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Federal Reserve’s Policy Actions during the Financial

Crisis and Lessons for the Future
 
By Guest Author - May 13th, 2010, 6:00PM

Vice Chairman Donald L. Kohn

At the Carleton University, Ottawa, Canada
May 13, 2010

The financial and economic crisis that started in 2007 tested central banks as they had not been
tested for many decades. We needed to take swift and decisive action to limit the damage to the
economy from the spreading distress in financial markets. Because the financial distress was so deep
and pervasive and because it took place in financial markets whose structure had evolved
dramatically, our actions also needed to be innovative if they were to have a chance of being effective.
Many central banks made substantial changes to traditional policy tools as the crisis unfolded. But
the epicenter of the financial shock was in U.S. mortgage markets, with severe effects on many of our
financial institutions, and our financial markets had perhaps evolved more than many others. As a
consequence, no central bank innovated more dramatically than the Federal Reserve

We traditionally have provided backup liquidity to sound depository institutions. But in the crisis, to
support financial markets, we had to provide liquidity to nonbank financial institutions as well. Just
as we were forced to adapt and innovate in meeting our liquidity provision responsibilities, we also
needed to adapt and innovate in the conduct of monetary policy. Very early in the crisis, it became
evident that lowering short-term policy rates alone would not be sufficient to counter
the adverse shock to the U.S. economy and financial system. We needed to go further–
much further, in fact–to ease financial conditions and thus encourage spending and
support employment. We took steps to reinforce public understanding of our inflation objective
to prevent the development of deflationary expectations; we provided guidance on the possible
future course of our policy interest rate; and we purchased large amounts of longer-term securities,
and in the process created unprecedented volumes of bank reserves. Now, careful planning is under
way to remove that stimulus at the appropriate time. My discussion today will focus on innovations
in both our role as liquidity provider and in our monetary policy tools: their motivation, their
effectiveness, and their lessons for the future. 1

The Federal Reserve’s Liquidity Tools

Before the crisis, the implementation of monetary policy was fairly straightforward, and our
approach minimized its footprint on financial markets. The Federal Reserve adjusted the liquidity it
provided to the banking system through daily operations with a relatively small set of broker-dealers
against a very narrow set of collateral–Treasury and agency securities. These transactions had the
effect of changing the aggregate quantity of reserve balances that banks held at the Federal Reserve,
and that liquidity was distributed by interbank funding markets through the banking system in the
United States and around the world. In addition, the Federal Reserve stood ready to lend directly to
commercial banks and other depository institutions at the “discount window,” where, at their
discretion, banks could borrow overnight at an above-market rate against a broad range of collateral
when they had a need for very short-term funding. Ordinarily, however, little credit was extended
through the discount window. Banks were able to obtain their funding and reserves in the open
market and generally turned to the window only to cover very short-term liquidity shortfalls arising
from operational glitches or transitory marketwide supply shortfalls, as opposed to more
fundamental funding problems.

During the financial crisis, however, market participants became highly uncertain about the financial
strength of their counterparties, the future value of assets (including any collateral they might be
lending against), and how their own needs for capital and liquidity might evolve. They fled to the
safest and most liquid assets, and as a result, interbank markets stopped functioning as an effective
means to distribute liquidity, increasing the importance of direct lending through the discount
window. At the same time, however, banks became extremely reluctant to borrow from the Federal
Reserve for fear that their borrowing would become known and thus cast doubt on their financial
condition. Importantly, the crisis also involved major disruptions of important funding markets for
other institutions. Commercial paper markets no longer channeled funds to lenders or to
nonfinancial businesses, investment banks encountered difficulties borrowing even on a short-term
and secured basis as lenders began to have doubts about some of the underlying collateral, banks
overseas could not rely on the foreign currency swap market to fund their dollar assets beyond the
very shortest terms, investors pulled out from money market mutual funds, and most securitization
markets shut down. These disruptions to financing markets posed the same threats to the availability
of credit to households and businesses that runs on banks created in the more bank-centric financial
system of the 1800s and most of the 1900s. As a result, intermediaries unable to fund themselves
were forced to sell assets, driving down prices and exacerbating the crisis; moreover, they were
unwilling to assume the risks necessary to make markets in the debt and securitization instruments
that were critical channels supporting household and business borrowing–and households and
businesses unable to borrow were thus unable to spend, thereby deepening the recession.

