It's clear from the transcripts that the FOMC was dealing with situations for which it was unprepared. Even for people with a knowledge of historical financial panics - the National Banking era panics (1863-1913) and the Great Depression - what happened in 2008 was unprecedented. The fact that the dysfunction was centered in very large financial institutions, and in the financial markets in which they were active, rather than in retail commercial banking, made all the difference. I'm going to focus on two main (and related) points: (i) Decisions by the FOMC about the fed funds rate target during most of 2008 ultimately mattered little for the effects of monetary policy, or for the unfolding crisis, during 2008; (ii) Effective power in the Federal Reserve System during the crisis was concentrated at the New York Fed and the Board of Governors. The Presidents of the regional Feds had little influence on the big decisions that drove the response to the crisis.
Monetary Policy and the Fed Funds Market
During the September 16 FOMC meeting, which occurred the day after the Lehman failure, Bernanke said the following:
We have been debating around the table for quite a while what the right indicator of monetary policy is. Is it the federal funds rate? Is it some measure of financial stress? Or what is it? I think the only answer is that the right measure is contingent on a model. As President Lacker and President Plosser pointed out, you have to have a model and a forecasting mechanism to think about where the interest rate is that best achieves your objectives. It was a very useful exercise to find out, at least to some extent, how the decline in the funds rate that we have put into place is motivated. In particular, the financial conditions do appear to be important both directly and indirectly—directly via the spreads and other observables that were put into the model and indirectly in terms of negative residuals in spending equations and the like. The recession dynamics were also a big part of the story. I hope that what this memo does for us—again, I think it’s extraordinarily helpful—is to focus our debate better. As President Plosser pointed out, we really shouldn’t argue about the level of the funds rate or the level of the spreads. We should think about the forecast and whether our policy path is consistent with achieving our objectives over the forecast period. I am sympathetic to the general view taken by the staff, which argues that those recession dynamics and financial restraints are important, that we are looking at slow growth going forward, and that inflation is likely to moderate. Based on those assumptions, I think that our policy is looking actually pretty good. To my mind, our quick move early this year, which was obviously very controversial and uncertain, was appropriate.The "quick move" Bernanke was referring to here was the 3/4% drop in the fed funds rate target (to 2.25%) on March 18, following the assisted merger of Bear Stearns with JP Morgan Chase on March 16. At the September 16 FOMC meeting, in spite of the Lehman collapse, Bernanke seemed confident that a 2% fed funds rate target could be maintained through the crisis, as he stated later in the FOMC conference call on October 7:
On the economic growth side, what is particularly worrisome to me is that, before this latest upsurge in financial stress, we had already seen deceleration in growth, including the declines, for example, in consumer spending. Everyone I know who has looked at it—outside forecasters and the Greenbook producers here at the Board—believes that the financial stress we are seeing now is going to have a significant additional effect on growth. Larry gave some estimates of unemployment above 7 percent for a couple of years. So even putting aside the extraordinary conditions in financial markets, I think the macro outlook has shifted decisively toward output risks and away from inflation risks, and on that basis, I think that a policy move is justified. I should say that this comes as a surprise to me. I very much expected that we could stay at 2 percent for a long time, and then when the economy began to recover, we could begin to normalize interest rates. But clearly things have gone off in a direction that is quite worrisome.Of course we know that things were about to go off in an even more worrisome direction, and a forecast in October 2008 of unemployment slightly above 7% for a couple of years was way off the mark.
So, was the decision to hold the fed funds rate target at 2% at the September 16 meeting a big mistake? On September 16, the most recent information the FOMC had was the July year-over-year PCE inflation rate, which was 4.2%, and the August unemployment rate number, which was 6.1%. Suppose the FOMC had been following Janet Yellen's "balanced" approach, i.e. a Taylor rule with equal weights on squared unemployment deviations and squared inflation rate deviations from their respective targets. Also assume, following Yellen, a target unemployment rate of 5.5% and a target inflation rate of 2%. Then, if the FOMC were thinking in terms of a long-run real interest rate of 2%, Yellen's rule would have dictated a fed funds rate target in excess of 4% in mid-September. Adjust downward for financial market stress (as Yellen would be inclined to do), and a 2% fed funds target does not look unreasonable. On September 16, the FOMC participants seemed to be thinking that financial market disruption would be on the order of what occurred in March 2008 when Bear Stearns was taken over. It's hard to argue why they should have thought otherwise, given what they knew at the time.
Thus, in order to make the case that the FOMC goofed on September 16, we would have to argue that Janet Yellen's view of the world is/was wrong. I don't think the people castigating the Fed for too-tight monetary policy in the face of the crisis want to make that argument.
But I think we can argue that the FOMC did not quite have a grip on how to read developments in the overnight financial markets, and the meaning of the fed funds rate at the time. To see this, first consider the time series for the effective fed funds rate and the 1-month T-bill rate (the shortest-maturity interest rate on U.S. government debt).
What do we know about the quantity of trading on the fed funds market? Perhaps not so much. This paper by Afonso, Kovner, and Schoar, at the New York Fed, measures fed funds quantities and prices using the "Furfine algorithm," which looks for patterns in payments through Fedwire that look like fed funds market transactions. The measurement is far from perfect, but the authors give us two important findings: (i) There was a substantial increase in the dispersion in interest rates across federal funds transactions following the Lehman collapse; (ii) there was only a small reduction in the quantity of fed funds market trading, post-Lehman. Thus, activity in the fed funds market reflected a substantial increase in counterparty risk after mid-September 2008, but the fed funds market did not "freeze."
