Speech

THE FEDERAL RESERVE

AND THE FINANCIAL CRISIS

Lecture 2:

The Federal Reserve

after World War II

1. Early Challenges

2. The Great Moderation

3. Origins of the Recent Crisis

What Is the Mission of

a Central Bank?

• Macroeconomic stability

- All central banks use monetary policy to strive for

low and stable inflation; most a so use monetary

policy to try to promote stable growth in output

and employment.

• Financial stability

- Central banks try to ensure that the nation's

financial system functions properly; importantly,

they try to prevent or mitigate financia panics or

crises.

Fed-Treasury Accord of 1951

• During World War II and subsequently, the Fed

was pressed by the Treasury to keep longer-term

interest rates low to allow the government debt

accrued during the war to be financed more

cheaply.

• Keeping interest rates low even as the economy

was growing strongly risked economic

overheating and inflation.

• In 1951, the Treasury agreed to end the

arrangement and let the Fed set interest rates

independently as needed to achieve economic

stability.

• The Fed has remained independent since 1951,

conducting monetary policy to foster economic

stability without responding to short-term

political pressures.

The Fed in the 1950s and Early 1960s

• Between World War II and the

recent financial crisis,

macroeconomic stability was

the predominant concern of

central banks.

• During most of the 1950s and

Chairman, 1951-1970

early 1960s, the Federal

[quote]"Inflation

is a thief in

Reserve followed a "lean

the night and if we

against the wind" monetary

don't act promptly and

policy that sought to keep

decisively we will

both inflation and economic

always be behind."

growth reasonably stable.

[end of quote.]

The Great Inflation: Monetary Policy

from the Mid-1960s to 1979

Inflation

• Starting in the mid1960s, monetary

policy was too easy.

• This stance led to a

surge in inflation and

inflation expectations.

• Inflation peaked at

about 13 percent.

[For the accessible version of this figure, please see the accompanying HTML.]

The Great Inflation:

Why Was Monetary Policy Too Easy?

• Monetary policymakers were too optimistic

about how "hot" the economy could run without

generating inflation pressures.

• When inflation began to rise, monetary

policymakers responded too slowly.

• Exacerbating factors included

- oil and food price shocks

- fiscal policies (such as spending for the

Vietnam War) that stretched economic

capacity

- Nixon's wage-price controls that artificially

held down inflation for a time

Central Banking in an Evolving Economy

• These experiences illustrate

how central banks have to

struggle with an evolving

economy and imperfect

knowledge.

[imageof]Arthur Burns

Chairman, 1970-1978

world the opportunities

for making mistakes are

legion."[end of quote].

The Volcker Disinflation

• To subdue double-digit

inflation, Chairman Volcker

announced, in October 1979,

a dramatic break in the way

that monetary policy would

operate.

• In practice, the new

approach to monetary policy

involved high interest rates

(tight money) to slow the

economy and fight inflation.

[imageof]Paul Volcker

Chairman, 1979-1987

[quote]

"To break the

c y c l e , ... w e m u s t

credible and

[inflation]

have

disciplined

m o n e t a r yp o l i c y . " [ e n dofquote].

Inflation in the 1980s

Inflation

• In the years after the

new disciplined

monetary policy began,

inflation fell markedly.

• When Chairman

Volcker left his post in

1987, the inflation rate

was around 3 to 4

percent.

[For the accessible version of this figure, please see the accompanying HTML.]

The 1981-1982 Recession

Unemployment Rate

• The high interest rates

needed to bring down

inflation were costly.

• In the sharp recession

during 1981 and 1982,

unemployment peaked

at nearly 11 percent.

[For the accessible version of this figure, please see the accompanying HTML.]

The Great Moderation

• During the Great Inflation of

the 1970s, both output and

inflation were highly volatile.

• Following the Volcker

disinflation, from the mid1980s through 2007

(primarily Chairman

Greenspan's term), both

output and inflation were

much less volatile.

• This was the period of "The

Great Moderation."

Chairman, 1987-2006

[quote] " . . .

g r e a t e r

h a s

a n

e n v i r o n m e n t

e c o n o m i c

b e e n

k e y

i m p r e s s i v e

s t a n d a r d s

o f

e c o n o m i c

w e l f a r e

e v i d e n t

t h e

i n

S t a t e s . "[endofquote.]

s t a b i l i t y

t o

g r o w t h

l i v i n g

o f

i n

t h e

a n d

s o

U n i t e d

The Variability of Real GDP Growth

Real GDP Growth

[For the accessible version of this figure, please see the accompanying HTML.]

The Variability of Inflation

CPI Inflation

[For the accessible version of this figure, please see the accompanying HTML.]

Understanding the Great Moderation

• Improved monetary policy after 1979 contributed

to the Great Moderation.

• In particular, low and stable inflation promoted

broader economic stability.

• Structural change (such as better inventory

management) and simple good luck may also

have contributed.

• Financial stresses occurred (for example, the

1987 stock market crash), but they did not cause

major economic damage.

- One exception was a boom and bust in the stock

prices of "dot-com" companies that touched off a

mild recession in 2001.

• Because of the relative tranquility during this

period, monetary policy generally received

greater emphasis than financial stability policies.

Prelude to the Financial Crisis:

The Housing Bubble

• From the late

1990s until early

2006, house prices

soared 130

percent.

• Meanwhile,

mortgage lending

standards

deteriorated.

Prices of Existing Single-Family Houses

[For the accessible version of this figure, please see the accompanying HTML.]