These liquidity pressures were evident in nearly every major country, and every central bank had to
adapt its liquidity facilities to some degree in addressing these strains. At the Federal Reserve, we
had to adapt somewhat more than most, partly because the scope of our activities prior to the crisis
was fairly narrow–particularly relative to the expanding scope of intermediation outside the banking
sector–and partly because the effect of the crisis was heaviest on dollar funding markets. Initially, to
make credit more available to banks, we reduced the spread of the discount rate over the target
federal funds rate, lengthened the maximum maturity of loans to banks from overnight to 90 days,
and provided discount window credit through regular auctions in an effort to overcome banks’
reluctance to borrow at the window due to concerns about the “stigma” of borrowing from the
Federal Reserve. We also lent dollars to other central banks so that they could provide dollar
liquidity to banks in their jurisdictions, thus easing pressures on U.S. money markets. As the crisis
intensified, however, the Federal Reserve recognized that lending to banks alone would not be
sufficient to address the severe strains affecting many participants in short-term financing markets.
Ultimately, the Federal Reserve responded to the crisis by creating a range of
emergency liquidity facilities to meet the funding needs of key nonbank market
participants, including primary securities dealers, money market mutual funds, and
other users of short-term funding markets, including purchasers of securitized loans. 2

Why couldn’t the Federal Reserve maintain its routine lending practices and rely on
lending to commercial banks, which in turn lend to nonbank firms? The reason is that
financial markets have evolved substantially in recent decades–and, in retrospect, by more than we
had recognized prior to the crisis. The task of intermediating between investors and borrowers has
shifted over time from banks–which take deposits and make loans–to securities markets–where
borrowers and savers meet more directly, albeit with the assistance of investment banks that help
borrowers issue securities and then make markets in those securities. An important aspect of the
shift has been the growth of securitization, in which loans that might in the past have remained on
the books of banks are instead converted into securities and sold to investors in global capital
markets. Serious deficiencies with these securitizations, the associated derivative instruments, and
the structures that evolved to hold securitized debt were at the heart of the financial crisis. Among
other things, the structures exposed the banking system to risks that neither participants in financial
markets nor regulators fully appreciated. Banks became dependent on liquid markets to distribute
the loans they had originated. And some parts of the securitized loans were sold to off-balance-sheet
entities in which long-term assets were funded by short-term borrowing with implicit or explicit
liquidity guarantees provided by the banks. Securitization markets essentially collapsed when banks
became unwilling to increase their exposure to such risks during the crisis, when the liquidity
guarantees were invoked, and when other lenders in securitization markets became unwilling to
supply credit.

Although the Federal Reserve’s lending actions during the crisis were innovative and to some degree
unprecedented, they were based on sound legal and economic foundations. Our lending to nonbank
institutions was grounded in clear authority found in section 13(3) of the Federal Reserve Act
permitting a five-member majority of the Federal Reserve Board to authorize a Reserve Bank to lend
to individuals, partnerships, or corporations in “unusual and exigent circumstances.” These actions
also generally adhered to Walter Bagehot’s dictum, a time-honored central banking principle for
countering a financial panic: Lend early and freely to solvent institutions at a penalty rate and
against good collateral.3 Central banks are uniquely equipped to carry out this mission. They
regularly lend to commercial banks against a wide variety of collateral and have the infrastructure to
value and perfect their interest in the underlying collateral. During a panic, market functioning is
typically severely impaired, with investors fleeing toward the safest and most liquid assets, and the
resulting lack of liquidity, even for sound banks with sound assets, can result in funding pressures for
financial institutions and others. By lending to solvent institutions against illiquid collateral, central
banks effectively step in to assume the liquidity risk of such assets–that is, the risk that assets can
only be sold in the near term at fire sale prices. And their ability to substitute for private-sector
intermediation in a panic is unlimited since they create reserves. For the most part, the Federal
Reserve priced these facilities to be attractive when markets were disrupted but not economical to
potential borrowers as market functioning improved.

