Federal Reserve What Everyone Needs To Know (Axilrod)
Federal Reserve What Everyone Needs To Know (Axilrod)
Federal Reserve What Everyone Needs To Know (Axilrod)
STEPHEN H. AXILROD
1
3
Oxford University Press is a department of the University of Oxford.
It furthers the University’s objective of excellence in research, scholarship,
and education by publishing worldwide.
With offices in
Argentina Austria Brazil Chile Czech Republic France Greece
Guatemala Hungary Italy Japan Poland Portugal Singapore
South Korea Switzerland Thailand Turkey Ukraine Vietnam
1 3 5 7 9 8 6 4 2
Printed in the United States of America
on acid-free paper
CONTENTS
PREFACE xi
1 Introduction 1
In what ways are the two great postwar crises similar? 111
How did the Fed becomes involved in the great inflation’s onset? 112
How did the Fed control inflation and regain credibility? 113
What again destabilized the economic and financial
background for Fed policy? 115
How did the Fed become involved in the great credit crisis? 116
What actions did the Fed take to help contain the crisis? 119
How did the Fed contribute to the recovery? 120
What lessons can be learned from the Fed’s management
of the two great postwar crises? 122
Contents ix
8 Conclusion 127
INDEX 137
This page intentionally left blank
PREFACE
in the United States and the rest of the world. At that time, the
financial panics and breakdowns in the banking system that had
all too frequently unsettled our economy impelled the Congress
to create an institution (the Federal Reserve System) with lend-
ing, regulatory, and other powers that could, it was thought,
moderate, if not avert, significant financial disruptions.
The Fed will celebrate its 100th anniversary in 2013. The Fed
of today came into its own after amendments to the Federal
Reserve Act by the mid-1930s improved, among other things,
the organizational basis for policy, and after 1951, when the
institution was freed from agreed restraints that helped finance
the Second World War at low interest rates. This book will draw
mainly on the experiences of the post–World War II years in its
discussion of the monetary policy structure and operation of
the institution, along with regulatory issues that have been so
prominently raised in recent years in connection with the Fed
and monetary policy.
How in general does the Fed compare with other central banks?
Central banks are a familiar species in our modern world. They
come in all shapes and sizes, and are freighted with varying
responsibilities and degrees of independence from the central
government.
Central banks have been prevalent and important to eco-
nomic and financial policy in the developed world for a long
time. In recent decades, as political conditions and economic
philosophies have changed around the world, central banks in
emerging and less developed countries have begun to evolve,
quite slowly in many instances, toward modern-style central
banks with powers more typical of those in the developed
world. How advanced or not a central bank may be, and while
differing in a number of important respects, they all tend to
feature, in one way or another, the essential central banking
power for strongly influencing overall credit and money con-
ditions in the country.
As a central bank, the Fed is akin to diverse institutions
among the major economic countries of the world such as the
Bank of England (BoE) in the United Kingdom, the European
Central Bank (ECB), the Bank of Japan (BoJ) and, although
rather more remotely, the Peoples Bank of China (PBC). All
except the PBC have a certain amount of basic independence
4 THE FEDERAL RESERVE
like the Fed and wield their policy instruments in similar ways.
In practice, the PBC differs in both respects at the present time.
However, the regulatory roles among major central banks dif-
fer and seem to be in a state of flux.
The BoE, whose day-to-day monetary operations are rather
similar to those of the Fed, has not been spared from the recent
spate of financial crises afflicting financially important coun-
tries or currency areas. Interestingly enough, the crisis was,
as in the United States, attributed in good part to inadequate
regulation. The result was to transfer back to the BoE respon-
sibilities that had been transferred out not so long before as
a result of political dissatisfaction with an earlier regulatory
oversight by the bank. What goes around comes around, so
it would seem. The BoE could, and did, of course continue to
carry out its monetary policy without regulatory authority, but
regulatory authority apparently could not be handled effec-
tively without a key role for the BoE.
The crisis in the United States initially caused a huge adverse
political reaction to the Fed’s handling of its regulatory respon-
sibilities, including many threats to remove them. In the end,
some peripheral ones were removed, but other important ones
were added by new fundamental financial legislation passed
in 2010.
The ECB, unlike other central banks, is not the bank for a sin-
gle country with its own overriding political and social system
and fiscal authority. Rather, the ECB serves as the sole monetary
and currency authority for a large group of countries (17 as of
this writing) within the European Union that employ the Euro
as their common currency. Regulatory and supervisory respon-
sibilities for banks and other financial institutions are dispersed
among the individual countries of both the Euro zone and the
EU as a whole. Of course, continuing efforts at coordination are
undertaken through various mechanisms within the area, and
greater efforts to bring regulation more closely into harmony
were set in motion by the intensified Euro credit crisis of very
recent years.
Introduction 5
in the United States). They provide the base for a rather rapid,
multiple expansion in bank credit and deposits that also affects,
through customer linkages, financial markets and interest rates
more broadly throughout the economy.
9 Cleveland
Minneapolis
2 1
Chicago Boston
12 Kansas City 7 3
4 New York
San Francisco 10 Philadelphia
St. Louis
5 Board of
8
11 Governors
Dallas Atlanta Richmond
6
There are other powers available to the Fed that are at least
tangential to success in achieving monetary policy objectives,
but for which it does not have either sole or ultimate control.
One has to do with foreign exchange market operations. The
other, and more important to financial market stability and
the Fed’s ability to employ its monetary policy instruments
most effectively, involves its regulatory and supervisory
responsibilities.
