2007 Annual Report
Page 1 | 2 THE ROLE OF THE FED IN RESPONSE TO FINANCIAL DISRUPTIONSUltimately, financial market participants have the strongest incentives to sort things out when a liquidity crisis hits. However, the Fed and other public policy institutions play an important role in monitoring and facilitating efficient market functioning. The Federal Reserve seeks to foster policies that mitigate the possible fallout from the financial market to the broader macroeconomy. This means that our policy should account for how events might affect the attainment of monetary policy objectives, which are to facilitate financial conditions that help the economy obtain both maximum sustainable growth and price stability. The Fed has a number of tools at its disposal. First, through its authority as a bank supervisor, the Fed sets regulatory standards aimed at fostering the safety and soundness of the banking system. This process serves an important role during times of turmoil because well-capitalized banks can act as shock absorbers for financial markets. Second, the Fed operates Fedwire, which is one of the key large-value payment systems supporting financial markets. Periods of financial stress tend to be associated with spikes in payments volume, so ensuring that interbank payments are made in a safe, reliable, and timely fashion removes a potential source of uncertainty (see related story). Third, the Federal Reserve Banks do major work to mitigate the impact of financial turmoil in the community. During the subprime disruption the Federal Reserve Bank of Chicago has worked closely with lenders, community leaders, and government officials to assist borrowers confronting foreclosures. In particular, we have strongly supported and contributed to the Home Ownership Preservation Initiative (HOPI). HOPI was originated and launched at our Reserve Bank in 2003, and is a partnership of Neighborhood Housing Services of Chicago, the City of Chicago, and the Fed (see related story). It works with all areas of the mortgage lending business, from Wall Street to Main Street, to reduce the number and impact of foreclosures in Chicago, and provides a model for service to the community that is adaptable to other areas of the country. Our most powerful tool for addressing a liquidity crisis is monetary policy. In setting the stance of monetary policy, the Fed has a dual mandate: to help foster maximum employment and price stability. Monetary policy is concerned with mitigating financial market stress to the extent that the stress impedes fulfillment of this dual mandate. Broadly speaking, our response to a financial shock is similar to the way we respond to other shocks to the economy. First, we consider the most likely effects of the shock on the future paths for economic activity and inflation. Second, we take a risk-management approach to policy. This means we consider less likely, but more costly, alternative outcomes that we may want to insure against. We then may adjust the stance of policy to guard against the risk of events that may have low probability but, if they did occur, would present an especially notable threat to sustainable growth or price stability. In this way we set policy to best fulfill our dual mandate. With regard to shocks to the financial system, the risks we must guard against concern the ability of financial markets to carry out their core functions of efficiently allocating capital to its most productive uses and allocating risk to those market participants most willing to bear that risk. Well-functioning financial markets perform these tasks by discovering the valuations consistent with investors' thinking about the fundamental risks and returns to various assets. A widespread shortfall in liquidity could cause assets to trade at prices that do not reflect these fundamental valuations, impairing the ability of the market mechanism to efficiently allocate capital and risk. Furthermore, reduced availability of credit could reduce both business investment and the purchases of consumer durables and housing by creditworthy households. We clearly must be vigilant about these risks to economic growth. However, overly accommodative liquidity provision could endanger price stability, which is the second component of the dual mandate. After all, inflation is a monetary phenomenon. Indeed, one of the many reasons for the Fed's commitment to low and stable inflation is that inflation itself can destabilize financial markets. For example, in the late 1970s and early 1980s, high and variable inflation contributed to large fluctuations in both nominal and real interest rates. The Fed has kept these various risks to growth and inflation in mind when responding to the financial turmoil that started in August of 2007. We have taken a number of monetary policy actions to insure against the risk of costly contagion from financial markets to the real economy. Our response to the onset of the turmoil focused on ensuring that the financial markets had adequate liquidity. For