We also worked closely with foreign agencies. I mentioned last time the currency swaps, in which the Fed gave dollars to foreign central banks in exchange for their own currencies. And those foreign central banks took the dollars and, at their own risk, made dollar loans to financial institutions that required dollar funding. We also, of course, continue to be in close touch with finance ministers and regulators around the world as we try to coordinate to deal with the crisis.
Putting out the most intense phase of the fire was not really enough. There has been a continuing effort to strengthen the financial and banking systems. For example, in a quite successful action that I think was very constructive, the Fed, working with the other banking agencies, led stress tests of the nineteen largest U.S. banks in the spring of 2009. This was not long after the most intense phase of the crisis. In an unprecedented way, we disclosed to the markets what the financial positions were of the major banks. Those stress tests, which confirmed that our banks could survive even a return to worse economic and financial conditions, created a great deal of confidence in investors and allowed banks to raise a great deal of private capital and, in many cases, to replace the government capital they received during the crisis. The process of stress testing has continued. Just a couple of weeks ago, the Fed led another round of stress tests, a very demanding set of stress tests. Our banks did quite well. They have raised a great deal of capital even since 2009. In many ways, they are in a stronger position in terms of capital than they were even prior to the crisis.
So these are steps that are being taken to try to get the banks back into full lending mode. It is still in progress, but restoring the integrity and the effectiveness of the financial system is obviously part of getting us back to a more normal economic situation.
Let me say a few words about the lender of last resort programs. As I have already argued at some length, the programs did appear to be effective. They arrested runs on various types of financial institutions and they restored financial market functioning. The programs, which were instituted primarily in the fall of 2008, were mostly phased out by March 2010. And they were phased out really in two different ways.
First, some of the programs just came to an end. But more often, in making loans to provide liquidity to financial institutions, the Fed would charge an interest rate that was lower than the crisis rate, the panic rate, but higher than normal interest rates. And so as the financial system calmed down and rates came back down to more normal levels, it was no longer economically or financially attractive for the institutions to keep borrowing from the Fed, and so the program wound down quite naturally. We did not have to shut them down; they basically disappeared on their own.
The financial risks that the Federal Reserve took in the lender of last resort programs were quite minimal. As I have described, lending was mostly short term. It was backed by collateral in most cases. In December 2010, we reported to Congress all the details involved in twenty-one thousand loans that the Fed made during the crisis. Of those twenty-one thousand loans, zero defaulted. Every single one was paid back. So even though the objective of the program was stabilizing the system rather than profit making, the taxpayers did come out ahead on those loans.
So that was lender of last resort activity. That was the fire hose to put out the fire of the financial crisis. But even though the crisis was contained, the impact on the U.S. and global economies was severe. And new actions were needed to help the economy recover. Remembering that the two basic tools of central banks are lender of last resort policy and monetary policy, we now turn to the second tool, monetary policy, which was the primary tool used to try to bring the economy back after the trauma of the financial crisis.
Conventional monetary policy involves management of the overnight interest rate called the federal funds rate. By raising and lowering the short-term interest rate, the Fed can influence a broader range of interest rates. That, in turn, affects consumer spending, purchases of homes, capital investment by firms, and the like, and that provides demand for the output of the economy and can help stimulate a return to growth.
Just a few words on the institutional aspects. Monetary policy is conducted by the Federal Open Market Committee, which meets in Washington eight times a year. During the crisis, it sometimes also held video conferences. When we have a meeting of the FOMC, there are nineteen people sitting around the table. There are the seven members of the Board of Governors, who are appointed by the president and confirmed by the Senate. And then there are the twelve presidents of the twelve Federal Reserve banks, each of whom is appointed by the board of directors of that regional Reserve Bank and then confirmed by the Board of Governors in Washington. So there are nineteen people around the table. We all participate in the monetary policy discussion.
When it comes time to vote, the system is a little bit more complicated. At any given meeting only twelve people are able to vote. The seven members of the Board of Governors have a permanent vote at every meeting. The president of the New York Federal Reserve Bank also has a permanent vote, which goes back to the beginning of the system and the fact that New York remains the financial capital of the United States. For the other four votes, there is a rotation system: each year, four of the eleven other Reserve Bank presidents vote, and then the next year, a different set of four vote. So again, there is a total of twelve votes in any given meeting or on any given decision on monetary policy but the entire group participates in the discussions.
Figure 30. Federal Funds Target Rate, 2003-2011
Source: Federal Reserve Board
Figure 30 shows the federal funds rate, the short-term interest rate that is a normal tool the Fed uses for monetary policy. You can see that at the end of Chairman Greenspan’s term and the beginning of my term in 2006, we were in the process of raising the federal funds rate in an attempt to normalize monetary policy after having easier policy earlier in the decade in order to help the economy recover from the 2001 recession. But in 2007, as problems began to appear in the subprime mortgage market, the Fed began to cut interest rates. You can see on the right side of the graph that interest rates were sharply reduced. And by December 2008, the federal funds rate was reduced to a range of between 0 and 25 basis points. A basis point is one-hundredth of 1 percent, so 25 basis points means one-quarter of 1 percent. By December 2008, the federal funds rate was reduced basically to zero. It cannot be cut any more, obviously.
