Bernanke: Federal Reserve Policies in the Financial Crisis

Ben Bernanke does not expect further interest cuts to have much of an impact on the economy, so they will have to rely upon other policy tools

Federal Reserve Policies in the Financial Crisis, by Ben Bernanke, Federal Reserve: ...[O]ur nation ... is being tested by economic and financial challenges. Those challenges and the Federal Reserve's policy responses are the topic of my remarks today.

Federal Reserve Policies during the Crisis
As you know, this extraordinary period of financial turbulence is now well into its second year. ...

The Federal Reserve's strategy for dealing with the financial crisis and its economic consequences has had three components.

First, to offset to the extent possible the effects of the crisis on credit conditions and the broader economy, the Federal Open Market Committee (FOMC) has aggressively eased monetary policy. ... By way of historical comparison, this policy response stands out as exceptionally rapid and proactive. ...

The Committee's rapid monetary easing was not without risks. Some observers expressed concern at the time that these policies would stoke inflation... However,... overall inflation appears set to decline significantly over the next year toward levels consistent with price stability.

Although monetary easing likely offset some part of the economic effects of the financial turmoil, that offset has been incomplete... In particular, many traditional funding sources for financial institutions and markets have dried up, and banks and other lenders have found their ability to securitize mortgages, auto loans, credit card receivables, student loans, and other forms of credit greatly curtailed. Consequently, the second component of the Federal Reserve's strategy has been to support the functioning of credit markets and to reduce financial strains by providing liquidity to the private sector--that is, by lending cash or its equivalent secured with relatively illiquid assets. ... It should be emphasized that the loans that we make to banks and primary dealers through our standing facilities are both overcollateralized and made with recourse to the borrowing firm, which serves to minimize the Federal Reserve's exposure to credit risk. ...

Judging the effectiveness of the Federal Reserve's liquidity programs is difficult. Obviously, they have not yet returned private credit markets to normal functioning. But I am confident that market functioning would have been more seriously impaired in the absence of our actions. ...

Consistent with the historical mission of the Federal Reserve, the third component of our policy response has been to use all our available tools to promote financial stability, which is essential for healthy economic growth. At times, this has required working to preserve the stability of systemically critical financial institutions, so as to avoid further costly disruptions to both the financial system and the broader economy during this extraordinary period. In particular, the Federal Reserve collaborated with the Treasury to facilitate the acquisition of the investment bank Bear Stearns by JPMorgan Chase and to stabilize the large insurer, American International Group (AIG). We worked with the Treasury and the Federal Deposit Insurance Corporation (FDIC) to put together a package of guarantees, liquidity access, and capital for Citigroup. Other efforts include our support of the actions by the Federal Housing Finance Agency and the Treasury to place the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac into conservatorship and our work with the FDIC and other bank regulators to assist in the resolution of troubled depositories, such as Wachovia. In each case, we judged that the failure of the institution in question would have posed substantial risks to the financial system and thus to the economy. ...

The Federal Reserve's efforts in conjunction with other agencies to prevent the failure of systemically important firms have been controversial at times. One view holds that intervening to prevent the failure of a financial firm is counterproductive, because it leads to erosion of market discipline and creates moral hazard. As a general matter, I agree that preserving market discipline is extremely important, and, accordingly, the government should intervene in markets only in exceptional circumstances. However, in my view, the failure of a major financial institution at a time when financial markets are already quite fragile poses too great a threat to financial and economic stability to be ignored. In such cases, intervention is necessary to protect the public interest. The problems of moral hazard and the existence of institutions that are "too big to fail" must certainly be addressed, but the right way to do this is through regulatory changes, improvements in the financial infrastructure, and other measures that will prevent a situation like this from recurring. Going forward, reforming the system to enhance stability and to address the problem of "too big to fail" should be a top priority for lawmakers and regulators.

In particular, recent events have revealed a serious weakness of our system: the absence of well-defined procedures and authorities for dealing with the potential failure of a systemically important nonbank financial institution. In the case of federally insured depository institutions, the FDIC has the necessary authority to resolve failing firms; indeed, in situations in which the failure of a firm is judged to pose a systemic risk, the FDIC's powers are quite broad and flexible. No comparable framework exists for nondepository financial institutions. ...

In the absence of an appropriate, comprehensive legal or regulatory framework, the Federal Reserve and the Treasury dealt with the cases of Bear Stearns and AIG using the tools available. ... However, neither route proved feasible in the case of the investment bank Lehman Brothers. No buyer for the firm was forthcoming, and the available collateral fell well short of the amount needed to secure a Federal Reserve loan sufficient to pay off the firm's counterparties and continue operations. The firm's failure was thus unavoidable, given the legal constraints...