Importantly, lending against good collateral to solvent institutions supplies liquidity, not capital, to
the financial system. To be sure, limiting a panic mitigates the erosion of asset prices and hence
capital, but central banks are not the appropriate authorities to supply capital directly; if government
capital is necessary to promote financial stability, then that is a fiscal function. This division of
responsibilities presented challenges in the crisis. The securitization markets were impaired by both
a lack of liquid funding and by concerns about the value of the underlying loans, and broad-based
concerns about the integrity of the securitization process. To restart these markets, the Federal
Reserve worked with the Treasury in establishing the Term Asset-Backed Securities Loan Facility
(TALF): The Federal Reserve supplied the liquid funding, while the Treasury assumed the credit risk.
The issue of the appropriate role of the central bank and fiscal authority was present in other
contexts as well. We were well aware that we were possibly assuming a risk of loss when we lent to
stabilize the systemically important firms of Bear Stearns and American International Group (AIG).
Unfortunately, at the time, alternative mechanisms were not available and we lent with the explicit
support of the Secretary of the Treasury, including a letter from him acknowledging the risks.

An important task before us now is to assess the effectiveness of these actions. Not surprisingly,
rigorous studies that evaluate the extent to which the emergency liquidity facilities contributed to
improved financial conditions are just beginning to emerge. Nonetheless, market reactions to the
announcement of the emergency facilities, anecdotal evidence, and a number of the studies we do
have suggest that the facilities forestalled potentially much worse outcomes and encouraged
improvements. For example, some asset-backed securities (ABS) spreads, such as those for
consumer ABS and commercial mortgage-backed securities, narrowed significantly following the
creation of the TALF, and activity in ABS markets has picked up. While the overall improvement in
the economic outlook has no doubt contributed to the improvement in ABS markets, it does appear
that the TALF helped to buoy the availability of credit to firms and households and thus supported
economic activity. Indeed, following the kick-start from the TALF, a number of these markets are
now operating without any governmental backing. Another example is the reduction in pressures in
U.S. dollar funding markets (as evidenced by the sharp narrowing of spreads between Libor (London
interbank offered rates) and OIS (overnight index swap) rates and the decline in premiums paid for
U.S. dollars in foreign exchange swap markets). These developments followed the establishment of
the Term Auction Facility (which auctioned discount window credit to depository institutions) and
also of liquidity swaps between the Federal Reserve and foreign central banks, which enabled those
banks to lend dollars to commercial banks in their jurisdictions. Our willingness to lend in support of
the commercial paper and asset-backed commercial paper markets helped to stem the runs on
money market funds and other nonbank providers of short-term credit. Of note, usage of these
emergency liquidity facilities declined markedly as conditions in financial markets improved,
indicating that they were indeed priced at a penalty to more normal market conditions. They were
successfully closed, suggesting that market participants had not become overly reliant on these
programs and were able to regain access to funding markets. Except for the TALF and the special
Bear Stearns and AIG loans, all were repaid without any losses to the Federal Reserve. The funding
markets evidently remain somewhat vulnerable, however. Just this week, with the reemergence of
strains in U.S. dollar short-term funding markets in Europe, the Federal Reserve reestablished
temporary U.S. dollar liquidity swap facilities with the Bank of Canada, the Bank of England, the
European Central Bank, the Bank of Japan, and the Swiss National Bank.4

Lessons for Handling Future Liquidity Disruptions

What lessons can be drawn from the Federal Reserve’s experience in the financial crisis when
designing a toolbox for dealing with future systemic liquidity disruptions? First, the crisis has
demonstrated that, in a financial system so dependent on securities markets and not just banks for
the distribution of credit, our ability to preserve financial stability may be enhanced by making sure
the Federal Reserve has authority to lend against good collateral to other classes of sound, regulated
financial institutions that are central to our financial markets–not on a routine basis, but when the
absence of such lending would threaten market functioning and economic stability. Thus, it would
seem that authority similar to that provided by section 13(3) will continue to be necessary.

Second, we recognize that holding open this possibility is not without cost. With credit potentially
available from the Federal Reserve, institutions would have insufficient incentives to manage their
liquidity to protect against unusual market events. Hence, emergency credit should generally be
available only to groups of institutions that are tightly regulated and closely supervised to limit the
moral hazard of permitting access to the discount window, even when such access is not routinely
granted. If the Federal Reserve did not directly supervise the institutions that would potentially
receive emergency discount window credit, it would need an ongoing and collaborative relationship
with the supervisor. The supervisor should ensure that any institution with potential access to
emergency discount window credit maintained conservative liquidity policies. The supervisor would
also provide critical insight into the financial condition of the borrower and the quality of the
available collateral and, more generally, whether lending was necessary and appropriate. Most
importantly, no such institution should be considered too big or too interconnected to fail, and any
losses should be shouldered by shareholders and other providers of capital, by management, and,
where consistent with financial stability, by creditors as well.