With regard to foreign exchange market operations, control
in practice has been in the hands of the U.S. Treasury, whose
secretary is considered to be the nation’s chief financial officer.
Nonetheless, the Fed’s own operations in that market require
approval by the FOMC. The Fed in that way has an important
influence on U.S. exchange market policy, but the Treasury in
practice has had ultimate control over the size of operations,
if any, whether for the Fed’s own account or the Treasury’s
account (for which the Fed acts as fiscal agent).
With regard to regulatory policy, the Fed may have more
independence in action than it does in the foreign exchange
market, but by no means does it have the same independence
as in monetary policy and instruments directly related to it. At
the same time, the Fed implicitly has responsibility for ensur-
ing the underlying stability of financial markets, obviously a
goal desirable in and of itself, but also a much-needed objec-
tive to support the effectiveness of monetary policy, as the
credit crisis and its damaging effect on the economy and mar-
ket functioning made clear. That responsibility will continue,
so it would appear, to require coordination with other regula-
tory authorities and agencies as modified by the DFA.
3
BASIC MONETARY POLICY
OBJECTIVES
How does the Fed take account of its long-run economic goals?
By all accounts, the Fed gives equal weight to its legally man-
dated employment and price objectives in framing monetary
policies. In press releases and speeches about policy during
recent years, the FOMC and its high officials have quite often
referred to them as a “dual mandate” or used other words
that represent variations on the same theme. For instance, in
early 2012, with economic recovery after the credit crisis still
slow, a policy release indicated a particular action taken would
be regularly reviewed and adjusted as needed “to promote a
stronger economic recovery in a context of price stability.”
But in practice, of course, the degree of emphasis given to
employment and price objectives in policy implementation nat-
urally varies with economic circumstances. In times of economic
recession, employment worries are of paramount importance,
and the FOMC will try to lower interest rates until recovery
takes hold. Inflation will normally be too low to be of concern
most of that time. When recovery advances far enough, infla-
tion tends to show signs of life, and the dual mandate will come
into full practical effect.
When inflation is running too high, the price stability part
of the mandate will take greater precedence and employment
will be of less concern. Then when Fed policies have brought
inflation under control, employment questions will become
more important, and the mandate will again become opera-
tionally dual.
But, for one reason or another, the world always turns out
to be more complicated than suggested by such a schematic
explanation. Policy does not normally unfold in a smooth and
predictable pattern. Monetary policymakers, like anyone else,
can have recognition problems about the dynamics driving
30 THE FEDERAL RESERVE
What role does the Fed chairman play in focusing the institution’s
economic goals?
While to a degree, hedged in by the economic and sociopo-
litical environment in which it functions, the Fed is not com-
pletely without room to maneuver. How boldly it dares to act
will depend for the most part on the personal characteristics
of the chairman of the Fed’s Board of Governors. He (thus far
only men have held the position) is the Fed’s undoubted leader
in the modern age, although not all chairmen have convinc-
ingly fulfilled that role in the eyes of history or of the public.
In practice, he alone has the national bully pulpit and internal
organizational position that yield a real opportunity to push
for significant attitudinal shifts about policy in the mindset of
Fed policymakers and concurrently the public.
Basic Monetary Policy Objectives 31
What makes the Fed prefer a little rather than no inflation as its
practical goal?
The Fed has stressed that if inflation were zero, its scope for
fighting against economic weakness by easing monetary pol-
icy may be unduly constrained. While an explanation may
involve more detail than “what everyone needs to know,” it
will at least reveal some information helpful in judging the
Fed’s performance over time in carrying out its monetary pol-
icy duties.
Basic Monetary Policy Objectives 35
do not impair real economic growth, but that higher rates are
more likely to do so.
Based in part on experience during the more stable parts
of the postwar years and of other countries with similar eco-
nomic and financial structures as the United States, a low rate
of inflation that may well be generally sustainable (in relatively
normal times) without raising problems over the longer run
for implementation of the dual mandate might be fairly repre-
sented as a 1.5% to 3% annual rate range, give or take a little.
and downs around that rate was given; presumably that will
depend on judgments that can only be made in light of actual
changing circumstances in the economy.
Some indication of what will enter into the Fed’s flexibility
in price judgments can be garnered from the other price index
for which FOMC makes projections. That is called the core
PCE. It represents the PCE excluding food and energy prices.
The Fed makes annual projections of that measure but does
not provide any longer-run projection since it does not repre-
sent the Fed’s fundamental goal for price stability.
In the shorter-run, however, the Fed has placed a lot of
emphasis on the core. It believes food and energy prices are
subject to considerable volatility and may provide misleading
indications of underlying inflation. That is certainly true, but
the essential question is: misleading for how long?
One answer would be until they are reflected in rising
labor costs as consumers seek higher wages to compensate for
greater food and travel expenses that undermine their stan-
dard of living. After all, people do have to eat and move about.
By that time, the more fundamental PCE and its rate of growth
may unfortunately have begun to experience a more lasting
upward shift as a result of the basic cost-push pressures. Since
monetary policy generally works with a long lag, the Fed may
then find itself, if it has not moved toward monetary restraint
soon enough, more behind the curve than is good for a smooth
and effective transition to a more active anti-inflation policy.
Such judgments will, of course, have to be made no matter
what particular aggregate price measures are looked at. But a
number of countries do not seem to pay as much attention to a
core inflation measure as does the Fed in the shorter run, and
some make different judgments about what the core should
reflect.
4
INSTRUMENTS OF
MONETARY POLICY
so during the worst of the credit crisis. The ups and downs of
the base reflect the extent to which the Fed’s monetary policies
are working to help expand or restrain, through impacts on the
banking system, the nation’s credit and money in an effort to
achieve its dual economic objectives.
