Question

What is the difference between the FED’s policy before the Great Recession and the FED policy after the Great Recession

Answer 1

Before the Fall

There is almost universal agreement that regulatory neglect, especially within the mid- the 2000s, helped set the stage for the financial crisis—and that while sort of the regulators’ somnolence was obvious only after the fact, much of it had been obvious beforehand.

There's such a lot blame to travel round the regulatory community that it's nice (for the Fed) that blame are often shared among six different agencies (in the United States) plus the Congress (e.g., for passing the odious Commodity Futures Modernization Act [CFMA] in 2000).

Yet the Federal Reserve System gets, and doubtless, merits, a healthy share of the blame because

(a) it had been the sole regulator with systemic responsibilities (tacit then, explicit now),

(b) it had been (and remains) the primus inter pares among financial regulators, and

(c) it had been assigned by Congress special responsibilities for both mortgages and consumer protection. Starting with some perspicacious warnings from then-Governor Ned Gramlich as early as 2000, continuing through an early 2002 article by economist Dean Baker, and including numerous press reports in 2003 and 2004, the Fed had ample warnings that something—indeed much—was amiss in the residential mortgage market, especially in the subprime sector.

It ignored them all. Notably, the Fed and other bank regulators didn't got to attend Congress for any additional authority so as to clamp down on the patently unsafe and unsound lending practices, or on the abusive and even predatory loan terms, that were visible all around them. Their pre- existing legal authority was ample; they only didn’t use it. And under malign neglect, bad visited worse.

For this abysmal performance, all of America’s bank regulators, including the Fed, deserve a failing grade. But that was not all. Financial regulators allowed far an excessive amount of leverage to create up within the system. Prominently, the Securities and Exchange Commission (SEC) permitted what can only be called reckless levels of leverage at the nation’s five giant investment banks. The Federal Reserve System and therefore the Office of the Comptroller of the Currency (OCC) seemed either unaware of or unfazed by the hyper- leveraged structured investment vehicles (SIVs) that sprouted alongside the balance sheets of the many of the most important commercial banks. The Office of Thrift Supervision was an embarrassment—and was subsequently abolished. No one seemed to pay any attention to the titanic amounts of leverage embedded in certain derivatives, which were exploding in volume, perhaps because Congress had instructed regulators to not look. Leverage embedded in derivatives poses particularly difficult challenges for regulators since, while most derivative contracts start at a zero net position (hence are neither an asset nor a liability), they can move sharply in either a negative or a positive direction. It is the exposure, not the literal amount of leverage (assets divided by capital), that matters.

One good question to ask is: could the Fed have stopped the leverage binge with the weapons at its disposal at the time? Certainly not fully, and certainly not by itself. For example, the SEC was needed to affect the foremost serious leverage addicts: the large investment banks. That said, the Fed and therefore the OCC could and will have arched more eyebrows sternly

at bankers, informed themselves better about SIVs, and worried more about exposures from derivatives than they did. Much more. And that would have helped. The compound average annual growth rate of real GDP from the third quarter of 2001 through the first quarter of 2003 was a paltry 1.9 percent. It looked like the economy needed help. Perhaps more fundamentally, one can ask whether short- term interest rates that were, say, even 1–2 percentage points higher, and mortgage rates that were perhaps 0.6–1.2 percentage points higher, would have stopped the housing bubble in its tracks.

The case of the United Kingdom, where the Bank of England kept short rates well above Federal Reserve levels throughout, suggests not. So does common sense when prospective home- buyers were expecting (no doubt, irrationally) 10–20 percent capital gains per year. Notice also that the housing bubble did not burst even after the Fed started raising the federal funds rate in June 2004. (The funds rate eventually went up by a cumulative 425 basis points.) House prices kept rising for at least another two years.

So I agree that the Fed kept monetary policy too loose for too long in 2002–2004. But that “mistake” was small, forgivable under the circumstances, and may not have done much harm.