Third, the United States needs a resolution facility for systemically important institutions that meets
the criteria I just enunciated. That authority must have access to liquidity to stabilize situations
where necessary, but the fiscal authorities, not the central bank, should be the ones deciding whether
to take on the credit risk of lending to troubled institutions in order to forestall financial instability.

Fourth, transparency about unusual liquidity facilities is critical. The public appropriately expects
that when a central bank takes innovative actions–especially actions that might appear to involve
more risk than normal lending operations–then it will receive enough information to judge whether
the central bank has carried out the policy safely and fairly. The required degree of transparency
might well involve more-detailed types of reporting than for normal, ongoing, lending facilities.

Finally, the problem of discount window stigma is real and serious. The intense caution that banks
displayed in managing their liquidity beginning in early August 2007 was partly a result of their
extreme reluctance to rely on standard discount mechanisms. Absent such reluctance, conditions in
interbank funding markets might have been significantly less stressed, with less contagion to
financial markets more generally. Central banks eventually were able to partially circumvent this
stigma by designing additional lending facilities for depository institutions; but analyzing the
problem, developing these programs, and gathering the evidence to support a conclusion that they
were necessary took valuable time. Going forward, if measures are adopted that could further
exacerbate the stigma of using central bank lending facilities, the ability of central banks to perform
their traditional functions to stabilize the financial system in a panic may well be impaired.

Monetary Policy and the Zero Bound

The Federal Reserve and other central banks reacted to the deepening crisis in the fall of 2008 not
only by opening new emergency liquidity facilities, but also by reducing policy interest rates to close
to zero and taking other steps to ease financial conditions. Such rapid and aggressive responses were
expected to cushion the shock to the economy by reducing the cost of borrowing for households and
businesses, thereby encouraging them to keep spending.

After short-term rates reached the effective zero bound in December 2008, the Federal Reserve also
acted to shape interest rate and inflation expectations through various communications. At the
March 2009 meeting, the Federal Open Market Committee (FOMC) indicated that it viewed
economic conditions as likely to warrant “exceptionally low” levels of the federal funds rate for an
“extended period.” This language was intended to provide more guidance than usual about the likely
path of interest rates and to help financial markets form more accurate expectations about policy in a
highly uncertain economic and financial environment. By noting that the federal funds rate was
likely to remain at “exceptionally low” levels for an “extended period,” the FOMC likely was able to
keep long-term interest rates lower than would otherwise have been the case.

To provide the public with more context for understanding monetary policy decisions, Board
members and Reserve Bank presidents agreed in late 2007 to prepare more frequent forecasts
covering longer time spans and explain those forecasts. In January 2009, the policymakers also
added information about their views of the long-run levels to which economic growth, inflation, and
the unemployment rate were likely to converge over time. The additional clarity about the long-run
level for inflation, in particular, likely helped keep inflation expectations anchored during the crisis.
Had expectations followed inflation down, real interest rates would have increased, restraining
spending further. Had expectations risen because of concern about the Federal Reserve’s ability to
unwind the unusual actions it was taking, we might have needed to limit those actions and the
resulting boost to spending.
Given the severity of the downturn, however, it soon became clear that lowering short-term policy
rates and attempting to shape expectations would not be sufficient alone to counter the
macroeconomic effects of the financial shocks. Indeed, once the Federal Reserve reduced the federal
funds rate to zero, no further conventional policy easing was possible. The Federal Reserve needed to
use alternative methods to ease financial conditions and encourage spending. Thus, to reduce longer-
term interest rates, like those on mortgages, the Federal Reserve initiated large-scale purchases of
longer-term securities, specifically Treasury securities, agency mortgage-backed securities (MBS),
and agency debt. All told, the Federal Reserve purchased $300 billion of Treasury securities, about
$175 billion of agency debt obligations, and $1.25 trillion of agency MBS. In the process, we ended up
supplying about $1.2 trillion of reserve balances to the banking system–a huge increase from the
normal level of about $15 billion over the few years just prior to the crisis.