The monetary base comprises over 90% of the Fed’s balance
sheet, which is put together for the system as a whole and pub-
lished weekly as the consolidated statement of condition of all
12 regional Reserve Banks. The currency component of the
base is automatically provided by the Fed in response to the
public’s demand for it. As a result, the Fed’s monetary policy
decisions are reflected in actions that directly affect only the
aggregate of bank reserve balances contained in the base.
Reserve balances ran at an exceptionally high 35% to 50% or
so of the Fed’s balance sheet in the credit crisis period because
banks held huge amounts of excess reserves. However, in nor-
mal times, banks usually hold far fewer excess reserves, so
that the aggregate of bank reserve balances would take up a
much smaller share of what would be a considerably reduced
balance sheet for the Fed. (See Appendices A-1 and A-2 for
examples of the Fed’s balance sheet before, during, and after
the credit crisis.)1
When normalcy does return to banking markets, however,
past experience with excess reserves will not be as good a pre-
dictor of future behavior as it once was. Since 2008, the Fed
has had the authority to pay interest to banks on their excess
reserves as well as on their required reserves. Exactly how it
will continue to exercise that authority remains to be seen. In
announcing its approach, the Fed publicly indicated that it
views the interest rate paid on excess reserves as serving mon-
etary policy purposes, while that on required reserves as com-
pensating banks for the implicit tax incurred in holding them.
No matter what the share of bank reserve balances turns out
to be on the Fed’s balance sheet, it is the Fed’s ultimate con-
trol over them that is crucial to its enormous power. An indi-
vidual commercial bank can become more or less aggressive
Instruments of Monetary Policy 43
directs the Federal Reserve Bank of New York to carry out the
decisions made at its most recent meeting.
For the most part, in recent decades, as already stressed,
instructions for open market operations focused almost solely
on attainment of reserve conditions consistent with a specific
funds rate objective. Such a strategy has, of course, been virtu-
ally dormant in the United States since the height of the credit
crisis in late 2008 and early 2009, with the federal funds rate
subsequently remaining at a rock bottom zero to one-quarter
of a percent range through 2012. It will probably revive when
economic recovery shows clear staying power. The funds rate
had in fact fluctuated widely during the past five decades,
reaching an unusually high peak in the area of 15–20% in the
vigorous inflation-fighting years of the early 1980s, while fluc-
tuating mostly in the vicinity of a 2–7% range in other postwar
years.
Using the funds rate and associated money market condi-
tions as an operating objective permits the Fed to fulfill its
basic central banking function of maintaining adequate liquid-
ity to sustain the economy and day-to-day market functioning
while also influencing the overall supply of credit as needed to
achieve its economic objectives over time. Setting aside major
credit crisis periods when exceptional actions are required, it
also has the advantage of minimizing interference in market
processes that efficiently balance credit supplies and demands
among uses that best satisfy the tastes and needs of businesses,
consumers, investors, and savers in the constantly evolving
dynamics of our enterprise economy. Presumably for similar
reasons, most major central banks in advanced economies
appear to focus on money market conditions, expressed one
way or another, as their day-to-day objective.
The Fed’s policy directive also includes whatever other
instructions may be needed to guide the intermeeting actions
of the account manager. Most recently for instance, in the after-
math of the credit crisis, they encompassed directions about
buying and selling securities for other particular purposes,
Instruments of Monetary Policy 47
How does the federal funds rate connect with money market
conditions in general?
The fed funds rate is one of a collection of rates that comprise
the money market, a market made up of diverse borrowers
and lenders with banks essentially serving as its backstop.
These include large businesses that issue their own commer-
cial paper and also place surplus funds in other money mar-
ket instruments; the U.S. government that funds its financing
need in part through Treasury bills that are short-term (up to
one year in maturity) and attractive to various institutions and
others for liquidity purposes; security and commodity deal-
ers who require short-term loans to fund inventories as part
of their market-making activity; and myriad borrowers and
lenders for any number of purposes, some more speculative
than others.
Because of the central bank’s well-understood power to
step in and do what is needed to set any rate it wishes (within
a narrow range of fluctuation), the funds rate unequivo-
cally functions as the key rate in the money market. With the
48 THE FEDERAL RESERVE
discount rate set at a penalty to it, the funds rate is the lowest
rate banks can pay to obtain funds urgently and unexpectedly
needed by their customers to meet business or other obliga-
tions. It is the rate that closely influences the pricing of other
money market rates—such as, to name a few, rates for com-
mercial paper, dealer loans, and U.S. Treasury bills. (Since
federal funds transactions are not traditionally collateralized,
they do not always trade at the lowest rate in their maturity
sector of the market.)
The ability of the banking system to stand as a reliable focal
point for the money market depends to a great extent on an
efficient, well-functioning interbank market. Such a market
permits the reserve balances held at Fed banks by member
banks and other depository institutions to be moved daily in
large volume around the country in response to shifting needs.
On balance, smaller banks traditionally have reserve surpluses
that can be loaned out, while larger nationwide banks, which
tend to run sophisticated and aggressive operations, are more
likely to need funds on any given day. They are subject to the
volatile day-to-day demands on their facilities from larger and
very active customers, especially so in New York and major
regional financial centers.