Inflationary House Price Psychology

• Rising house prices and

weakening mortgage standards

fed off each other:

- Rising house prices created an

expectation that housing was a

"can't lose" investment.

- Lax underwriting and the

availability of exotic mortgages

drove up demand for housing,

raising prices further.

Deterioration of Mortgage Quality

• Prior to the early 2000s, homebuyers typically

made a significant down payment and

documented their finances in detail.

• But as house prices rose, many lenders began

offering mortgages to less-qualified borrowers

(nonprime mortgages) that required little or no

down payment and little or no documentation.

The Deterioration of Mortgage Quality

Nonprime Mortgage Originations

( A s a s h a r e of total o r i g i n a t i o n s )

[For the accessible version of this figure, please see the accompanying HTML.]

P e r c e n t of N o n p r i m e L o a n s with

L o w o r No D o c u m e n t a t i o n

[For the accessible version of this figure, please see the accompanying HTML.]

The House Price Bubble Bursts

• House price increases

made housing less

affordable.

• Mortgage payments

as a share of income

rose sharply.

• Eventually, rising

costs of

homeownership

began to damp

housing demand.

Mortgage Debt S e r v i c e Ratio

[For the accessible version of this figure, please see the accompanying HTML.]

• Declining demand for

houses led to a drop

in house prices

beginning in early

2006.

• Since then, house

prices have fallen

more than 30

percent.

P r i c e s of E x i s t i n g S i n g l e - F a m i l y H o u s e s

[For the accessible version of this figure, please see the accompanying HTML.]

The Aftermath of the House Price Bust

Mortgages with Negative Equity

• As house prices fell,

borrowers—especially

those who had made

little or no down

payment—increasingly

went "underwater"

(owed more on their

mortgages than their

houses were worth).

[For the accessible version of this figure, please see the accompanying HTML.]

Mortgage D e l i n q u e n c i e s

• Mortgage delinquencies

and foreclosures

surged.

[For the accessible version of this figure, please see the accompanying HTML.]

• Banks and other holders of mortgage-related

securities suffered sizable losses—a key trigger of

the crisis.

How a Housing Bust Became a Financial

Crisis: Triggers versus Vulnerabilities

• It is important to distinguish between triggers

and vulnerabilities:

- The decline in house prices and the associated

mortgage losses were key triggers of the crisis.

- The effects of those triggers were amplified by

vulnerabilities in the economy and financial

system.

Private-Sector Vulnerabilities

• Perhaps lulled into complacency during the Great

Moderation, borrowers and lenders took on too

much debt (leverage).

• Banks and other financial institutions failed to

adequately monitor and manage the risks they

were taking (for example, exposures to subprime

mortgages).

• Firms relied excessively on short-term funding,

such as commercial paper.

• The increased use of exotic financial instruments

concentrated risk.

• Gaps in the regulatory structure left important

firms without strong supervision (for example,

AIG).

• There were failures of regulation and supervision,

including consumer protection.

• Insufficient attention was paid to the stability of

the financial system as a whole.

The Role of Monetary Policy

• Some have argued that the Fed's low interest rate

monetary policy in the early 2000s contributed to

the housing bubble, which in turn was a trigger of

the crisis.

• Most evidence suggests otherwise:

- International comparisons: For example, the

United Kingdom had a house price boom during

the 2000s despite tighter monetary policy than the

United States.

- Size of the bubble: Changes in mortgage rates

during the boom years seemed far too small to

account for the magnitude of house price

increases.

- Timing of the bubble: House prices began to pick

up (late 1990s) before monetary policy began

easing and rose sharply after monetary policy

began tightening (2004).

• Economists continue to debate this issue.

References on Monetary Policy Role

•

Kenneth Kuttner (forthcoming). "Low Interest Rates and Housing Bubbles:

Still No Smoking Gun," in Douglas Evanoff, ed., The Role of Central Banks in

Financial Stability: How Has it Changed? Hackensack, N.J.: World Scientific.

• Jane Dokko and others (2011). "Monetary Policy and the Housing Bubble,"

Economic Policy, vol. 26 (April), pp. 237-87.

• Carmen Reinhart and Vincent Reinhart (2011). "Pride Goes before a Fall:

Federal Reserve Policy and Asset Markets," NBER Working Paper Series 16815.

Cambridge, Mass.: National Bureau of Economic Research, February.

• Ben S. Bernanke (2010). "Monetary Policy and the Housing Bubble," speech

delivered at the Annual Meeting of the American Economic Association,

Atlanta, Ga., January 3,

www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm.

Economic Consequences of the Crisis

F i n a n c i a l S t r e s s Index

• Financial stress

skyrocketed. (Note:

Shaded areas represent

periods of recession.)

[For the accessible version of this figure, please see the accompanying HTML.]

S A P 500 C o m p o s i t e Index

[For the accessible version of this figure, please see the accompanying HTML.]

• The stock market

plunged.

Single-Family Housing Starts

[For the accessible version of this figure, please see the accompanying HTML.]

• Home construction

continued its sharp

decline.

U n e m p l o y m e n t Rate

• The unemployment rate

rose sharply.

[For the accessible version of this figure, please see the accompanying HTML.]

• The next two lectures examine the unfolding of

the crisis and the recession and describe the policy

response:

- Lecture 3 describes the financial stability policy

responses to the crisis and recession by the Fed

and others.

- Lecture 4 discusses monetary policy responses to

the recession, the sluggish recovery, post-crisis

changes in financial regulation, and the

implications of the crisis for central bank practice.

t

THE FEDERAL RESERVE

AND THE FINANCIAL CRISIS