How effective have these various steps been in reducing the cost of borrowing for households and
businesses while maintaining price stability? Central banks have lots of experience guiding the
economy by adjusting short-term policy rates and influencing expectations about future policy rates,
and the underlying theory and practice behind those actions are well understood. The reduction of
the policy interest rate to close to zero led to a sharp decline in the cost of funds in money markets–
especially when combined with the creation of emergency liquidity facilities and the establishment of
liquidity swaps with foreign central banks that greatly narrowed spreads in short-term funding
markets. Event studies at the time of the release of the March 2009 FOMC statement (when the
“extended period” language was first introduced) indicate that the expected path of policy rates
moved down substantially. Market participants reportedly interpreted the characterization of the
federal funds rate as likely to remain low for “an extended period” as stronger than the “for some
time” language included in the previous statement.5 Nonetheless, the extended period language has
not prevented interest rates and market participants’ expectations about the timing of exit from the
zero interest rate policy from reacting to incoming economic information, though each repetition of
the extended period language has appeared to affect those expectations a little.

By contrast, the economic effects of purchasing large volumes of longer-term assets, and the
accompanying expansion of the reserve base in the banking system, are much less well understood.
One question involves the direct effects of the large-scale asset purchases themselves. The theory
behind the Federal Reserve’s actions was fairly clear: Arbitrage between short- and long-term
markets is not perfect even when markets are functioning smoothly, and arbitrage is especially
impaired during panics when investors are putting an unusually large premium on the liquidity and
safety of short-term instruments. In these circumstances, purchasing longer-term assets (and thus
taking interest rate risk from the market) pushes up the prices of the securities, thereby lowering
their yields. But by how much and for how long? Good studies of these sorts of actions also are
sparse. Currently, we are relying in large part on event studies analyzing how much interest rates
declined when purchases were announced in the United States or abroad. According to these studies,
spreads on mortgage-related assets fell sharply on November 25, 2008, when the Federal Reserve
announced that it would initiate a program to purchase agency debt and agency MBS. A similar
pattern for Treasury yields was observed following the release of the March 2009 FOMC statement,
when purchases of longer-term Treasury securities were announced.6 Effectiveness, however, is hard
to quantify, partly because we are uncertain about how, exactly, the purchases put downward
pressure on interest rates. My presumption has been that the effect comes mainly from the total
amount we purchase relative to the total stock of debt outstanding. However, others have argued that
the market effect derives importantly from the flow of our purchases relative to the amount of new
issuance in the market. Some evidence for the primacy of the stock channel has accumulated
recently, as the recent end of the MBS purchase program does not appear to have had significant
adverse effects in mortgage markets.

A second issue involves the effects of the large volume of reserves created as we purchased assets.
The Federal Reserve has funded its securities purchases by crediting the accounts that banks hold
with us. In explanations of our actions during the crisis, we have focused on the effects of our
purchases on the prices of the assets that we bought and on the spillover to the prices of related
assets, as I have just done. The huge quantity of bank reserves that were created has been seen
largely as a byproduct of the purchases that would be unlikely to have a significant independent
effect on financial markets and the economy. This view, however, is not consistent with the simple
models in many textbooks or the monetarist tradition in monetary policy, which emphasizes a line of
causation from reserves to the money supply to economic activity and inflation. According to these
theories, extra reserves should induce banks to diversify into additional lending and purchases of
securities, reducing the cost of borrowing for households and businesses, and so should spark an
increase in the money supply and spending. To date, this channel does not seem to have been
effective: Interest rates on bank loans relative to the usual benchmarks remain elevated, the quantity
of bank loans is still falling, and money supply growth has been subdued. Banks’ behavior appears
more consistent with the standard Keynesian model of the liquidity trap, in which demand for
reserves becomes perfectly elastic when short-term interest rates approach zero. But the portfolio
behavior of banks might shift as the economy and confidence recover, and we will need to watch and
study this channel carefully.