So, as of December 2008, conventional monetary policy was exhausted. We could not cut the federal funds rate any further. And yet, the economy clearly needed additional support. Into 2009, the economy was still contracting at a rapid rate. We needed something else to support recovery, and so we turned to less conventional monetary policy. The main tool we have used is what we in the Fed call the large-scale asset purchases, or LSAPs, known in the press and elsewhere as quantitative easing, or QE. These large-scale asset purchases were an alternative way of easing monetary policy to provide support to the economy.
So how does this work? To influence longer-term rates, the Fed began to undertake large-scale purchases of Treasury and GSE mortgage-related securities. So, just to be clear here, the securities that the Fed has been purchasing are government-guaranteed securities, either Treasury securities, that is, government debt of the United States, or Fannie and Freddie securities, which were guaranteed by the U.S. government after Fannie and Freddie were taken into conservatorship.
There have been two major rounds of large-scale asset purchases, one announced in March 2009, often known as QE1, and another announced in November 2010, known as QE2. There have been some additional variations since then, including a program to lengthen the maturity of our existing assets, but these were the two biggest programs in terms of their size and their impact on the Fed’s balance sheet. Taken together, these actions increased the Fed’s balance sheet by more than two trillion dollars.
Figure 31 shows the asset side of the Fed’s balance sheet, to help us see the effects of the la
rge-scale asset purchases. The bottom layer is the traditional securities holdings. To be absolutely clear, even under normal circumstances the Fed always owns a substantial amount of U.S. Treasuries. We owned more than eight hundred billion dollars’ worth of U.S. Treasuries before the crisis began. It is not as though we began buying them from scratch. We have always owned a significant amount of these securities. So the bottom layer shows the baseline from which we started.
Figure 31. Federal Reserve Balance Sheet, Assets, 2007-2011
*Traditional security holdings reflect Treasury holdings through November 28, 2008; they are held constant after November 28, 2008.
Source: Federal Reserve Board
What else appeared on the Fed’s balance sheet on the assets side during this period? The dark segment just above the traditional securities holdings represents assets acquired or loans made during the crisis period. You can see that in late 2008, our loans outstanding to financial institutions and to some other programs rose very sharply. But you can also see that as time passed, and certainly by early 2010, those initiatives to address financial strength had been greatly reduced.
If you look at the far right, you see a little bump recently. That is the currency swaps. We instituted and extended swap agreements with the European Central Bank and other major central banks, and there has been some usage of that in an attempt to try to reduce strains in Europe, and that shows up as a little bump there at the far right of the graph. Now again, we owned about eight hundred billion dollars in Treasury securities at the beginning of the crisis. But as you can see from the large area labeled “LSAPs,” we added about two trillion dollars in new securities to the balance sheet during the period starting in early 2009. And then at the top, you have other assets, a variety of things, security reserves, physical assets, and other miscellaneous items.
Why were we buying these securities? This is, by the way, an approach that monetarists such as Milton Friedman and others have talked about. The basic idea is that when you buy Treasuries or GSE securities and bring them onto the balance sheet, that reduces the available supply of those securities in the market. Investors want to hold those securities and they have to settle for a lower yield. Or, put another way, if there is a smaller available supply of those securities in the market, investors are willing to pay a higher price for those securities, which is the inverse of the yield.
So by purchasing Treasury securities, bringing them onto our balance sheet, and reducing the available supply of those Treasuries, we effectively lowered the interest rate of longer-termed Treasuries and GSE securities as well. Moreover, to the extent that investors no longer having available Treasuries and GSE securities to hold in their portfolios, to the extent that they are induced to move to other kinds of securities, such as corporate bonds, that also raises the prices and lowers the yields on those securities. And so the net effect of these actions was to lower yields across a range of securities. And as usual, lower interest rates have supportive, stimulative effects on the economy.
So this was really a monetary policy by another name: instead of focusing on the short-term rate, we were focusing on longer-term rates. But the basic logic of lowering rates to stimulate the economy is really the same.
Figure 32. Federal Reserve Balance Sheet, Liabilities and Capital, 2007-2011
*Term deposits and other deposits held by depository institutions
Source: Federal Reserve Board
You might ask, “The Fed is buying two trillion dollars’ worth of securities. How do we pay for that?” The answer is that we paid for those securities by crediting the bank accounts of the people who sold them to us. And those accounts at the banks showed up as reserves that the banks would hold with the Fed. So the Fed is a bank for the banks. Banks can hold deposit accounts with the Fed, essentially, and those are called reserve accounts. And so as the purchases of securities occurred, the way we paid for them was basically by increasing the amount of reserves that banks had in their accounts with the Fed.
