CENTRAL BANKING IN THE CREDIT TURMOIL:
AN ASSESSMENT OF FEDERAL RESERVE PRACTICE

Marvin Goodfriend1

Carnegie Mellon University
andNational Bureau of Economic Research

May 2009

1

Professor of Economics, Chairman of the Gailliot Center for Public Policy, Tepper School of Business.
The paper was prepared for a presentation at the Bank of Japan 2009 International Conference: Financial
System and Monetary Policy Implementation, May 27-8, 2009, Institute for International and Economic
Studies, Bank of Japan, Tokyo, and a presentation at the Conference on “Monetary-Fiscal Policy
Interactions, Expectations, and Dynamics in the Current Economic Crisis,” May 22-3, 2009, Princeton
University, Princeton, New Jersey.

Introduction
The credit market turmoil and severe contraction of economic activity
have challenged central banks around the world as never before. Central
banks increased the stock of aggregate bank reserves enormously, andbrought targeted short-term interest rates to (near) zero in many countries.
For instance, the Federal Reserve increased the stock of bank reserves in the
United States from under 10 billion dollars in August 2007 to around 800
billion dollars in April 2009 as the federal funds rate approached zero.
Central bank lending expanded greatly to facilitate credit flows. For
instance, Federal Reserve loans to depository institutions stand at over 400
billion dollars at the end of April 2009. Previously, the most expansive,
prolonged Fed lending was a loan of roughly 5 billion dollars to Continental
Illinois Bank from May 1984 until February 1985.2 Since the turmoil began
in 2007 the Fed extended its credit well beyond depository institutions. Most
significantly, the Fed purchased around 400 billion dollars of mortgagebacked securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae.
And the Fed extended over 200 billion dollars of loans to a special purpose
vehicle created to purchase commercial paper.3
Still farther afield, the Fed extended credit to three limited liability
companies in conjunction with efforts to stabilize institutions that it deemed
to be critically important. In mid-March 2008 the Fed agreed to extend
roughly 29 billion dollars to Maiden Lane I LLC so that it could acquire avariety of mortgage obligations, derivatives, and hedging products tofacilitate the acquisition of Bear Stearns by JP Morgan Chase. Maiden Lane
II and III LLC were both created to restructure the Fed’s lending to AIG in
the aftermath of its financial support of AIG in September 2008. Together,
the Fed lent Maiden Lane II and III roughly 50 billion dollars to purchase,respectively, residential mortgage-backed securities from AIG, and multisector collateralized debt obligations on which AIG has written credit
default swap contracts.4
All together, the Fed grew its balance sheet from around 900 billion
dollars in mid-2007 to over 2 trillion dollars as of April 2009. The Fed did
so while reducing its purchases of US Treasury securities from over 800
billion to 550 billion dollars. The Fed funded its enormous increase inlending with over 250 billion dollars from the sale of Treasury securities,
2

For a brief period following 9/11, fed lending to banks rose above 30 billion dollars. Fed credits
referenced here and in the text are overnight loans.
3
See Federal Reserve Statistical Release H.4.1 “Factors Affecting Reserve Balances,” April 30, 2009.
4
See the Appendix to the Federal Reserve’s Monetary Policy Report to Congress, February 24, 2009.

1

plus around 800 billion dollars growth of bank reserves, and around 300
billion dollars of additional deposits provided by the Treasury, for a grand
total of over 1.3 trillion of Fed lending as of April 2009.
The extraordinary scale and scope of the policy actions undertaken by
the Fed and other central banks to stabilize the banking system, to facilitate
non-bank credit flows, and to act against the contraction of employment andoutput presents a unique opportunity to reconsider the nature of central
banking. The Fed and other central banks around the world have undergone
a stress test of their own, a test that is still very much in progress. Yetenough time has passed to take stock, not so much to evaluate the timing,
magnitude, and effectiveness of particular extraordinary actions, but toobserve how central banks put their various powers to work in extraordinary
circumstances, and to use those observations to rethink central banking moregenerally.
Our reconsideration begins by classifying core central banking
initiatives as monetary policy, credit policy, or interest rate policy. Monetary
policy refers to open market operations that expand or contract highpowered money (bank reserves and currency) by buying or selling Treasury
securities. Credit policy shifts the composition of the central bank balance
sheet, holding high-powered money fixed, from Treasuries to credit to theprivate sector or other government entities in the form of loans or securities
purchases. Interest rate policy involves adjusting interest paid on bankreserves to influence the level of short-term interest rates.
This three-fold taxonomy did not matter much in the past. For
instance, until the recent credit turmoil the Fed’s credit policy played arelatively minor role, the Fed could not pay interest on reserves, andmonetary policy was utilized to target the federal funds rate. However, thetaxonomy is useful in the current context for a number of reasons. For
instance, it will allow us to appreciate the potential for monetary policy
alone to stimulate economic activity at the zero bound on interest rate policy.
And it will allow us to understand how interest on reserves will enableinterest rate policy to exit from the zero bound, regardless of the size of the
Fed’s balance sheet.
Monetary, credit, and interest rate policy involve fiscal policy inimportant but different ways. We will see that monetary policy needs more
support than is usually granted from the fiscal authorizes to be effective at
the zero bound, in part because interest on reserves needs fiscal support toassure its effectiveness in exiting from the zero bound. And credit policy
owes its effectiveness to the fact that it is fiscal policy pursued by a central
bank. One of the main points of this essay is that because credit policy is
2