Another uncertainty deserving of additional examination involves the effect of large-scale purchases
of longer-term assets on inflation expectations. The more we buy, the more reserves we will
ultimately need to absorb, and the more assets we will ultimately need to dispose of before the
conduct of monetary policy, the behavior of interbank markets, and the Federal Reserve’s balance
sheet can return completely to normal. As a consequence, these types of purchases can increase
inflation expectations among some observers who may see a risk that we will not reduce reserves and
raise interest rates in a timely fashion. So far, longer-term inflation expectations have generally been
well anchored over the past few years of unusual Federal Reserve actions. However, many unsettled
issues remain regarding the linkage between central bank actions and inflation expectations, and
concerns about the effect of the size of our balance sheet are often heard in financial market
commentary.

Lesson from Conducting Monetary Policy in a Crisis

It is certainly too soon to fully assess all the lessons learned concerning the conduct of monetary
policy during the crisis, but a few observations seem worth noting even at this early stage.

First, commitments to maintain interest rates at a given level must be properly conditioned on the
evolution of the economy. If they are to achieve their objectives, central banks cannot make
unconditional interest rate commitments based only on a time dimension. The Bank of Canada has
recently illustrated that need by revising its time commitment based on changing circumstances. To
further clarify that the “extended period” language is conditional on the evolution of the economy,
the FOMC emphasized in the November 2009 statement that its expectation that the federal funds
rate is likely to remain at an “exceptionally low” level for an “extended period” depended on the
outlook for resource utilization, inflation, and inflation expectations following the anticipated
trajectories.

Second, as I previously pointed out, firmly anchored inflation expectations are essential to successful
monetary policy at any time. That’s why central banks have not followed the standard academic
recommendation to set a higher inflation target–either temporarily or, as has been recently
suggested, over the longer run–to reduce the likelihood of hitting the zero lower bound. Although I
agree that hitting the zero bound presents challenges to monetary policy, I do not believe central
banks should raise their inflation targets. Central banks around the world have been working for 30
years to get inflation down to levels where it can largely be ignored by businesses and households
when making decisions about the future. Moreover, inflation expectations are well anchored at those
low levels.

Increasing our inflation targets could result in more-variable inflation and worse economic outcomes
over time. Inflation expectations would necessarily have to become unanchored as inflation moved
up. I doubt households and businesses would immediately raise their expectations to the new targets
and that expectations would then be well anchored at the new higher levels. Instead, I fear there
could be a long learning process, just as when inflation trended down over recent decades. Moreover,
a higher inflation target might also mean that inflation would be higher than can be ignored, and
businesses and households may take inflation more into account when writing contracts and making
investments, increasing the odds that otherwise transitory inflation would become more persistent.

For both these reasons, raising the longer-term objective for inflation could make expectations more
sensitive to recent realized inflation, to central bank actions, and to other economic conditions. That
greater sensitivity would reduce the ability of central banks to buffer the economy from bad shocks.
It could also lead to more-volatile inflation over the longer run and therefore higher inflation risk
premiums in nominal interest rates. It is notable that while the theoretical economic arguments for
raising inflation targets are well understood, no major central bank has raised its target in response
to the recent financial crisis.

Third, it appears that large-scale asset purchases at the zero bound do help to ease financial
conditions. Our best judgment is that longer-term yields were reduced as a result of our asset
purchases. The lower rates on mortgages helped households that could refinance and supported
demand to help stabilize the housing market. Moreover, low rates on corporate bonds contributed to
a wave of longer-term business financing that has strengthened the financial condition of firms that
could access securities markets and contributed to the turnaround in business investment.

Fourth, central banks also need to be mindful of the potential effects on inflation expectations of the
expansion of their balance sheet. Most policymakers do not tend to put too much stock in the very
simple theories relating excess reserves to money and inflation that I mentioned earlier. But we are
aware that the size of our balance sheet is a potential source of policy stimulus, and we need to be
alert to the risk that households, businesses, and investors could begin to expect higher inflation
based partly on an expanded central bank balance sheet. As always, the Federal Reserve monitors
inflation developments and inflation expectations very closely and any signs of a significant
deterioration in the inflation outlook would be a matter of concern to the FOMC.

