Federal Reserve and Financial Crisis

- Based on Lecture (4) by Ben Bernanke in George Washington University 

This lecture discusses monetary policy responses to the recession, the sluggish recovery, post-crisis changes in financial regulation, and implications of the crisis for central bank practice.

A financial panic in the fall of 2008 threatened the stability of the global financial system. As the lender of the last resort, the Fed provided liquidity to help stabilize key financial institutions and markets. The fed worked closely with the Treasury and other regulatory agencies like FDIC and SEC as well as with the foreign central banks to provide enough liquidity (internationally through currency swaps providing dollars to foreign central banks).

The fed continued its efforts to strengthen the banking system post-crisis. It undertook the stress test of 19 major banks of the US economy in 2009 and disclosed the results to the public to make them realize their financial situations. This helped restore the confidence of investors and raise around $140 billion in private capital. Later, more stress tests were performed which even showed improved performances.

One of the two policy tools, that is, the lender of last resort has been discussed, where the fed used it to help stabilize the financial system. Now the monetary policy during the crisis would be discussed, which helped stabilize the economy and promote economic recovery.

1. Conventional monetary policy involves the management of a target short term interest rate (the federal funds rate). Because longer-term interest rates tend to fall when the Fed lowers the short term rate, and because lower longer-term rates tend to encourage purchases of long-lasting consumer goods, houses and capital goods, cutting the federal rate helps stimulate the economy. The monetary policy is conducted by the Federal Open Market Committee (FOMC). 7 Governors, 12 Presidents of the 12 Reserve banks constitute this committee, however, only 12 (7 governors and 5 presidents) vote during the policy.

2. To support the recovery, the Fed reduced the federal funds rate from 5.25 per cent in September 2007  to nearly zero (0-25 basis points; basis point equals 0.01%) in December 2008. With the federal funds rate near zero, the scope for the conventional monetary policy was exhausted but the economy remained weak and risks of deflation remained. So, the Fed adopted an unconventional policy or the Quantitative Easing (QE) or Large Scale Asset Purchase (LSAP). To influence longer-term rates directly, the Fed undertook large-scale purchases of Treasury and government-sponsored enterprise (GSE) mortgage-related securities. Two large purchase programs in March 2009 and November 2010 was announced, and as a result, the Fed's balance sheet ballooned more than $2 trillion dollars. These securities purchases were financed by adding to the reserves held by banks at the Fed; they did not significantly affect the amount of money in circulation. The Fed has multiple ways to unwind the large-scale asset purchases (LSAPs), including selling the securities back into the market. With the available supply of Treasury and GSE securities reduced by Fed purchases, investors were willing to accept lower yields. Lower longer-term interest rates helped stimulate the economy, just as they do under conventional policies.

So what did LSAPs or QE do? LSAPs lowered the longer-term rates. Even the spread between corporate bond rates and treasury rates have fallen, showing confidence in the financial system. Also, the Fed's credibility and long-standing commitment to price stability have helped anchor inflation and inflation expectations, which have remained low. At the same time, LSAPs ensured that the economy doesn't go into deflation. Also note that the Fed's asset purchases are not government spending, because the assets the Fed acquired will ultimately be sold back into the market. Indeed, the Fed has made money on its purchases so far, transferring about $200 billion to the Treasury from 2009 through 2011.

3. Clear communication from the central bank can help make monetary policy more effective by helping investors better understand policy goals and better anticipate future policy actions. So, the Fed has begun to provide guidance to investors and the public about how it expects to adjust the federal funds rate in the future, given the current information about the outlook.

Aided by the effects of monetary and fiscal policy as well as the economy's natural power began healing economy as it began to recover in mid-2009. The National Beaurae of Economic Research, which officially designates the beginning and end of recessions announced that this recession began in December 2007 and ended on July 2009. The recovery, however, has been quite sluggish. One of the reasons for a slower recovery is that in general the resurgence of the housing helps power the economy, however, it has not been the case this time.

The foreclosure rates are still high, and house prices are still falling. Generally, the decline in house prices make the consumers feel poorer and thus reduce their willingness to spend. But the US banking system is significantly stronger than it was during the crisis, and credit is more available to households and businesses. Concerns about European fiscal and banking conditions at the same time have also stressed the financial markets and led to more conservative lending and reduced confidence.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 instituted wide-ranging reforms of financial regulation in the US. This Act expanded the financial stability duties of financial regulators, including the Fed, 
1. It created the Financial Stability Oversight Council (FSOC) to help regulators coordinate their efforts
2. It gave all regulators the responsibility to track and respond to possible risks to the financial system as a whole.
3. It closed gaps in the oversight of the financial system by designating systematically important non-bank institutions to be supervised by the Fed. It can also designate key financial market utilities (like the stock exchange) to be supervised
4. The act subjected systematically important financial institutions to tougher supervision and regulation than other firms (for example higher capital requirements, regular stress tests etc)
5. It now requires more transparency in trading with derivatives 
6. It created a new agency with board powers to protect consumers in their financial dealings