Figure 32 shows the liability side of the Fed’s balance sheet. Of course, assets and liabilities including capital have to be equal. So the liability side had to rise to nearly three trillion dollars, as you can see. As you look at this, look first at the bottom layer, which is currency, Federal Reserve notes in circulation. Sometimes you hear that the Fed is printing money in order to pay for the securities we acquire. But as a literal fact, the Fed is not printing money to acquire the securities. And you could see it from the balance sheet here. That layer is basically flat; the amount of currency in circulation has not been affected by these activities.
What has been affected is the layer above that, reserve balances. Those are the accounts that commercial banks hold with the Fed, assets to the banking system and liabilities to the Fed, and that is basically how we pay for those securities. The banking system has a large quantity of these reserves, but they are electronic entries at the Fed. They basically just sit there. They are not in circulation. They are not part of any broad measure of the money supply. They are part of what is called the monetary base, but they certainly are not cash. Then the top layer is other liabilities, including Treasury accounts and a variety of other things that the Fed does. We act as the fiscal agent for the Treasury. But the two main items you can see are the notes in circulation and the reserves held by the banks.
So what do the LSAPs or the quantitative easing, what does it do? We anticipated when we took these actions that we would be able to lower interest rates, and that was generally successful. For example, thirty-year mortgage rates have fallen below 4 percent, which is a historically low level, but other interest rates have fallen as well. The interest rates corporations have to pay on bonds, for example, have fallen, both because the underlying safe rates have fallen but also because the spreads between corporate bond rates and Treasury rates have fallen as well, reflecting greater confidence in the financial markets about the economy. And lower long-term rates, in my view and in the Fed’s analysis, have promoted growth and recovery.
Nonetheless, the effect on housing has been weaker than we hoped. We have gotten mortgage rates down very low. You would think that would stimulate housing, but the housing market has not yet recovered.
The Fed has a dual mandate; we always have two objectives. One of them is maximum employment, which we interpret to mean trying to keep the economy growing and using its full capacity, and low interest rates are a way of stimulating growth and trying to get people back to work. The second part of our mandate is price stability, low inflation. We have been quite successful in keeping inflation low. It has been a help that Volcker, in particular, and also Greenspan made it much easier for me because they had already persuaded markets that the Fed was committed to low inflation, and the Fed has built up a lot of credibility over the past thirty years or so. As a result, markets have been confident that the Fed will keep inflation low; inflation expectations have stayed low. And except for some swings up and down related to oil prices, overall, inflation has been quite low and stable.
At the same time, while we have kept inflation low, we have also made sure that inflation has not gone negative. Particularly around the time of QE2, in November 2010, there was concern that inflation had been falling. It was well below normal levels. The concern was we might get into negative inflation or deflation. Deflation has been a big problem for Japan’s economy now for quite a few years, and I talked about deflation also in the context of the Great Depression. We certainly wanted to avoid deflation. So monetary ease also guarded against the risk of deflation by making sure that the economy did not get too weak.
One more comment on large-scale asset purchases. A lot of people do not distinguish between monetary and fiscal policy. Fiscal policy is the spending and taxation tools of the federal government. Monetary policy has to do with the Fed’s management of interest rates. These are very different tools. And in particular, when the Fed buys assets as part of an LSAP or QE program, this is not a form of government sp
ending. It does not show up as government spending because we are not actually spending money. What we are doing is buying assets, which at some point will be sold back to the market, and so the value of those purchases will be earned back. In fact, because the Fed gets interest on the securities we hold, we actually make a very nice profit on these LSAPs. What we have done over the past three years is transfer about two hundred billion dollars in profits to the Treasury. That money goes directly to reducing the deficit. So these actions are not deficit-increasing; they are in fact significantly deficit-reducing.
So a major tool we used when we ran out of room to lower short-term interest rates was LSAPs, asset purchases. The other tool we have used to some extent is communication about monetary policy. To the extent that we can clearly communicate what we are trying to achieve, investors can better understand our objectives and our plans, and that can make monetary policy more effective. The Fed has taken a lot of steps to become more transparent about monetary policy to try to make sure people understand what we are trying to accomplish.
For example, four times a year, after two-day FOMC meetings, I give a press conference and answer questions about monetary policy decisions. This is a new thing for the Fed in terms of trying to explain what our policies are.
Another recent step that we took in communicating our policies more clearly was to put out a statement that described our basic approach to monetary policy and, in particular, for the first time gave a numerical definition of price stability. Many central banks around the world already have a numerical definition of price stability, and in our statement we said that, for our purposes, we were going to define price stability as 2 percent inflation. And so, the markets will know that over the medium term, the Fed will try to hit 2 percent inflation, even as it also tries to hit its objectives for growth and employment.
The Federal Reserve and the Financial Crisis Page 10