The key measure of the effect of conventional monetary policy is the riskless overnight interest rate. That was certainly not the fed funds rate, especially during the financial crisis. Afonso, Kovner, and Schoar find a high degree of dispersion in fed funds transactions prices in fall 2008, reflecting substantial counterparty risk. But there seems to be something else going on, stretching back into 2007, which shows up in the charts in the time series for the 1-month T-bill rate and the fed funds rate. Unless there is something peculiar about 1-month T-bills, I think we can infer that the risk free overnight rate had fallen substantially below the fed funds rate as far back as mid-2007. Here's what the two interest rates look like from August-December 2008:
MR. LACKER. ...I think it would be worthwhile, as we go on with financial markets in such turmoil, to reflect on whether ... our lending is the equivalent of pushing on a string, to use another metaphor from the Great Depression.Once the riskless overnight rate goes to zero, there's a liquidity trap. Broad-based lending programs or overnight repo transactions by the Fed will have no effect, though if trading has indeed ceased in segments of the financial market, or financial insitutions are indeed facing liquidity crises, then targeted lending or targeted asset purchases by the Fed can matter. You'll note in the quote above that central bankers can have a little fun while dealing with financial crises, apparently. Lacker is known for being on the laissez faire end of the central-bank-intervention spectrum, and Bernanke is kidding him for sounding like a Keynesian (though there is actually nothing particularly Keynesian about a liquidity trap).
CHAIRMAN BERNANKE. Quoting Keynes, I see, Jeff.
So, what to make of this? There are hints that, when the Fed achieves "liftoff" (an increase in the Fed's policy rate above 0.25%), the New York Fed's standard day-to-day intervention mechanism will change. In particular, it seems the Fed plans on having a substantial quantity of reverse repos on its balance sheet on a regular basis, and may target an overnight repo rate rather than the fed funds rate. This will require that the Fed have timely information on overnight repo transactions on some homogeneous set of repos - e.g. those collateralized with a standard class of Treasury securities. I'm not sure if such information is readily available, but it needs to be for this to work. This will eliminate the effects of counterparty risk on the targeted overnight rate, and other features that were creating the margin between the fed funds rate and Treasury securities in 2007-8. This can only make monetary policy more effective when the next financial crisis happens. As well, repo market intervention by the Fed would tighten up arbitrage in the overnight market of interest for the Fed, for reasons discussed here.
Financial Crisis Intervention and the Distribution of Power in the Fed System
As I've mentioned before, the key policy decisions made by the Fed during the financial crisis related to lending programs (discount window and TAF), institution-specific interventions (e.g. related to the Bear-Stearns merger and lending to AIG), and unusual asset purchases (e.g. of commercial paper). Some of the regional Fed Presidents played some role in these decisions. For example, the Richmond Fed President would have played some role in the takeover of Wachovia (headquartered in Charlotte, NC) Wells Fargo, and the Boston Fed President would have been consulted in relation to intervention with respect to money market mutual funds (headquartered in Boston). But, much of the intervention involved only decisions by the Board of Governors and the New York Fed, or day-to-day judgement calls by the New York Fed. For example, the lending program to AIG, announced September 16, resulted from a decision by the Board, in consultation with the Treasury.
Some FOMC participants were worried about the ad hoc nature of the interventions, particularly with regard to large financial institutions. This statement by Bernanke is particularly revealing:
I have been grappling with the question I raised for President Lacker, and I would be very interested in hearing other views either now or some other time. The ideal way to deal with moral hazard is to have in place before the crisis begins a well-developed structure that gives clear indications in what circumstances and on what terms the government will intervene with respect to a systemically important institution. We have found ourselves, though, in this episode in a situation in which events are happening quickly, and we don’t have those things in place.The idea that a consistent policy framework for crisis intervention did not exist at the Fed, and that the absence of such a framework may have contributed to the severity of the crisis, is an idea that has been explored, post crisis, by Jeff Lacker.
We don’t have a set of criteria, we don’t have fiscal backstops, and we don’t have clear congressional intent. So in each event, in each instance, even though there is this sort of unavoidable ad hoc character to it, we are trying to make a judgment about the costs—from a fiscal perspective, from a moral hazard perspective, and so on—of taking action versus the real possibility in some cases that you might have very severe consequences for the financial system and, therefore, for the economy of not taking action. Frankly, I am decidedly confused and very muddled about this. I think it is very difficult to make strong, bright lines given that we don’t have a structure that has been well communicated and well established for how to deal with these conditions. I do think there is some chance—it is not yet large, but still some chance—that we will in fact see a much bigger intervention at the fiscal level. One is tempted to argue that by doing more earlier you can avoid even more later, but of course that is all contingent and uncertain. So we will collectively do our best to deal with these very stressful financial conditions, which I don’t think will be calm for some time.
Here's something I think is interesting. The next chart shows repurchase agreements and reverse repurchase agreements on the Fed's balance sheet.
Next, look in more detail at only 2008:
The New York Fed has a substantial amount of latitude in how it manages the System Open Market Account (SOMA). For example, the decisions about the repo market interventions that we can see in the last two charts appear to have emanated from the New York Fed. Over time, power in the Fed has become increasingly concentrated in Washington and New York. During the financial crisis, there was even more relative power wielded by the New York Fed in particular, given its proximity to Wall Street, and the nature of the policy interventions. Further, I think the crisis produced a permanent increase in the power of the Board of Governors and the New York Fed relative to the rest of the Fed system. I haven't looked at these numbers, but my guess is that we would see a substantial shift in resources - wages and other costs - in terms of what is spent in Washington and New York, vis-a-vis the regional Feds. That should certainly cause some concern in the regional Feds, and I think it's also a public concern. Part of the strength of U.S. central banking is (was?) decentralization.