Fifth, central banks need to have the tools to reverse unusual actions–to drain reserves and raise
interest rates–when the time comes. Confidence in those tools should help allay any fears by the
public that unusual actions will necessarily lead to inflation. And having or developing those tools is
essential to allow aggressive action to ease financial conditions as the economy heads into recession.
In the case of the Federal Reserve, our ability to pay interest on excess reserves, which we received
only in September 2008, is a very important tool that made us more comfortable taking
extraordinary steps when they were needed; it allows us to put upward pressure on short-term
interest rates even with very elevated levels of reserves. In addition, we are developing new tools,
including reverse repurchase agreements and term deposits that will allow us to drain significant
quantities of reserves when necessary.

Finally, let me close with some comments on a “lesson learned” that some observers have
emphasized–that long periods of low interest rates inevitably lead to financial imbalances, and that
the Federal Reserve should adjust its policy setting to avoid the buildup of such imbalances. As I
have indicated at other times, I don’t think we know enough at this point to answer with any
confidence the question of whether monetary policy should include financial stability along with
price stability and high employment in its objectives. Given the bluntness of monetary policy as a
tool for addressing developments that could lead to financial instability, given the side effects of
using policy for this purpose (including the likely increase in variability of inflation and economic
activity over the medium term), and given the need for timely policy action to realize greater benefits
than costs in leaning against potential speculative excesses, my preference at this time is to use
prudential regulation and supervision to strengthen the financial system and lean against developing
financial imbalances. I don’t minimize the difficulties of executing effective macroprudential
supervision, nor do I rule out using interest rate policy in circumstances in which dangerous
imbalances are building and prudential steps seem to be delayed or ineffective; but I do think
regulation can be better targeted to the developing problem and the balance of costs and benefits
from using these types of instruments are far more likely to be favorable than from using monetary
policy to achieve financial stability.

Conclusion
The most severe financial crisis since the Great Depression has caused suffering around the world. It
also has been a difficult learning experience for central bankers. Monetary policymakers must ask
whether the strategies and tools at their disposal need to be adapted to fulfill their responsibilities for
price and economic stability in modern financial markets. As with the most interesting questions, the
answers aren’t at all clear. But we should use our experience to foster a constructive discussion of
these critical questions, because addressing these issues will enable central banks to more effectively
promote financial stability and reduce the odds of future crises.
1. The views expressed are my own and not necessarily those of my colleagues on the Federal Open
Market Committee. James Clouse and Fabio Natalucci of the Board’s staff contributed to these
remarks.

2. Primary dealers are broker-dealers that trade in U.S. government securities with the Federal
Reserve Bank of New York.

3. Walter Bagehot ([1873] 1897), Lombard Street: A Description of the Money Market (New York:
Charles Scribner’s Sons).

4. See Board of Governors of the Federal Reserve System (2010), “Federal Reserve, European Central
Bank, Bank of Canada, Bank of England, and Swiss National Bank Announce Re-establishment of
Temporary U.S. Dollar Liquidity Swap Facilities,” press release May 9; and Board of Governors of the
Federal Reserve System (2010), “FOMC Authorizes Re-establishment of Temporary U.S. Dollar
Liquidity Swap Arrangement with the Bank of Japan,” press release, May 10.

5. A clear-cut assessment of the effects of the introduction of the “extended period” language,
however, is complicated by the fact that the FOMC also decided at the March 2009 meeting to
increase the size of the Federal Reserve balance sheet further by purchasing up to an additional $750
billion of agency MBS, bringing its total purchases of these securities to up to $1.25 trillion, and to
increase its purchases of agency debt by up to $100 billion to a total of up to $200 billion.

6. Treasury yields also declined notably on December 1, 2008, following a speech by the Chairman
noting that the Federal Reserve could purchase longer-term Treasury securities in substantial
quantities. See Ben S. Bernanke (2008), “Federal Reserve Policies in the Financial Crisis,” speech
delivered at the Greater Austin Chamber of Commerce, Austin, Tex., December 1.

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Comments
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7 Responses to “Federal Reserve’s Policy Actions during the Financial Crisis

and Lessons for the Future”

1. KidDynamite Says: 
May 13th, 2010 at 7:27 pm

“Importantly, lending against good collateral to solvent institutions supplies liquidity, not
capital, to the financial system. ”

oy vey…

there are two big assumptions there, neither of which I’d take as a “given”… “good collateral”
and “solvent institutions.”

the Fed, of all entities, should understand the difference between liquidity and solvency.
Without extend and pretend, and a trillion plus dollars of asset price support, our banks
were/are insolvent.