While the Fed’s operating target for open market operations
has been expressed as a federal funds rate in recent decades, in
earlier times—particularly when the discount window at the
Fed was structured very differently from now—some numeri-
cal measure of liquidity pressures on banks, like member
banks’ borrowing at the Fed or so-called net free reserves (the
difference between excess reserves and member bank borrow-
ing), was employed as a guide rather than a specific rate. Such
liquidity measures were for much of the time reasonably well
correlated with money market rate behavior generally.
However, a money market rate, like that on federal funds, is
a significantly better overall guide for open market operations
than a particular quantitative measure of bank liquidity. Use
of such a measure would be counterproductive, for example,
Instruments of Monetary Policy 49
How does the funds rate decision affect other credit markets?
The effect on money market rates of an FOMC decision is, of
course, only the beginning of a story that works its way among
many markets and which in the end influences spending and
saving decisions basic to the economy, although with variable
lags and uncertain intensity. Money market rates are the base
rates in the economy, but not the rates that have the most direct
effect on whether spending will become stronger or weaker
over time. The impact of interest rates on spending occurs to
a greater extent in other markets, especially longer-term credit
markets where housing and business capital outlays for plant
and equipment are financed, as well as in the shorter-term con-
sumer finance markets.
Money market rates are often, but not always, the lowest
ones in the nation’s market and financial system. When low-
est, the structure of yields by maturity (from short to long)
and by credit quality (by perceived degree of credit risk from
low to high) that encompasses and cuts across the major credit
and security markets in the country rises from there. The yield
curve is said to be upward sloping.
However, as the Fed tightens policy and short-term rates
rise commensurately, at some point markets will believe that
50 THE FEDERAL RESERVE
they have peaked or soon will, and longer-term rates will begin
rising less than they had or begin declining. They will antici-
pate lower short-term rates in the future as policy’s efforts
to moderate the economy begin succeeding, credit demands
abate, and the economy weakens. The yield curve will flatten
out and then become downward sloping for a while until con-
ditions for a more natural upward slope take over.
The Fed often stresses the need to keep inflation expecta-
tions, an important influence on the yield curve, in check as
a major influence on their policies. When volatile, they com-
pound problems of maintaining a satisfactory balance in meet-
ing monetary policy’s dual economic mandate.
For instance, if the market comes to expect more inflation in
the future even while the economy is still producing well below
its capacity, longer-term yields will tend to rise in anticipation
and potentially work against a further economic recovery that
may be in process. Also, the more deeply inflation expectations
become embedded in interactive wage and price decision-
making as the economy approaches full capacity, the harder it
will be for policy to curb inflation without serious recessionary
repercussions, such as occurred in the early 1980s.
role, both here and in Europe, during the recent credit crises
and aftermath.
State and local government spending too is heavily influ-
enced by politics but also by revenue streams that rise and fall
along with the national economy. For the latter reason, such
spending often is pro-cyclical. However, outlays probably tend
to be encouraged a little by lower interest rates that permit debt
service to take up less room in restricted budgets.
While some sectors of the economy are inherently more sen-
sitive than others to interest rate changes, all may become more
or less so relative to their norm at particular times for a num-
ber of reasons. It can depend on market expectations of how
much more money market tightening (or easing) is in store. It
can depend on expectations about the strength (or weakness)
of the overall economy and employment in the periods ahead.
It can depend on confidence that inflation is restrained. It can
depend on expectations about how federal government bud-
get policies are likely to evolve. It can depend on perceived
developments in the rest of the world. It can depend, most par-
ticularly, on broad political, cultural, and social factors that can
make or break confidence in the future and make people and
institutions more or less conservative or liberal in their deci-
sions about spending and saving.
Notes
1 Appendices A-1 and A-2 show four examples of the Fed’s bal-
ance sheet, its key components for policy analysis, and their
relation to reserve balances. The examples are for specific dates
chosen to illustrate (in A-1) normal conditions in the balance
sheet before the credit crisis and then conditions just prior to
the distinct worsening of the crisis after mid-September 2008,
and (in A-2) the exceptionally massive expansion in the bal-
ance sheet as the crisis peaked around mid-December and that
even rose further, though transformed in its source, in the Fed’s
accounts after nearly four years of sluggish economic recovery.
Instruments of Monetary Policy 63
in normal times, are clearly the outlooks for the economy and
inflation. Voting members must continuously bear in mind
whether their decision is consistent with the dual economic
mandate given to them by law.
Of course, in periods of major crises, such as the great infla-
tion and credit crises of the postwar years, the need to com-
bat the crisis would dominate policy decisions. For instance,
the credit crisis period evidently required, for quite a while, a
laser-like focus by the Committee on market stability and func-
tioning. Success in containing a crisis, which might entail poli-
cies more or less unthinkable in more normal times, would be
required for the Fed’s dual mandate again to assume its central
place in deliberations—not that it is ever really out of sight or
mind. Questions related more specifically to the Fed’s unusual
policy strategies in the two major postwar crises are discussed
in chapter 7.
While Committee members clearly determine policy based
on their own judgments, it appears that the staff’s economic
forecast is a major background influence on the Committee’s
thinking—that is nearly inevitable, considering the thorough-
ness in the forecast’s preparation and the history of ongoing,
interactive discussions from meeting to meeting that frame
and influence the thinking processes of both Committee mem-
bers and the staff.
In the end, the Committee’s policy judgment depends not
only on its view about the strength or weakness of the econ-
omy but also, of course, as continually noted in this book, on
their view of the potential for inflation, their principal target
over the long run. In that respect, their assessment appears to
depend to a great extent on the so-called output gap, which
represents the extent to which the nation’s actual output (rep-
resented by real GDP) is above or below what the nation can
produce at something like maximum employment.