Fortunately, we now have tools to address any similar situation that might arise in the future. The ... Administration, with the support of the Federal Reserve, asked the Congress for a new program aimed at stabilizing our financial markets. The resulting legislation, the Emergency Economic Stabilization Act (EESA), provides the necessary authorizations and resources to strengthen the financial system and, in particular, to deal with the potential failure of a systemically important firm. Notably, funds provided under the act facilitated the recent government actions to stabilize Citigroup. ...

Economic Outlook
Despite the efforts of the Federal Reserve and other policymakers, the U.S. economy remains under considerable stress. ... [E]conomic activity appears to have downshifted further in the wake of the deterioration in financial conditions in September. ...

The likely duration of the financial turmoil is difficult to judge, and thus the uncertainty surrounding the economic outlook is unusually large. ... The time needed for economic recovery ... will depend greatly on the pace at which financial and credit markets return to more-normal functioning.

The Outlook for Policy
Going forward, our nation's economic policy must vigorously address the substantial risks to financial stability and economic growth that we face. I will conclude my remarks by discussing the policy options of the Federal Reserve, focusing on the three aspects of policy that I laid out earlier: interest rate policy, liquidity policy, and policies to stabilize the financial system.

Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited. Indeed, the actual federal funds rate has been trading consistently below the Committee's 1 percent target in recent weeks, reflecting the large quantity of reserves that our lending activities have put into the system. ... We will continue to explore ways to keep the effective federal funds rate closer to the target.

Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver--the provision of liquidity--remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. ...

Second, the Federal Reserve can provide backstop liquidity not only to financial institutions but also directly to certain financial markets, as we have recently done for the commercial paper market. Such programs are promising because they sidestep banks and primary dealers to provide liquidity directly to borrowers or investors in key credit markets. In this spirit, the Federal Reserve and the Treasury jointly announced last week a facility that will lend against asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. The Federal Reserve's credit risk exposure in this facility will be minimized because the collateral will be subject to a "haircut" and because the Treasury is providing $20 billion of EESA capital as supplementary loss protection. Each of these approaches has the potential to improve the functioning of financial markets and to stimulate the economy.

Expanding the provision of liquidity leads also to further expansion of the balance sheet of the Federal Reserve. To avoid inflation in the long run and to allow short-term interest rates ultimately to return to normal levels, the Fed's balance sheet will eventually have to be brought back to a more sustainable level. The FOMC will ensure that that is done in a timely way. However, that is an issue for the future; for now, the goal of policy must be to support financial markets and the economy.

Finally, working together with the Treasury, the FDIC, and other agencies, we must take all steps necessary to minimize systemic risk. ...

I am not suggesting the way forward will be easy. But I believe that the policy responses..., together with the underlying vitality and resilience of the American economy, will help to restore confidence to our financial system and place our economy back on the path to vigorous growth.

Better, e.g. they discuss plans to perhaps purchase long-term securities, but probably still not enough specificity to satisfy Tim Duy, particularly their plans and targets, if any exist, for quantitative easing.

Comments

[pgl]

Our FED chair is working from the same economic model that Dean Baker and Paul Krugman are working from:

econospeak.blogspot.com/2008/12/cost-and-benefits-from-fiscal-stimulus.html

Time for a very significant fiscal stimulus boost!

[Nick Rowe]

I find it interesting to see that he refers to lending using student loans, auto loans, credit card loans, etc. as collateral, rather than just buying those assets outright. Buying those assets outright (in sufficient quantities) could raise the price of those assets and push down the rate of interest. But it's not obvious to me that merely using those assets as collateral would be much different from an open market purchase of government bonds. (The same question applies equally to Bernanke's 2002? paper on quantitative easing.)

[Eric L. Prentis]

The financial ruling class is forcefully, financially raping America under the guise of saving us. We have the worst of two worlds, a private Federal Reserve unilaterally spends three trillion dollars of public money to ensure that the banking crooks who got us into this mess don’t go bankrupt. This is allowed to happen in broad daylight because the financial sector pays huge campaign contributions to the slimy politicians. The ineffectual Federal Reserve should be disbanded and the banks nationalized.

[ndk]

Time for a very significant fiscal stimulus boost!

Treasury CDS at 68.4 today and counting.

I think President Bush was the most prescient official thus far: "this sucker could go down. By helping to increase risk premiums and through portfolio crowding out, we may be adding thrust to that sucker. No market touched by intervention has become functional yet, and through all this direct contact with the wounded, I fear the Treasury itself has now contracted financial ebola.

All the pressures that originally diverted so much of US investment towards consumption and finance are still present. In fact, China's devaluing the yuan further. I'd prefer we point ourselves in the right direction before turning on the booster jets.

[ndk]

But it's not obvious to me that merely using those assets as collateral would be much different from an open market purchase of government bonds.

Nick, depending on your perspective, there's a tremendous difference. The credit risk involved with buying ABS rather than Treasuries comes to rest directly on the shoulders of the government rather than the shoulders of the bank. Buying Treasuries shortens the term structure of the U.S. government's funding, exposing it to interest rate changes rather than having a fixed repayment schedule. Different kinds of risks.