example, on August 10, the Fed injected $38 billion in reserves via open market trading. In one sense, this was a routine action to inject sufficient reserves to maintain the target federal funds rate, which at that time was 5-1/4 percent. The nonroutine part was the size of the injection required to do so (the largest such injection since the days following September 11, 2001). On August 16, with conditions having deteriorated further, the Federal Reserve Board, in consultation with the District Reserve Banks, moved to improve the functioning of money markets by cutting the discount rate by 50 basis points and extending the allowable term for discount window loans to 30 days. The Board also reiterated the Fed's policy that high-quality ABCP is acceptable collateral for borrowing at the discount window. At its regular meeting on September 18, the FOMC cut the federal funds rate 50 basis points, the first in a series of rate cuts that brought the target funds rate to 2.25 percent by mid-March of 2008. This target funds rate was a full 300 basis points below the level that prevailed at the onset of the financial turmoil. In addition, the Fed inaugurated a new Term Auction Facility (TAF) that allocates Federal Reserve credit via an auction mechanism. The TAF allows banks to borrow for a longer term than the usual discount window practice, and the auction mechanism can deliver an interest rate for these term loans that is below the posted discount rate. It appears that the $140 billion provided by the TAF in December of 2007 through February of 2008 was useful in alleviating funding pressures around the start of 2008. As the turmoil continued through the first three months of 2008, the Fed undertook several initiatives to help provide liquidity to stressed markets. On March 7, the Fed announced an expansion of the TAF, increasing the size of the two March auctions to $50 billion each. That same day, the Fed announced its intention to conduct a series of term repurchase (RP) transactions with primary dealers totaling $100 billion. These RPs could be collateralized by a variety of securities, including Treasury debt, agency debt, and agency mortgage-backed securities. On March 11, the Fed increased its existing dollar swap lines with the European Central Bank and the Swiss National Bank. And on March 16, the Fed increased the maximum maturity of primary credit loans to 90 days from 30 days. Two other policy innovations in mid-March are particularly noteworthy, in that they expanded liquidity provision to institutions other than commercial banks. First, on March 11 the Fed announced a new Term Securities Lending Facility (TSLF). Under the TSLF, the Fed can lend up to $200 billion of Treasury securities to primary dealers for a term of 28 days, collateralized by assets that include both agency and AAA-rated private-label mortgage-backed securities. Second, on March 16 the Fed created a lending facility that extends overnight credit directly to primary dealers. These loans can be collateralized by a broad range of investment-grade debt securities. Since the primary dealers are nondepository institutions, these loans required the Fed to invoke its authority to lend to nonbanks under section 13(3) of the Federal Reserve Act. Under this act, such lending is only permissible under "unusual and exigent circumstances." Such loans are the first extensions of credit by the Federal Reserve to nondepository institutions since the 1930s. Together, these policy actions expand the Fed's role of providing liquidity in exchange for sound but illiquid securities. While these actions represent major innovations in Fed practice, they are in the spirit of the oldest traditions of central banking. As described by Walter Bagehot in his 1873 treatise Lombard Street, the job of the central bank is to "lend freely, against good collateral" whenever there is a shortage of liquidity in markets. These actions by the Fed will provide support to financial markets and to the economy as a whole during this period of turmoil. But we certainly cannot rule out the possibility of continued market difficulties. We cannot be sure how long it will take for financial intermediaries to complete the process of re-evaluating the risks in their portfolios and restructuring their balance sheets accordingly. Moreover, further mortgage defaults due to declines in house prices and the fact that many sub-prime adjustable rate mortgages will see their rates rise over the next few months could have negative feedbacks onto housing and financial markets. Furthermore, there remains a good deal of uncertainty about the creditworthiness of many key market participants. Given these risks going forward, the Fed must be diligent in applying the risk-management approach to policy formulation, in order to ensure that the economy is well cushioned against financial turmoil that seems to be an occasional concomitant to the beneficial process of financial innovation. Notes: Page 1 | 2 |
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