Rate 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1973 1973 1974 1975 1976 1976 1977 1978 1979 1979 1980 1981 1982 1982 1983 1984 1985 1985 1986 1987 1988 1988 1989 1990 1991 1991 1992 1993 1994 1994 1995 1996 1997 1997 1998 1999 2000 2000 2001 2002 2003 2003 2004 2005 2006 2006 Source: Federal Reserve Board
14 Moving through the chain Fed Funds Rate Intermediate to long-term rates Cost of Credit Equity Prices Exchange Rate Inflation Employment Spending
15 Federal Funds Rate at the Zero Lower Bound 6% 5% 4% 3% 2% 1% 0% 2007 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 2010 2010 2010 2010 2011 2011 2011 2011 2012 2012 2012 2012 2013 2013 2013 2013 2014 2014 Source: Federal Reserve Board What to do? Start targeting longer term rates directly.
16 Large Scale Asset Purchases/Quantitative Easing QE1 Nov 08 to March 09: $1.25 billion in MBS and Treasuries. QE2 Sep 10 to June 10: $600 billion in long-term treasuries. Operation Twist: bought $400 billion in longterm Treasuries; sold $400 billion in shortterm Treasuries. QE3: Sep 12 to Oct 14: $40 billion/mo in MBS. $45 billion/mo in Treasuries.
17 Billions of Dolalrs Federal Reserve Securities Portfolio $4,500 $4,000 $3,500 $3,000 $2,500 $2,000 $1,500 $1,000 $500 $0 Mortage Backed Securities US Treasuries Federal Agency Debt Total Securities Large scale asset purchases had two effects on longer term rates» A direct price effect: portfolio balance channel.» A signal effect: expectations channel.
18 Percent Change from a Year ago 5.0 The Dual Mandate: Why were multiple steps needed? Inflation 4.0 3.0 2.0 1.0 0.0-1.0-2.0 January-07 November-07 September-08 July-09 May-10 March-11 January-12 November-12 September-13 July-14 Unemployment Rate 12.0 10.0 8.0 6.0 4.0 2.0 Headline Inflation (PCE) Core Inflation (PCE) Fed Target Rate Unemployment 0.0 January-07 November-07 September-08 July-09 May-10 March-11 January-12 November-12 September-13 July-14
19 Give forward guidance on interest rates Forward Guidance was designed to bolster market expectations that monetary policy will remain loose» December 16, 2008: the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time» March 18, 2009 the Committee anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period
20 Give forward guidance on interest rates» August 9 th, 2011 likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.» December 12 th, 2012 appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation... is projected to be no more than a half percentage point above the Committee s 2 percent longer-run goal» October 29 th, 2014 the Committee will assess progress--both realized and expected-- toward its objectives of maximum employment and 2 percent inflation. and maintain the current range for a considerable time after the asset purchase program ends.
21 Did it work? Interest rates fell and asset prices increased. But the economic recovery was lackluster. The counterfactual: What would the economy have been like if the Fed had not acted?
22 Fed Exit from an unprecedented response Quantitative Easing» Purchases have wound down and will stop in October 2014. The portfolio will remain large for some time. Zero Interest Rates» When risk management. It is better to raise rates too late than too soon.» How raising rates with a very large portfolio. This requires new tools.
23 Conclusion In unprecedented circumstances innovate until something works to achieve the Fed s goals. New tools should be based on rigorous analysis and proven principles. Public communication is hard but essential.