The Fed Funds Market since Last June
Another Journalistic Buyout...

Note to Self: What the Federal Reserve Has Been Doing...

Steve Cecchetti writes:

Federal Reserve policy responses to the crisis of 2007-08 | vox - Research-based policy analysis and commentary from leading economists: Central bankers are conservative people. They take great care in implementing policy; they speak precisely; they explain changes completely; and they study the environment trying to pinpoint where the next disaster looms. Good monetary policy is marked by its predictability, but when the world changes, policymakers change with it. If a crisis hits and the tools at hand are not up to the job, then central bank officials can and will improvise....

For some time now, there has been a consensus among monetary economists... policymakers' operational instrument should be an interest rate; and officials need to be transparent and clear in communicating what they are doing and why they are doing it. Furthermore, there is agreement that the central bank is the right institution to monitor and protect the stability of the financial system as a whole.

An important part of the consensus has been that central banks should provide short-term liquidity to solvent financial institutions that are in need. But, as events in 2007 and 2008 have shown, not all liquidity is created equal. And critically, the consensus model used by monetary economists to understand central bank policy offers no immediate way to organise thinking about this sort of problem....

On 9 August 2007, the crisis hit and central banks swung into action, supplying large quantities of reserves in response to stresses in the interbank lending market. The spread on 3-month versus overnight interbank loans exploded. And, as problems worsened into the winter, the spread between U.S. government agency securities -- those issued by Fannie Mae, Freddie Mac and the like -- and U.S. Treasury securities of equivalent maturity rose as well. Investors shunned anything but U.S. Treasury securities themselves.... Reductions in the target federal funds rate, the objective of Federal Reserve policy in normal times, had little impact on interbank lending markets... the purchase of securities through open market operations enabled policymakers to inject liquidity... [but] could not insure that it went to the institutions that needed it most.

In response... Fed officials created... the Term Auction Facility (TAF) and the Primary Dealer Credit Facility (PDCF), and... the Term Securities Lending Facility (TSLF). The TAF... seeks to eliminate the stigma attached to normal discount borrowing. The PDCF extends lending rights from commercial banks to investment banks... the TSLF allows investment banks to borrow Treasury bills, notes and bonds using mortgage-backed securities as collateral.... [T]he Fed made adjustments to existing procedures... extended the term of their normally temporary repurchase agreements to 28 days... accepted mortgage-backed securities rather than the normal Treasury securities.... extended swap lines to the European Central Bank and the Swiss National Bank that allowed them to offer dollars to commercial banks in their currency areas... provided a loan that allowed the investment bank Bear Stearns to remain in operation and then be taken over by JP Morgan Chase.

These new programs are very different from the ones that had been in place prior to the crisis.... By changing the level of the monetary base (really commercial bank reserve deposits at the central bank) Fed officials keep the market-determined federal funds rate near their target.... Given the quantity of assets it owns, the Fed can decide whether it wants to hold Treasury securities, foreign exchange reserves, or a variety of other things.... By the end of March 2008, the Fed had committed more than half of their nearly $1 trillion balance sheet to these new programs:

  • $100 billion to the Term Auction Facility,
  • $100 billion to 28-day repo of mortgage-backed securities,
  • $200 billion to the Term Securities Lending Facility,
  • $36 billion to foreign exchange swaps,
  • $29 billion to a loan to support the sale of Bear Stearns,
  • $30 billion so far to the Primary Dealer Credit Facility.

Changes in the composition of central bank assets are intended to influence the relative price a financial assets -- that is, interest rate spreads. So, by changing its lending procedures, Fed officials hoped that they would be able to reduce the cost of 3-month interbank loans and the spread between U.S. agency securities and the equivalent maturity Treasury rate. At this writing, these programs have met with only modest success.

As I have said before, I find it helpful to group all the things the Fed does and might do into three baskets, each corresponding to a different stage of the seriousness of the financial crisis and the soundness of the financial system.

Stage I policies are "Bagehot rule" policies: the central bank acts to keep the economy at the good equilibrium in a panic when multiple equilibria are possible by lending freely to solvent but illiquid institutions at a penalty rate. Emergency discount window operations are of this kind--and the conventions that the discount rate should be higher than the bank-to-bank federal funds market rate and that borrowing from the discount window should create a stigma and a presumption of a higher degree of future regulatory and counterpary scrutiny are part of the "penalty rate" charged for asking for such help from the central bank. The idea is that institutions that have gotten themselves underreserved and need emergency liquidity should feel some pain as a result of the systemic risk they caused.

Stage II policies are conventional consensus monetary policies: the central bank uses open-market operations to buy Treasury securities for cash in order to flood the market with liquidity--so that nobody will be illiquid--and also to push down real borrowing costs (thus encouraging investment) and push up the cash values of all kinds of debt. If there was worry about the liquidity or solvency of the system before, the hope is that these open-market purchases will drive such worry away.

Then comes stage III. It comes after stage I policies aimed at curing a temporary inability to turn assets into cash at any but fire-sale prices have failed to repair matters. It comes after stage II policies of lowering interest rates across the entire spectrum and flooding the system with liquidity have failed to ease worries that one's counterparties are still insolvent or still at risk of becoming illiquid at an awkward moment. The purpose of stage III policies is to boost relative demand for risky assets and thus to opeate on the margin that is the spread in prices and yields between safe assets like Treasury securities and the risky assets whose falling prices are threatening the stability of the financial system and the macroeconomic flow of investment.

Since last fall the Federal Reserve has done eight things:

  1. five cuts in the target federal funds rate totaling 225 basis points, or 2¼ percentage points;
  2. a drop in the premium on primary (discount) lending from 100 to 50 and then to 25 basis points, above the federal funds rate target;
  3. the creation and then enlargement of the "Term Auction Facility" (TAF) ($100 billion);
  4. the extension of collateral status for 28-day repos to mortgage-backed securities ($100 billion)
  5. the extension of credit to the European Central Bank and the Swiss National Bank ($36 billion);
  6. the change in the preexisting securities lending program to initiate the "Term Securities Lending Facility" (TSLF) ($200 billion);
  7. extension of credit to primary dealers through the newly created "Primary Dealer Credit Facility" (PDCF) ($30 billion)
  8. the authorization of lending to support the JP Morgan Chase purchase of Bear Stearns ($29 billion)

Policy move (1) is conventional stage II open-market operation monetary policy: flood the system with liquidity and tilt the intertemporal price system to the advantage of financial institutions that borrow short and lend long in order to boost investment spending and relieve fears of counterparty illiquidity or insolvency that might lead to financial meltdown. Policy moves (2) and to some degree (3) are attempts to take stage I tools and use them for stage II purposes by removing the stigma and penalty rate attached to discount borrowing. This reflects a decision that the time to punish the underreserved for their fecklessness has passed and is an obstacle to effective monetary policy.

The rest of (3)--and (4) through (8)--strike me as stage III policies of various kinds, aimed at boosting demand for and the prices of risky assets more directly, given that stage II policies have failed to fix the problem. But I have a hard time analyzing exactly how these programs should be expected to have meaningfully different effects, or how effective they could possibly be.

Paul Krugman is very pessimistic: