Speech

Lecture 4:

The Aftermath of the Crisis

2

The Fed’s Efforts to

Restore Financial Stability

• A financial panic in fall 2008 threatened the

stability of the global financial system.

• In its lender-of-last-resort role, the Federal

Reserve provided liquidity (short-term

collateralized loans) to help stabilize key financial

institutions and markets.

3

The Fed’s Efforts to

Restore Financial Stability

• The Fed worked closely with the Treasury, other

regulatory agencies (such as the FDIC and SEC).

• Coordination with foreign central banks included

the creation of foreign currency swaps.

– The Fed provided dollars to other central banks in

exchange for foreign currencies.

– The swaps enabled foreign central banks to meet the

dollar funding needs of their own financial

institutions.

4

The Fed’s Continuing Efforts to

Strengthen the Banking System

• The Fed led stress tests of the 19 largest U.S.

banks in the spring of 2009, which helped restore

investor confidence and allowed banks to raise

about $140 billion in private capital.

• Recent stress tests conducted by the Fed showed

substantial further improvements in bank capital

and banks’ resilience to shocks.

5

Evaluation of the Special

Lender-of-Last-Resort Programs

• Results: The programs

– arrested runs on various types of financial

institutions

– restored financial market functioning, restarted

flow of credit, and supported resumption of

economic growth

• Programs were largely phased out by March

2010.

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Evaluation of the Special

Lender-of-Last-Resort Programs

• Financial risks to the Federal Reserve were

minimal:

– Lending was mostly short-term and backed by

collateral; thousands of loans were made, none

defaulted.

– Although the objective of these programs was

stabilization, not profit, taxpayers came out

ahead.

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Monetary Policy during the Crisis

• The Fed used lender-of-last-resort policy to help

stabilize the financial system. To stabilize the

economy and promote economic recovery, the

Fed turned to monetary policy.

8

Monetary Policy during the Crisis

• Conventional monetary policy involves

management of a target short-term interest rate

(the federal funds rate). Because longer-term

rates tend to fall when the Fed lowers the shortterm rate, and because lower longer-term rates

tend to encourage purchases of long-lasting

consumer goods, houses, and capital goods,

cutting the federal funds rate helps stimulate the

economy.

9

Monetary Policy during the Crisis

• Monetary policy is conducted by the Federal Open

Market Committee (FOMC).

• The FOMC meets in Washington, D.C. eight times a

year. During the crisis, it sometimes also held

unscheduled videoconferences.

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Monetary Policy during the Crisis

• The FOMC consists of 12 members:

– the 7 members of the Board of Governors of the

Federal Reserve System

– the president of the New York Federal Reserve Bank

– 4 of the remaining 11 Reserve Bank presidents, who

serve one-year terms on a rotating basis

• Other Reserve Bank presidents participate in

deliberations but do not vote.

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Federal Funds Rate

• To support the

recovery, the Fed

reduced the federal

funds rate from

5¼ percent in

September 2007 to

nearly zero in

December 2008,

where it has

remained since.

12

Large-Scale Asset Purchases

• With the federal funds rate near zero, the scope

for conventional monetary policy was exhausted.

But the economy remained weak and some

worried about the risk of deflation (falling wages

and prices).

13

Large-Scale Asset Purchases

• To influence longer-term rates directly, the Fed

undertook large-scale purchases of Treasury and

government-sponsored enterprise (GSE)

mortgage-related securities.

• Large purchase programs were announced in

March 2009 and November 2010.

• These actions boosted the Fed’s balance sheet by

more than $2 trillion.

14

Large-Scale Asset Purchases

15

Large-Scale Asset Purchases

• With the available supply of Treasury and GSE

securities reduced by Fed purchases, investors

were willing to accept lower yields. Lower

longer-term rates helped stimulate the economy,

just as they do under conventional policies.

• Reduced availability of Treasury and GSE

securities led investors to purchase other assets,

such as corporate bonds, lowering the yields on

those assets as well.

16

Large-Scale Asset Purchases

• 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.

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Large-Scale Asset Purchases

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Effects of Large-Scale Asset Purchases

• LSAPs (also known as quantitative easing)

lowered longer-term interest rates.

– 30-year mortgage rates fell below 4 percent.

– Corporate credit became more available, and stock

prices rose.

• Lower longer-term interest rates helped promote

recovery, though the effect on housing was

weaker than hoped.

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Effects of Large-Scale Asset Purchases

• The Fed’s credibility and long-standing

commitment to price stability has helped anchor

inflation and inflation expectations, which have

remained low.

• At the same time, LSAPs guarded against the risk

of deflation (falling wages and prices).

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Effects of Large-Scale Asset Purchases

• 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, money

that benefited taxpayers by reducing the federal

deficit.

21

Monetary Policy Communication

• 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.

22

Monetary Policy Communication

• The Fed has

become more

transparent about

monetary policy.

For example, the

Chairman began

holding news

conferences in

2011.

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Monetary Policy Communication

• The Fed also has recently provided more

information about its goals and policy approach

(for example, by defining price stability as

inflation of 2 percent in the medium term).

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Monetary Policy Communication

• The Fed has also begun providing guidance to

investors and the public about how it expects to

adjust the federal funds rate in the future, given

current information about the economic outlook.

• This guidance helps the public better understand

the FOMC’s views and policy.

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Economic Recovery

• Aided by the effects of monetary and fiscal policy

as well as the economy’s natural recuperative

powers, economic activity began to recover in

mid-2009.

• Since then, real GDP has increased at an average

annual rate of about 2½ percent.

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Sluggish Economic Recovery

• But the pace of

recovery has been

extremely sluggish

compared with

previous post–

World War II cyclical

recoveries.

Note: On June 21, 2012, the above Real GDP chart was revised

to correct the calculation of GDP during the average of

previous recoveries.

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Sluggish Economic Recovery

• As a result, job

prospects have

improved only

gradually and the

unemployment rate

remains painfully

high.

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Slowing the Recovery: Housing

• Why has the recovery

been slower than

hoped?

• A resurgent housing

market normally helps

power economic

recoveries, but not

this time.

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Slowing the Recovery: Housing

• Factors weighing on

the housing market

include

– a continuing high

foreclosure rate

– an overhang of

unsold homes

– falling house prices

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Slowing the Recovery: Housing

• Very tight lending

standards on

mortgages have

blunted some of the

effects of low

mortgage rates.

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Slowing the Recovery: Housing

• Declining house prices

discourage new

construction.

• More generally, sharp

declines in house

prices make

consumers feel poorer,

and thus less willing to

spend.

32

Slowing the Recovery:

Financial and Credit Markets

• The U.S. banking system is significantly stronger

than it was three years ago, and credit is more

available to households and businesses.

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Slowing the Recovery:

Financial and Credit Markets

• However, difficulties remain for some borrowers:

– For households, mortgages are difficult to obtain

for borrowers with less-than pristine credit scores.

– For small businesses, credit market conditions

remain tight but appear to have begun to

improve.

34

Slowing the Recovery:

Financial and Credit Markets

• Concerns about European fiscal and banking

conditions have also stressed financial markets

and led to more-conservative lending and

diminished confidence.

35

Long-Term Economic Growth

in the United States

• The financial crisis and recession were a major

trauma. Many people who have been

unemployed for a long time have seen their skills

erode. And longer-term problems, like rising

federal deficits, have not gone away.

36

Long-Term Economic Growth

in the United States

• On the upside, however:

– The U.S. economy remains the largest in the

world, with a highly diverse mix of industries.

– Our economy has a robust entrepreneurial

culture, with flexible capital and labor markets.

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Long-Term Economic Growth

in the United States

• On the upside, however:

– We remain a technological leader, with many of

the world's top research universities and the

highest spending on research and development of

any nation.

– And, in the aftermath of the crisis, we have

strengthened our financial regulatory system.

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Long-Term Economic Growth

39

Post-crisis Regulatory Changes

• The crisis revealed many important regulatory gaps

and weaknesses.

• Lehman Brothers and AIG endangered the financial

system and highlighted the need for new tools to

address problems at systemically important

financial institutions.

• More oversight of the system as a whole was

needed.

40

Post-crisis Regulatory Changes

• The Dodd–Frank

Wall Street Reform

and Consumer

Protection Act of

2010 instituted

wide-ranging

reforms of financial

regulation in the

United States.

Rep. Barney Frank

Sen. Christopher Dodd

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Key Provisions of the Dodd–Frank Act:

Supervision and Regulation

• The act expanded the financial stability duties of

financial regulators, including the Fed:

– It created the Financial Stability Oversight Council

(FSOC) to help regulators coordinate their efforts.

– It gave all regulators the responsibility to track and

respond to possible risks to the financial system as

a whole.

42

Key Provisions of the Dodd–Frank Act:

Supervision and Regulation

• It closed gaps in the oversight of the financial

system:

– The FSOC can “designate” systemically important

nonbank institutions to be supervised by the Fed.

– The FSOC can also designate key financial market

utilities (for example, stock exchanges) for

enhanced supervision.

43

Key Provisions of the Dodd–Frank Act:

Systemically Important Institutions

• The act subjected systemically important financial

institutions to tougher supervision and

regulation:

– Higher capital requirements were established for

most systemic firms.

– Bank affiliates are prohibited from trading on their

own account (Volcker rule).

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Key Provisions of the Dodd–Frank Act:

Systemically Important Institutions

• The act made systemically important financial

institutions subject to tougher supervision and

regulation:

– Regular “stress tests” are being conducted to

ensure that firms will have adequate capital even

in bad economic scenarios.

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Key Provisions of the Dodd–Frank Act:

Systemically Important Institutions

• It also tackled the problem of “too big to fail”

financial firms:

– New “orderly liquidation authority” allows the

Federal Deposit Insurance Corporation (FDIC) to

close failing systemic firms in a way that causes

less damage to the financial system.

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Key Provisions of the Dodd–Frank Act:

Other Features

• The act took steps to make the financial system

more resilient:

– It required more transparency and standardization

of derivative transactions.

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Key Provisions of the Dodd–Frank Act:

Other Features

• It created a new agency (the Consumer Financial

Protection Bureau) with broad powers to protect

consumers in their financial dealings.

• Financial regulators are implementing these and

other provisions, in consultation with foreign

regulators.

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The Effects of the Crisis on

Central Bank Practice

• In the decades before the crisis, central banks

often viewed financial stability policy as the

junior partner to monetary policy.

• The crisis underscored that maintaining financial

stability is an equally critical responsibility.

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The Effects of the Crisis on

Central Bank Practice

• Financial crises will always be with us. But as

much as possible, central banks and other

regulators should try to anticipate and defuse

threats to financial stability and mitigate the

effects when a crisis occurs.

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Conclusion

• We began by noting the two principal tools and

responsibilities of central banks

– serving as lender of last resort to prevent or

mitigate financial crises

– using monetary policy to enhance economic

stability

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Conclusion

• The Fed and other central banks used both tools

extensively in the crisis and its aftermath. These

tools helped prevent a repeat of the Great

Depression of the 1930s and set the stage for a

slow but continuing economic recovery.

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Conclusion

• A new regulatory framework will reduce, but not

eliminate, the risk of financial crises in the future.

Greater monitoring of potential systemic risks

should help.

• However, the recent financial crisis shows both

that a crisis can be hard to anticipate and that it

can cause major damage to the economy.

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