2. Simon Says: 
May 13th, 2010 at 7:47 pm

Doesn’t America need to look across the Atlantic to see what happens when people perceive
there to be a greater risk of not getting their money back? Eventually people are going to want
more for their money. And if there are no good alternatives they may just give up a look to the
metals.

I mean does not sovereign debt become a ponzi scheme when it starts to become clear that
without the presence of future buyers there is no chance everyone getting all their money back
intact? Or do people who purchase treasuries not care about that?

Clearly they do sometimes.

3. pmorrisonfl Says: 
May 13th, 2010 at 8:14 pm

Like KidDynamite said:

solvent institutions?
penalty rate?
good collateral?

I wonder what Bagehot would think.

4. gloppie Says: 
May 13th, 2010 at 8:19 pm

Who’s going to read all that garbage ?

The Federal Reserve is not a Central Bank, but a private Corporation of for-profit businesses
(banks) with a semi-legitimate public mandate, just like Fannie and Freddy, and we know how
that ended…..

5. Mark E Hoffer Says: 
May 13th, 2010 at 10:48 pm

gloppie,

worry not, they believe they have it, well, in-hand..

“…Many studies have been conducted in the past century to measure the effects of mass media
on the population in order to discover the best techniques to influence it. From those studies
emerged the science of Communications, which is used in marketing, public relations and
politics. Mass communication is a necessary tool the insure the functionality of a large
democracy; it is also a necessary tool for a dictatorship. It all depends on its usage.

In the 1958 preface for A Brave New World, Aldous Huxley paints a rather grim portrait of
society. He believes it is controlled by an “impersonal force”, a ruling elite, which manipulates
the population using various methods.

“Impersonal forces over which we have almost no control seem to be pushing us all in the
direction of the Brave New Worldian nightmare; and this impersonal pushing is being
consciously accelerated by representatives of commercial and political organizations who have
developed a number of new techniques for manipulating, in the interest of some minority, the
 thoughts and feelings of the masses.”
- Aldous Huxley, Preface to A Brave New World

His bleak outlook is not a simple hypothesis or a paranoid delusion. It is a documented fact,
present in the world’s most important studies on mass media. Here are some of them:…”
http://vigilantcitizen.com/?p=3571

Why do think that the FCC was created, in the first place?
http://clusty.com/search?input-form=clusty-simple&v
%3Asources=webplus&query=FCC+control+of+Media

6. Greg0658 Says: 
May 14th, 2010 at 7:11 am

I woke up hearing its the end of law and order .. well it was that tv drama they were talking
about .. but got me thinking what my POTUS should be thinking (in the wake of disasters that
are all at the feet of the POTUS to fix) .. what is the correct move if cash in all denominations
and markets of all denominations lost their law and order .. we may have reached that .. I sorta
believe that .. point . my pension package repackaged because the cash isn’t in the accounts ..
am I* to await for another re-adjustment or total disappearance**

* actually my pension handlers

** yes – possession is 9/10ths of the law

Should a plan be in the works .. a marshall law on financial instruments and their
perpetrators .. its been bantered we have Banksters and the week old trade Thursday afternoon
spike was a hit job ..

marshall law on financial instruments is a BIG TASK bigger than a Gulf oil-gusher cleanup ..

I do believe we have a loss of trust .. we’re all puppets of the system .. with everyone thinking
they control their sandbox and you play in it at their disposition .. thats not quite right .. you
can go tell your mommy – the state of your toys when you get back with the authorities? the
story that prevails in the court of reasonable doubt and evidence?

Would POTUS be able to:

- Freeze accounts as of a day . close the instrument and order its disbursement in a trustfully
way back to a cash equivalent . dollar or gold
- coinage . dollars . gold . I can not fathom shopping with gold in my pocket . am I to believe
the metal I get in change is any more real than a 50 spot with a security strip (doesn’t turn
 black with the special brown marker)
- $#s in a computer account seems just as good – depends on that trust of the facilitators
- electronic transfer . seems the most workable martial plan

One thing with the nature of our system of business .. the consumer pays in the end under the
incorporated businessman rules.
Public Debts and Private Profits

7. wally Says: 
May 14th, 2010 at 8:36 am

Since it isn’t over and the bill has not yet come due, it is way, way too early to be doing an
assessment.