When the economy is running well below its potential, there
is considerable room for improvement in employment condi-
tions, and inflation is viewed as a minor current problem, if one
74 THE FEDERAL RESERVE
with one eye on current conditions but with the other, very
wary, eye on the future.
Economic difficulties to a great extent are rooted in mis-
judgments about the future—for instance, in the formation of
expectations about the overall economic outlook by businesses
that lead them either to over- or underinvest in capital equip-
ment, or judgments by borrowers and investors that lead them
either to become ebullient and risk being caught overextended
or to remain too fearful and hold the economy back. And for
the Fed especially, there is always the overriding problem of
assuring the public and markets that it is doing all it can to
keep the real economy moving along without also arousing
inflation expectations and all the difficulties they entail for
smooth implementation of policy.
These problems are compounded by the fact that monetary
policy works with a lag, uncertain as its length may be. Policy
actions today impact the economy over time, with peak effects
often several months away. So indications about the Fed’s atti-
tude toward the future are important to private markets and
businesses. In recent years, Fed intentions have become more
frequently and more clearly revealed, but businesses and mar-
kets are, nevertheless, still left with an unavoidable uncertainty.
They can be pretty sure, based on historical experience that the
Fed’s current judgments about policy strategy will inevitably
change, and neither they nor the Fed can be sure when.
The minutes released two weeks following an FOMC meet-
ing provide further detail about the discussion and are a fur-
ther effort toward clarifying the policy stance as quickly as
possible. They have, on occasion, led to further market adjust-
ments as the public changed its perception of policy’s intent,
such as when the minutes showed that support for a particu-
lar policy move was less strongly held than the market had
expected.
In addition, the chairman has recently initiated televised
press conferences, held four times per year right after the deci-
sion has been announced, where he responds to questions and
The Formulation and Communication of Monetary Policy 77
Why has the Fed become much more open about policy in
recent decades?
It appears that changing times and attitudes in the country
have led the Fed to become more open in recent years. The
public has become less and less tolerant of secrecy on the part
of elected decision-makers and their appointees—both here
and more widely around the world. The more developed
countries are at the forefront of the issue; although, the idea of
transparency is beginning to seep into public consciousness in
less developed, less democratic countries.
This changing trend was reflected legislatively here in the
latter part of the 1960s in the Freedom of Information Act
(FOIA) passed during the Johnson presidency. It was amended
The Formulation and Communication of Monetary Policy 79
What policies outside the Fed’s control most influence its policy
effectiveness?
With regard to policies that are, like the Fed’s monetary policy,
aimed at influencing the economy as a whole, the federal gov-
ernment’s fiscal policy would be at the top of the list. Fiscal
policy does not have the unique power to control inflation that
the Fed has, but it can help stimulate economic growth, some-
times more effectively than monetary policy. The Fed’s influ-
ence on the country’s spending is indirect through its effects
on liquidity and interest rates, but fiscal policy’s influence is
more direct through taxation and spending decisions of the
government that affect jobs and the amount of income avail-
able for spending or saving.
Coordination of fiscal and monetary policies has long been
viewed as a key policy issue for the nation, in particular since
the influential economic analysis of the British economist, John
Maynard Keynes, in the 1930s highlighted the importance of
fiscal policy in promoting recovery from depressions. Indeed,
one of the main purposes behind the semiannual monetary
The Fed’s Role, Other Domestic Policies, and Conditions Abroad 85
banking crisis that led to the very deep and lasting 1930s
depression. At that time, it was not only because the market
participants were too shell-shocked to be sufficiently respon-
sive to the Fed’s easing efforts. It was also because policy-
makers in those days—though admittedly using monetary
instruments more technically limited than now (by various col-
lateral requirements for instance)—still did not seem to recog-
nize how strongly expansive a monetary policy was required
in such drastic conditions to make any dent at all.
With such an unfortunate precedent in mind and given the
subsequent advances in economic understanding and instru-
mental flexibility, the Fed has done a much better job following
the highly threatening credit crisis of 2008–2009. The crisis was
followed by a recession that was bad but hardly comparable
to the extreme unemployment, pervasive bread lines, and
other economic and social disasters of the earlier depression.
Nonetheless, the ensuing recovery has been discouragingly
slow and social disruptions not easily repaired.
What was missing in both cases was adequately support-
ive use of the other major macro-economic tool, fiscal policy.
Situations in which monetary policy instruments are unable
to provide sufficient impetus to the economy—either because
public confidence in the future is so badly shaken or because
there is already so much liquidity in the economy that even
more can have no further significant positive impact on the
public’s willingness to borrow and spend (often termed a
liquidity trap)—are precisely the times when fiscal policy is
most required to step in.
Unlike monetary policy instruments, the instruments of
fiscal policy—governmental outlays and taxation powers—
have a more direct and certain impact on the nation’s total
spending and the private sector’s income. An expansive fis-
cal policy, via increased government spending or lower taxes,
will initially and directly raise the nation’s real GDP and dis-
posable income, as well as the country’s budgetary deficit of
course. The knock-on effects from that initial action as the new
The Fed’s Role, Other Domestic Policies, and Conditions Abroad 89
How does the Fed’s own regulatory authority fit into the nation’s
regulatory structure?
The nation’s financial regulatory structure is complex and
overlapping. Our political system entails involvement of not
only both federal and state authorities but also overlapping
federal agencies’ jurisdictions, especially those connected to
banking.
The Fed is a major player in the regulation and supervi-
sion of banking organizations, probably the major player. It
directly regulates and supervises bank holding companies and
state-chartered member banks. It shares regulatory responsi-
bilities for activities of national banks with the Office of the
Comptroller of the Currency (OCC), a bureau of the U.S.