From another perspective, there's no difference. The government has already declared that it will unconditionally stand behind anything too big to fail, which due to our CDS strands entangling so many entities, is most everything. In that way, all these bad assets are already our liabilities, so repurchasing them by issuing new Fed or Treasury liabilities is arbitraging our own liabilities into a cheaper cost structure.

[im1dc]

The Federal Reserve Bank of Cleveland

TIPS Expected Inflation Estimates
October 31, 2008

We have discontinued the liquidity-adjusted TIPS expected inflation estimates for the time being. The adjustment was designed for more normal liquidity premiums. We believe that the extreme rush to liquidity is affecting the accuracy of the estimates.

http://www.clevelandfed.org/research/data/tips/index.cfm

[ndk]

That's a little older, im1dc, but there's another methodology change today:

* Starting 12/01/2008, the TIPS yield curve will use on-the-run TIPS as knot points rather than all securities under 20 years.

It looks like there's severe illiquidity in the shorter TIPS, which I guess is a lot of arbs getting obliterated, whereas real money would be more likely to buy the longer dated paper. That was causing most of the discrepancy, so I'm partially wrong.

Still quite a bit higher than nominal yields using the on-the-run marks. That's got to be a risk premium.

[Nick Rowe]

ndk: thanks.

OK, in terms of (default) risk for the Fed, it seems that buying treasuries is safest, lending to banks using ABS as collateral is riskier (depending on the haircut), and buying ABS outright is the most risky.

But what about the effect on aggregate demand (in a liquidity trap)? For a given $100 billion of quantitative easing, how should we rank those three options in terms of stimulus? My view would be that buying ABS outright would have a bigger and surer effect than lending using ABS as collateral.

[ndk]

OK, in terms of (default) risk for the Fed, it seems that buying treasuries is safest, lending to banks using ABS as collateral is riskier (depending on the haircut), and buying ABS outright is the most risky.

Basically, yes. Repos are kind-of a formality right now too because you can't put this stuff back to the banks without blowing them up. They're being rolled indefinitely.

But what about the effect on aggregate demand (in a liquidity trap)? For a given $100 billion of quantitative easing, how should we rank those three options in terms of stimulus? My view would be that buying ABS outright would have a bigger and surer effect than lending using ABS as collateral.

Your view would be correct in normal times, because the bank wouldn't have to hold the lent funds in reserve. But banks have tons of liquidity already and they're just sitting on it anyway. They see no positive risk-adjusted return anywhere. They might be wrong, paralyzed, stupid, or just enjoying their nice 0.1% return from the Fed arbitraged out of the GSE's via the Fed Funds Market, but they're not about to start lending.

As the Fed becomes a direct buyer in those markets, it becomes less likely these private entities will lend. When a price-insensitive buyer that isn't profit motivated comes into a market, it's pretty foolish to buy in front of them unless you hope to turn it around to them at a later date. Which would probably be, in fact, exactly why T-bonds soared on Bernanke's comments today, increasing the cost to the government to repurchase its debt. Awesome.

We've seen the pattern of markets frozen by the well-intentioned fingers of government recapitulated time and again through this crisis.

[mmckinl]

Our economic model is broken. The consumer consumption model for the economy through ever increasing debt is dead, dead, dead.

It has only been through wars, bubbles, securitization and inceasing the debt load that the economy has gotten this far.

Stimulus of this old model will only produce more over consumption, unpayable debt and steeper economic decline while worsening the transition to either a productive economy or third world status.

We need a truly Public Central Bank that treats the creation of currency and credit as a public utility. The current model seeks out the highest return irregardless of productivity or merit. Until we use our resources to regain a productive economy any stimulus will be counterproductive.

The aggregate U.S. debt is 50 trillion dollars. With economy contracting violently this amount is unpayable yet Bernanke and Paulson backstop debt.

[ndk]

The aggregate U.S. debt is 50 trillion dollars. With economy contracting violently this amount is unpayable yet Bernanke and Paulson backstop debt.

That's what has saddened me so much here. We needed to reduce aggregate debt loads, not increase them. Bankruptcy is our traditional way to do that. Again, I know the implications of that bankruptcy for banks, savings accounts, and all kinds of other leveraged entities.

That would have at least left government's reputation, credit, and trust intact, rather than everyone considering them Wall Street's enabler and a bunch of liars. It also may have enabled the Treasury to avoid some of these liabilities, reducing them through bankruptcy of the individual, independent firms instead.

Enormously difficult times indeed either way, but I want to protect the citizen's faith in our own government.

[Demand Side]

Bernanke's policy is to buy a larger belt and expect to get fat, to paraphrase Keynes. A larger belt will keep the expansion from being uncomfortable, and some may say without it, expansion is impossible. But all this liquidity will not make it happen.