After the Fall

The outright panic ended in the spring of 2009. One of the main reasons was the highly successful “stress tests” on nineteen systemically important financial institutions (SIFIs)—not all of which were banks—that Secretary of the Treasury Tim Geithner had announced in February. The tests themselves were administered by all the bank regulatory agencies working together, but the Fed was clearly in first chair. We see these 2009 stress tests now as a smashing success—and instrumental to ending the crisis. But it's easy to forget that they were a riverboat gamble at the time. Two opposite risks loomed large. If the strain tests were seen as too easy, markets may need viewed them as a whitewash, concluded that the issues with the large banks were far deeper than suspected—and panicked. If the stress tests had turned up a much greater need for bank capital than they did, markets might have deemed the announced capital needs impossible to meet—and panicked. The regulators managed to string the needle with credible and amazingly transparent—stress tests that estimated capital needs that, while not trivial, were manageable. After that, confidence in the banking industry came back rapidly. Once the strain test results were in, financial markets bounced back quickly and vigorously, but the economy didn't. Several data revisions later, we see that annual GDP growth over the next two years (from the second quarter of 2009 to the second quarter of 2011) averaged just 2.25 percent. At the time of the Brookings- Hoover conference (October 2013), the percentage, which peaked at 10 percent, was still 7.3 percent—and most knowledgeable observers thought the downward movement of the official unemployment rate overstated the improvement in the labor market. For example, the employment- to- population ratio barely budged. The reasons for the sluggish recovery are many and varied—and a subject for another day. But that they had induced the FOMC, by the time of the conference, to stay with its near-zero interest- rate policy for nearly five years; and therefore the near-zero federal funds rate will probably last another two or more. Additionally, the Fed has unrolled one QE policy after another, the newest (QE3) being an almost- equal blend of buying long Treasuries and buying agency MBS. These unconventional monetary policies (UMPs) are controversial since their inception—and still are. I give the FOMC mostly high marks for its UMPs. Others do not. Apart from the very fact that “hawks” virtually always want tighter monetary policy than “doves” do, I find this controversy rather puzzling. After all, most UMPs are just continuations

of conventional monetary policies into a world during which the federal funds rate can not be pushed down. Think about QE in Treasuries, for example. Under normal conditions, when the Fed wants to give the economy a boost, it goes out into the marketplace and purchases Treasury securities, mostly T- bills. That’s called “open- market operations,” and that we teach the essential idea in Economics 101. (I know because I teach Economics 101.) But QE is just another form of open- market operations. The two differences are that (a) when open- market operations are conducted at the zero lower bound, the federal funds rate cannot fall any further, and that (b), partly for that reason, the Fed acquires longer- dated Treasury notes and bonds, instead of bills, to undertake to down intermediate and long rates. Another quantitative- but- not- qualitative difference is that QE in Treasuries seems to have rather low bang for the buck. For that reason, the magnitudes of Federal Reserve purchases must be large. QE in MBS raises another issues, including the unveiled plan to channel more credit into the housing sector. But is that basically so different, in its effects, from conventional monetary policy? Under normal conditions, when the Fed buys T- bills and lowers interest rates to raise aggregate demand, the strongest expansionary effects are always felt in the housing market—and conversely when the Fed tightens. QE in MBS is meant to possess precisely such a “biased” effect. But when buying MBS, the credit

allocation is explicit and highly visible, whereas it is tacit and (to some extent) hidden under conventional monetary policy. Has QE worked? Should it be continued, tapered down, or even eliminated? Opinions vary. The overwhelming weight of the empirical evidence seems to mention that the varied episodes of QE have pushed down interest rates, although the post- QE1 effects are far smaller than those from QE1—which, after all, rescued the moribund MBS market.

Krishnamurthy and Vissing- Jorgenson (2013) even suggest, somewhat surprisingly, that the impacts on rates might not spread very far along the yield curve or the risk curve. Critics of QE don’t dispute these findings (much). Mainly, they argue that any such benefits must be weighed against the market-distorting and/or potentially inflationary (eventually!) effects. Curiously, the undisputed incontrovertible fact that the economy remains weak is employed by both proponents and opponents of continuous QE to bolster their arguments. The pro- QE camp argues that the economy still needs more

support from monetary policy. The anti- QE side argues that the Fed has little to point out for trillions of dollars of QE.

Are there other options? For quite three years, I even have been urging the Fed to lower—probably into negative territory—the rate of interest it pays on excess reserves (IOER). The idea is to blast some of the current mountains of excess reserves out of the banks and gets these dollars functioning, as they do in normal times, as “high- powered” money. Notice that, to the extent, this effort works, cutting the IOER might actually enable the Fed to trim its record somewhat without, on the net, withdrawing monetary stimulus.