Innovative Federal Reserve Policies During the Great Financial Crisis

The following sections are included:

• Preface and Acknowledgements
• About the Editors
• About the Contributors
• Contents

In this chapter, after discussing the theoretical underpinnings of unconventional monetary policy measures, we review the existing empirical evidence on their effectiveness, focusing on those adopted by central banks, particularly the Federal Reserve. These measures operate in two ways — through the signaling channel and through the portfolio balance channel. In the former, the central bank uses communication to steer interest rates and to restore confidence in the financial markets; the latter hinges on the imperfect substitutability of assets and liabilities in the balance sheet of the private sector and postulates that the central bank’s asset purchases and liquidity provision lower financial yields and improve funding conditions in some markets. Our review of the empirical literature suggests that the unconventional measures were effective and that their impact on the economy was sizeable. However, a large degree of uncertainty surrounds the precise quantification of these effects.

This paper examines how monetary policy implementation with a large balance sheet relies upon interest on excess reserves. The paper then examines the Federal Reserve System balance sheet from its inception in 1914 until the end of 2015. Noting periods when it either increased rapidly or was large relative to activity measures, we focus on the onset of the U.S. participation in World War One (WWI), the Great Depression, and the World War Two (WWII) experience. The rapid reduction in the Fed balance sheet following WWI was associated with a sharp real contraction, whereas the more gradual decline that followed WWII was associated with better real outcomes. The current Federal Reserve balance sheet will likely contract by between $1 trillion to $1.75 trillion to “normalize,” and can contract gradually by allowing securities to mature without reinvestment. The large balance sheet might compromise policymaking if it persists indefinitely. Effective monetary policy could be threatened if, through a misunderstanding, interest on excess reserves was made unavailable. In a scenario analysis, the paper shows how Federal Reserve interest rate control would be compromised and force a sharp contraction of Federal Reserve credit, a speed more rapid than the unfavorable WWI credit contraction.

The following sections are included:

• Introduction
• The Crowding-Out Role of Short-Term Government Liabilities
• Fed versus Treasury as the Primary Supplier of Short-Term Claims
• Implementation Issues
• Looking Forward: Crowding Out as the Economy Leaves the ZLB
• Conclusions
• References

The expansion of the Federal Reserve’s balance sheet ended with the completion of the tapering process last October, but we still are a long way from normalizing either short-term interest rates or our balance sheet. As a result, it may be some time before a full assessment of the effects of our quantitative easing policies can be made, since a full evaluation will require a successful return to a normalized monetary policy. Nonetheless, I think it is quite possible and appropriate at this point to consider which design features of the Federal Reserve’s asset-purchase program were effective, and which were less successful, in achieving our monetary policy goals…

FDICIA’s prompt corrective action did not prevent a subsequent financial crisis. After the 2007–2008 crisis, the international financial community turned to macroprudential regulation/supervision to forestall future financial crises. While many countries enthusiastically adopted macroprudential policies, U.S. adoption is thwarted by its clumsy supervisory system. Aided by its unshared responsibility for overseeing financial holding companies, the Federal Reserve is working with the Basel Committee and other international bodies to increase the resilience of large systemically important financial institutions by raising their capital standards, imposing liquidity requirements, testing their ability to withstand stress, requiring them to make plans for recovery and resolution, and revamping supervision. The Fed’s efforts can be criticized, however. First, its actions are still largely micro- rather than macroprudential. Second, its confidential rules are open to court challenge when they do not conform to the Administrative Procedures Act. Third, by dovetailing regulatory requirements to banks’ stress tests, the Fed violates the American presumption that similar institutions will face identical regulatory requirements. Fourth, while FDICIA favored rules over discretion, Fed discretion now rules according to the Board and the staff’s best judgment. Fifth, the Fed’s rules have become so complex and its supervisory actions so opaque that accountability to the press, Congress and the public is deficient. These developments are not healthy in a democracy.

Most central banks share at least one common element in their design, the ability to serve as a Lender of Last Resort to banks, and sometimes, other financial institutions. By having this power, central banks can maintain credit flows to the financial system when the private sector, or other government entities, are unable or unwilling to provide credit. During the 2008–2009 Financial Crisis, the Fed provided massive flows of credit to a wider variety of financial institutions and businesses than it had ever done in its prior 93-year history. This likely shortened and reduced the impact of the Great Recession. However, the Fed’s actions essentially made it appear to be the fourth branch of government that usurped the prerogatives and authorities of the Legislative Branch. In writing the Dodd– Frank Act, an angry and jealous U.S. Congress sought to curtail the Fed’s abilities to serve as Lender of Last Resort in the future. In the name of ending bailouts and reducing moral hazard, the Congress has essentially eliminated the Fed’s abilities to serve as First Responder in the next financial panic. This sets a dangerous precedent, akin to eliminating fire departments and emergency medical teams. The Fed’s duties as First Financial Responder need to be restored long before the next financial crisis.

What a government calls its financial safety net has three components: (1) actions officials take to restrict the risk of ruin that institutions assume; (2) measures officials take to limit the damage creditors, customers, employees, and stockholders suffer when and if an institution becomes hopelessly insolvent; and (3) an ability, in the event of financial turmoil, to make taxpayers and surviving institutions pay explicitly or implicitly for whatever rescue operations they undertake…

This chapter argues that asset price bubbles need to be re-examined carefully because their adverse impact on an economy has often been very substantial. The bursting of the housing bubble in 2006 and its consequences on triggering the near global financial crisis is such example. After reviewing the general literature on asset bubbles on housing and stock markets bubbles and their impacts on an economy, we contribute to the literature by proposing a fundamental housing price model that allows us to estimate the magnitude of residential housing bubbles and their starting and ending dates. The duration and the magnitude of the U.S. housing bubble in the early 2000s are estimated under alternative assumptions about the nature of forces affecting the demand for housing and housing prices.

Since 2008, the Eurozone has undergone two recessions, which together constitute the “Great Recession.” The combination of a decline in output and disinflation as well as a persistent decline in inflation suggests that contractionary monetary policy was one factor. This chapter makes two methodological points. First, in analyzing the causes of the Great Recession, it is important to distinguish between credit and monetary policy. Second, a multiplicity of estimated models can “explain” the Great Recession. In practice, economists choose between models through an associated narrative that adds additional information about causation.

The Great Recession, which encompassed back-to-back recessions in the Eurozone, has reinvigorated debate over the causes of recession. Given the prominence of disruptions to financial markets, it has also generated controversy about the desirability of central bank “inflation targeting,” especially the question of whether central banks should add a measure of financial stability to their traditional objectives for output and inflation (Curdia and Woodford, 2009; Woodford, 2012). Answers are complicated if the origin of the Great Recession lay in a combination of contractionary monetary policy and disruption to financial intermediation. The discussion here of recession in the Eurozone suggests this possibility and makes two methodological points…

This chapter reviews the evolution of the Shadow Financial Regulatory Committee’s statements on payment system and systemic risk. Six major themes emerge. First, from the outset, the Committee has argued against forbearance and taxpayer bailouts and instead advocated early regulatory intervention and prompt corrective action to force recognizing losses and recapitalizing troubled institutions. Second, when taxpayer bailouts take place there is a pressing need to protect taxpayer interests. Third, the Committee favored regulatory simplicity over complexity when it comes to structuring capital requirements and macroprudential policies. Fourth, the committee favored market price mechanisms when it comes to structuring capital constraints. Fifth, market mechanisms and prices should also be relied upon to monitor risk. Finally, the Committee urged the Fed to modernize how it implements monetary policy and cease its reliance upon the primary dealer system as the main conduit for such policy.