Treasury and the chartering authority of those banks. And it is
solely responsible for regulatory oversight of foreign branches
of all member banks, whether state or nationally chartered, as
well as of certain other international banking activities includ-
ing those of foreign banks in the United States. The Federal
Deposit Insurance Company (FDIC) also has an oversight
responsibility over all insured banks to evaluate their suitabil-
ity for deposit insurance.
This diverse group of regulators and supervisors is the prod-
uct of our nation’s historical development and of a philosophy
that has attempted to balance local and national interests, as
well as differing national interests. The regulators are continu-
ously confronted by a need to negotiate reasonably consistent
positions to guide examiners and supervisors of the various
institutions in the midst of market changes that do not let up,
especially in recent decades. They have had to take account of
a rapid pace of market integration across states and, interna-
tionally, across borders. Latterly, more consideration has had
to be given to the increased intermingling of traditional bank-
ing activities with other (more speculative, or risky) financial
services in judging the condition of banking organizations.
As one might imagine, over time, agreements are reached
and modified as circumstances change. A financial institutions
98 THE FEDERAL RESERVE
would rescue them, with the ultimate cost (if any) being borne
by the taxpayer.
That problem was recognized by Fed, so it would seem, and
instances in which such loans were in fact made during the
crisis were also approved by the U.S. Treasury, as indicated
by its modest participation in the loans. This suggested gov-
ernmental agreement that the loan was in the national inter-
est. The potential cost was considered by the government to be
offset by the gain in overall financial stability—a fair enough
requirement for such controversial loans since they enter into
the territory of political judgments that are the province of the
government, not the Fed.
The DFA now limits emergency lending by the Fed to a “pro-
gram or facility with broad-based eligibility,” designed for last
resort liquidity assistance and not structured to assist a specific
firm. This would not seem very different at all from the pro-
grams under which the great bulk of lending during the crisis
took place. Setting up such a program now by law specifically
requires Treasury approval—which was not legally required
by the previous law governing Fed emergency lending. Other
provisions of the DFA provide rather complicated routes for
governmental assistance to firms faced with actual bankruptcy
as possible alternatives to normal bankruptcy procedures in
the courts.
Whether these changes have or have not improved the Fed’s
ability to enhance financial stability through regulation and
use of its discount window is not really knowable in advance.
On the regulatory side, it has been given a better opportunity
to act promptly to avert major troubles, through its authority
over large banking and other financial institutions, but whether
they will be recognized one can never be sure. And it will take
time and strong convictions to act far enough in advance and
work through coordination procedures with the Oversight
Council to be as effective as one might hope. The worst of
the recent credit crisis crashed upon us in such force not so
much because public policy instruments were inadequate but
102 THE FEDERAL RESERVE
because the potential for a really, really severe crisis was not
recognized by monetary and regulatory policymakers almost
up to the last minute; partly because of blinders embedded
in the market, policy, and political cultures of the period; and
partly because of the sheer, unadulterated difficulty of seeing
the future before it arrives.
As to the emergency lending change, that would seem to
remove a potentially potent weapon from the Fed; it will not
have the ability to lend to a troubled nonmember institution
facing financial difficulties unless it is made within a facility
with broad-based eligibility for liquidity assistance. However,
such an individual loan made promptly before an institution
is viewed as bankrupt could be a crucial element in keeping
a crisis from seriously worsening. The recent credit crisis was
greatly intensified after the Fed decided not to lend to Lehman
Brothers. It will never be known what would have happened
if it had, but the DFA provisions, read literally, would not have
given it the opportunity. They clearly suggest that the Congress
does not favor such a loan.
Although occurring in much more stable times, a counter-
example of a stabilizing individual loan made by the Fed (in
cooperation with the FDIC), may be illustrative of what can be
lost. In the 1980s, very large sums were loaned to a large mem-
ber bank experiencing substantial deposit drains, partly caused
by rumors about the deterioration in the quality of its assets—a
liquidity crisis at an individual institution that would in due
course raise the threat, if not the reality, of bankruptcy and cast
doubt on other large institutions. The official loans kept the
bank in business, though at considerable financial cost to share-
holders and chief officers, until another large bank acquired it.
This process helped defuse an iffy situation at the time.
The DFA provisions make it very difficult to implement such
a solution for an individual nonmember institution suffering
liquidity strains but not yet bankrupt; it would have no access
to the discount window except as part of some broad-based
emergency program. The Act seems to focus on provisions
The Fed’s Role, Other Domestic Policies, and Conditions Abroad 103
policy role. They can and should help establish and maintain
a banking and overall financial system that is fundamentally
sound and at little risk of destabilizing crises.
However, so perfect a continuing financial world is some-
thing like a dream from a historical perspective. Crises, unpre-
dicted and unexpected, seem to have been with us always.
So circumstances may well arise in practice when it would
be desirable to employ regulatory adjustments, such as in
capital or liquidity standards, in a flexible, timely way to aid
current monetary policy. That would fall under the author-
ity of the Board of Governors, not the FOMC. To date, they
have not been given much consideration, if any, as a useful
complement to the Fed’s usual monetary policy instruments.
A closer and more fruitful connection between independent
monetary policies and associated regulatory policies remains
to be achieved.
