Transcript The Federal Reserve

The Fed and the Financial Crisis
Jonathan Cotten
Roger Kone
Davorin Kuljasevic
Outline
• Feds role in causing the crisis
▫ Monetary Policy
• Feds reaction to the crisis
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Lower Target Funds Rate
Discount window/TAF
Bailouts
Lending Facilities
Scap
• Critique and concerns
▫ Easy money, what should have happened
▫ Current Policy
▫ Concerns about Fed and Economy
Monetary Policy
Overview
2001 – 2002
2003 – 2004
2005 - 2006
Overview of Monetary Policy
2001 – 2006
• Focus on federal funds target rate and
Taylor rule
• Monetary policy lag of 12-18 months
Economic indicators:
• GDP
• Unemployment rate
• Inflation
• DJIA returns
• Geo-political factors
Period 2001-2002: Recession
• Mild recession in 2001
• Negative or low GDP growth
• Unemployment rate increased to 6% from 4.3%
• DJIA dropped by 23% in 2002
• 9/11 & corporate scandals in 2002
 Fed funds rate cut from 6.5% to 1.75% - close to
Taylor rule  appropriate reaction
Period 2001-2002: Recession
• November 2002 - Fed funds target reduced to
1.25% from 1.75%
• Two factors: 1) weak and “jobless” recovery –
actual data support it
• 2) fear of deflation – actual data don’t
support it  inflation doubled in this period
 Fed should have kept the target at 1.75%
Period 2003-2004: Recovery
• June 2003 – Fed further reduced the fed funds
target to 1.00%
• August 2003 – policy accommodative for a
“considerable period”
• However, the economy was recovering rapidly
• 1) GDP grew 1.6%, 3.2%, 6.9%, and 3.6% in each
respective quarter of 2003
• 2) unemployment high, but under control
• 3) DJIA up 30% in 2003
• 4) Taylor rule suggested increase in the fed funds
target
Period 2003-2004: Recovery
• Fed kept the fed funds target rate at 1.00% until
Q2 2004 – too low for too long  created
excess liquidity
• Monetary policy lag – this excess liquidity had
an impact on the economy in 2004 & 2005
Period 2005-2006: Boom
• The Fed began gradually increasing the target
from mid-2004 until 2006
• Economic boom (stock market, housing
market, GDP growth, drop in unemployment)
• Taylor rule suggested that the target should have
been increased more sharply  monetary
policy was too easy in this period as well
Fed Funds Rate Relative to Taylor Rule
Lowering Funds Rate
Discount Window/TAF
Bailouts
Feds Reaction to the Crisis
• Lowered the Target Fed Funds Rate
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Sep 18 07: A 1/2 point cut to 4.75%.
Oct 31 07: A 1/4 point cut to 4.5%.
Dec 11 07: A 1/4 point cut to 4.25%.
Jan 22 08: A 3/4 point cut to 3.5%.
Jan 30 08: A 1/2 point cut to 3%.
Mar 18 08: A 3/4 point cut to 2.25%.
Apr 30 08: A 1/4 point cut to 2%.
Oct 8 08: A 1/2 point cut to 1.5%.
Oct 29 08: A 1/2 point cut to 1%.
• Did this to facilitate lending to attempt to avoid
potential liquidity crisis.
Target Federal Funds Rate
Discount Window/TAF
• Fed begins urging banks to borrow from the
discount window in 2007, attempts to downplay the
negative implications of borrowing from window
• Decreases prime rate to encourage borrowing
• Creates Term Auction Facility in December 2008
▫ Allowed Fed to lend directly and on longer term
▫ Enabled Fed to control when, and how much, liquidity
supplied to market
▫ Negate stereotype
Bailouts
• Bear Stearns
▫ Provided 29 Billion in Financing to facilitate
acquisition by JP Morgan
• Lehman Brothers Failure
▫ Allowed Lehman to fail in September 2008
• Fannie and Freddie
▫ Did not play major role, did authorize FBNY to extend
funding if needed
• AIG
▫ Loaned a total of 85 Billion to AIG in beginning in late
2008
Critique and Concerns
Our critique
Reasons given by the Fed for easy money policy between 2000 and
2003:
• Restoring confidence
• Global imbalances
Our observation: failure to assume their supervisory and regulatory
power
What should have been done:
• On depository institutions: Increase the required reserve
requirements
• On investment banks: Impose an explicit leverage ratio
• On GSE’s: Prevent them from having access to low-interest loans
Critique and Concerns
Our critique
Reasons given by the Fed for easy money policy from
2007 until now:
• Loosen credit markets
Our observation: No effect
What should have been done:
Increase the Fed funds rate target to reward savings
and discourage borrowing and risk taking
Critique and Concerns
Our concerns
Biggest Controversy!: Bailouts and lending actions
of the Fed during the crisis
Concerns about the Fed:
• Effectiveness of their monetary policy
• Effectiveness of their regulatory and supervisory
power
• Concerns about the fed being the principal liquidity
provider
• Concerns about moral hazard the Fed engaged into
Critique and Concerns
Our concerns
Concerns about the economy:
• Possible losses to be incurred by the Fed in the
future, and will affect the economy
• Probable inflation spiral in the coming years
• Rise in unemployment
“Those who do not learn from
history are doomed to repeat it”,
George Santayana.
Our proposals:
• Move the current target of the Fed funds rate to
a neutral stance
• Have legislation to limit the Fed powers
• Audit the Fed without restrictions