Note
1 The Fed’s view of its role as supervisor of a bank holding
company is described in the following quote from its booklet,
Purposes and Functions of the Federal Reserve System, published by
the Board of Governors in June 2005 (the latest edition available
as of this writing): “The Federal Reserve’s role as the supervisor
of a bank holding company or a financial holding company is to
review and assess the consolidated organization’s operations,
risk-management systems, and capital adequacy to ensure
that the holding company and its nonbank subsidiaries do not
threaten the viability of the company’s depository institutions.
In this role, the Federal Reserve serves as the “umbrella super-
visor” of the consolidated organization. In fulfilling this role,
the Federal Reserve relies to the fullest extent possible on infor-
mation and analysis provided by the appropriate supervisory
authority of the company’s bank, securities, or insurance sub-
sidiaries.” (p. 65)
7
THE FED’S TWO GREAT
POSTWAR CRISES
How did the Fed become involved in the great inflation’s onset?
The great inflation evolved slowly and then later burst forth.
Initially, it crept up as military spending expanded in the
course of the Vietnam War. The Fed did not keep inflation as
fully under control as it should have at the time. This seemed
to occur in part because federal budgetary estimates under-
estimated the full extent of the military buildup, so that its
impacts on real GDP were not fully realized by policymakers.
The public began to become more sensitized to aggregate price
behavior and inflation expectations appeared to pick up by the
early 1970s, following the long postwar period of relatively
low, stable inflationary conditions.
Subsequently, the oil price shocks, noted in the preceding
chapter, precipitated the shift of what had been a moderate
inflation into, in the end, a great one in size and duration.
The shocks were transnational, strongly raising inflationary
The Fed’s Two Great Postwar Crises 113
How did the Fed become involved in the great credit crisis?
As related earlier, the first fairly evident market manifestation
of the great credit crisis seemed to occur in 2007, when the lon-
ger end of the normally very efficient and smoothly function-
ing interbank federal funds market began faltering. The Fed, in
response, by year-end had been forced to implement a special
program of term borrowing at its discount window.
But going back somewhat further, the implosion of the spec-
ulatively driven stock market bubble around the beginning
of the new century and the threatening, though fairly brief,
eight-month recession that followed, seemed to herald—in
reality revealed—a new, less stable background environment
for monetary policy. In fact, for a time after the stock market
crash, the Fed conducted a prolonged highly easy monetary
policy, in part to guard against the small but dangerous risk of
falling into disinflation.
Unfortunately, as discussed before, a feature of Greenspan’s
easy money policy in the early years of the new century that
The Fed’s Two Great Postwar Crises 117
seemed to assure low rates for a long period might have unwit-
tingly reinforced this attitudinal shift. It seemed to reduce the
risk to leverage—of borrowing short to invest long. It was
probably more significant, or more prone to over interpreta-
tion, because it was taking place within a receptive broad cul-
tural shift that was influencing the behavior of the populace,
markets, and regulators.
As the first decade of the new century progressed, individ-
uals were leveraging themselves into quite expensive homes
relative to their income. Financial institutions also seemed to
take on more risk by increasing the degree of leverage, borrow-
ing more to hold profitable assets. In that context, institutions
also became involved in a complex link of borrowing and lend-
ing among themselves here and abroad. Risk may have been
dispersed, but the financial system itself, highly leveraged and
interlinked as it was, became subject to more systemic risk.
Markets had come to be viewed as highly liquid, capable of
diluting risk by shifting and sharing it through more extensive
use of derivative instruments, such as options and futures con-
tracts, and through newly developed credit default swaps and
complex collateral debt obligations marketed by banks and
other financial institutions. Unfortunately, as the new century
progressed, distinctions between hedging, pure speculation,
and marketing and holding investments became increasingly
hazy and the risk parameters often seemed unclear even to
allegedly sophisticated investors.
As financial markets became more complex and competi-
tively interactive, the risks to the financial system as a whole
were tending to expand as problems in one area or sector had
more potential to affect others. It was believed by a number of
powerful officials that markets would resolve their own prob-
lems should they arise—as they often (but not always) did.
Ultimately, it appeared that banking and other financial
regulators both here and abroad were too relaxed in face of
the huge technological innovations in finance and the change
in attitudes toward credit. They seemed enmeshed, as were
118 THE FEDERAL RESERVE
its support. This author would place most emphasis on the last
two, although that is one man’s opinion. In any event, within
several hours, the Fed, with Treasury support, was forced by
dangerously weakening market circumstances to make a large
emergency loan to the insurance giant, AIG, to avert a total
credit market collapse.
The stock market had been declining on balance for some
time, much as it normally does in anticipation of a recession, but
in that environment, it shifted gears into a decline that threat-
ened a free fall. It was spurred on by contentious and delayed
negotiations with and within the Congress for legislation
needed by the Treasury to help it alleviate the crisis. Authority
was needed, for example, to remove, at a price, the balance sheet
burden of bad and deteriorating securities from market institu-
tions, or otherwise strengthen their weakening capital positions.
The process was unconscionably in a state of disarray and delay,
partly because the Treasury (and apparently the Fed) showed
no evidence of any contingency planning that might provide a
useful guidepost, and mainly because the Congress was closely
divided in an election period. Legislation was finally passed,
though not without further damaging public confidence in the
government’s ability to manage crises and also itself.
What actions did the Fed take to help contain the crisis?
It was around this time that the Fed, out of sheer necessity,
transformed itself from a conventional central bank whose
balance sheet had for the postwar period remained relatively
limited in size as needed for focusing almost entirely on its
monetary policy objectives. Instead, it became a central bank
whose balance sheet was greatly enlarged in order to provide
the enormous liquidity needed by financial institutions to keep
credit markets from collapsing (see especially the Fed balance
sheets shown in Appendix A-2 as they contrast with those in
Appendix A-1). It was as if the Fed was forced to become a
key player in the business of finance, in addition to its central
120 THE FEDERAL RESERVE
easy for the Fed to create credit, the Fed needs readily saleable
assets on hand to reduce credit as quickly as might be needed
for, say, anti-inflationary purposes—these traditionally being
Treasury bills and other government securities with very short
remaining maturities. The greatly enlarged and less liquid bal-
ance sheet that the Fed has been left with following the crisis
could complicate problems for it when the economy returns
closer to normal, and it becomes necessary to mop up the excess
liquidity created during the credit crisis and its troublesome
aftermath. The Fed probably now has the instruments to do so-
including the newly available term deposits that can be placed at
the Fed, as well as extensive continued use by the open market
desk of reverse repurchase agreements. Still, the process, given
its magnitude, could be testingly complex and unpredictable.
As a general point, though, the more the Federal government
directly shares in ameliorating the financial risks in resolving a
major crisis and in moderating the sluggish economic recovery
that may well ensue, the less will the Fed’s balance sheet suf-
fer potentially debilitating distortions that may make it more
difficult to conduct monetary policy once the crisis passes. The
government did in fact take on a major part of the longer-run
financial risks in the recent crisis. But it did not do its part, via
a more proactive fiscal policy, in encouraging recovery from
such a confidence-shaking major crisis.
Nonetheless, thus far confidence in the Fed’s ability, once
normal times loom, to overcome its extraordinary balance
sheet acrobatics during the crisis and its aftermath has been
reasonably well-maintained. This can be seen in the dollar’s
relatively strong performance on exchange markets and in the
stability of domestic inflation expectations. As to the future,
we will find out.
Notes
1 For a detailed discussion of the Fed’s monetary policy activi-
ties during the periods covering the two crises see Stephen
126 THE FEDERAL RESERVE
Notes
1 It was first popularized in mid-nineteenth-century disputes
in England during the early years of the economic “science’s”
founding.
2 The average annual rate of inflation of the CPI in the United
States over the major inflationary period of 1973–1979 was 8.5%,
according to statistics published by Organisation for Economic
132 THE FEDERAL RESERVE
Fed Balance Sheet Organized as Factors Affecting Reserve Balances (figures in billions of
dollars; daily averages for week ending)
I II
Sept. 27, Sept. 10,
2006 2008
Total of factors supplying reserves (Assets) 876.6 940.3
Outright holdings of U.S. Treasury securities 768.9 479.8
Repurchase agreements 16.6 110.8
Regular discount window credit .4 19.9
Crisis related credit extensions 0 179.4
Various other 90.6 150.5
Total of factors absorbing reserves (Liabilities) 876.6 940.3
Reverse repurchase agreements 28.4 42.7
Deposits at F.R. Banks other than reserve balances 11.6 12.3
Other liabilities and capital 36.2 42.5
Currency in circulation 790.8 834.6
Reserve balances with F.R. Banks 9.7 8.0
Addendum: Implied Monetary Base 800.5 842.6
Note: Appendix tables are based on figures in table 1 of the H.4.1 statistical releases
published weekly by the Federal Board of Governors. Some items in the published
accounts have been either renamed or grouped together for clarity in presentation in the
context of this book. For instance, the loans termed primary, secondary, and seasonal
credits have been grouped under the title “regular discount window credit.” The term
“Crisis related credit extensions” encompasses a variety of other loan programs for
banks and other financial institutions designed to ease the crisis, such as term auction
credit, commercial paper funding facility, money market mutual fund liquidity facility,
broker dealer credit, and credit extended to individual financial institutions. Other credit
crisis-related debt has also elevated regular discount window credit to a degree and also
items shown as other in the balance sheet. Components may not add to total because
of rounding. The addendum measure of the monetary base is the sum of the entries for
“currency in circulation” and “reserve balances with F.R. Banks” on the liability side of
the balance sheet.
This page intentionally left blank
Appendix A-2
Fed Balance Sheet Organized as Factors Affecting Reserve Balances (figures in billions of
dollars; daily averages for week ending)
III IV
B organization/responsibilities
Bank Holding Company Act of, 3–5
(1956), 99 reason for independence of, 8–9
banking organizations relationship with governments,
benefits of Fed membership, 25
19–20 trade imbalances and, 107
regulation/supervision of, 97–99 consumer price index (CPI), 39,
Bank of England (BoE), 3–4 131n2
Bank of Japan (BoJ), 3–4 credit crisis (2007–2009)
base drift, 113 conditions surrounding, 111,
Bear Stearns, 100, 118 115–116
Bernanke, Ben, 31, 38, 78, 80–82 Fed’s contribution to, 116–119
blue book, 11, 68–70, 71–72 Fed’s response to, 119–122,
Board of Governors 130–131
appointment/organization of, lessons learned from, 122–125
13–14
policy formulation and, 64–65 DFA. See Dodd-Frank Wall Street
role in Fed’s operation, 10 Reform and Consumer
borrowing terms. See discount Protection Act
window discount window
Burns, Arthur F., 31, 78, 113 control of, 11–12
business cycles. See economic Dodd-Frank Act and, 100–102
cycles policy formulation and, 64
policy implementation and,
central banks 43–44
delicate job of, 9 as primary policy instrument,
effect on financial markets, 7–8 96
essential powers of, 3 Dodd-Frank Wall Street Reform
money-creating power of, 6–7 and Consumer Protection
necessity of regulatory Act (DFA)
authority to, 4 future considerations for, 127
138 Index