fiscal policy, central bank independence is incompatible over time with all
but limited, temporary last resort lending to depository institutions.
The essay presents a framework for rethinking central banking in lightof the extraordinary developments in the credit turmoil—near zero interest
rates, the huge expansion of bank reserves, the unprecedented expansion of
the scale and scope of central bank lending. The contention is that one must
understand central banking in terms of its essence—the independent
authority to manage monetary policy, (limited) credit policy, and interest
rate policy—and build an institutional framework to preserve thatindependence so that central banks can make their greatest possible
contribution to stabilization policy.
With that in mind, the balance of the essay proceeds as follows.
Section 1 details the taxonomy to be employed in the remainder of the essay.
Section 2 outlines the fiscal dimensions of monetary, credit, and interest rate
policies. Section 3 explains how monetary policy can stimulate economic
activity at the zero bound, and how interest on reserves could allow interest
rate policy to exit the zero bound. Section 4 reviews the fiscal policy
dimensions of five actual Federal Reserve initiatives in the credit turmoil—
the Term Auction Facility, lending to facilitate the acquisition of Bear
Stearns by JP Morgan Chase, Fed support for AIG, emergency authority to
pay interest on reserves, and the joint statement by the Treasury and the Fed
on the role of the Fed in preserving financial and monetary stability. Section
5 proposes a set of principles to clarify the boundary between the Treasury
and Fed in an “Accord for Federal Reserve Credit Policy” along the lines ofthe famous 1951 “Fed-Treasury Accord on Monetary Policy.”
1. Monetary Policy, Credit Policy, and Interest Rate Policy
Monetary policy refers to central bank policy actions that change thestock of high-powered money, i.e., currency plus bank reserves. A central
bank can add reserves to the banking system or supply currency to the publicby purchasing securities; it can drain reserves or currency by sellingsecurities. The Fed’s power to determine the stock of high-powered money
has enabled it to manage the federal funds rate and to pursue interest rate
policy as directed by the Federal Open Market Committee. At the start of thecredit turmoil in the summer of 2007, the Fed had on its balance sheet
roughly 850 billion dollars of securities obtained in the course of supplying
the economy with currency and bank reserves.
To avoid carrying credit risk on its balance sheet, ordinarily the Fed
satisfied virtually all of its asset acquisition needs in support of monetary3policy by purchasing Treasury securities and those securities deemed to havethe explicit backing of the Treasury, an acquisition policy known as“Treasuries only.”5 A pure monetary policy action is one in which the Fed
either injects newly-created reserves into the banking system by buying
Treasury securities or drains reserves from the banking system by selling
Treasury securities. The Fed returns to the Treasury all but a small fractionof the interest on the Treasury securities that it holds; the remainder isutilized to pay its operating expenses. Fed interest payments to the Treasury
in 2006 were around 30 billion dollars. Given the huge volume of Treasury
debt outstanding and likely to remain outstanding, the Fed could manage
monetary policy indefinitely without abandoning “Treasuries only.”
Things changed recently with the Fed’s aggressive use of credit policy
to deal with the turmoil in credit markets. The Fed takes a pure credit policy
action as distinct from a monetary policy action by shifting the compositionor size of its portfolio of assets, holding high-powered money fixed. For
example, the first large-scale credit policy actions undertaken by the Fed inearly 2008 involved lending to banks funds acquired by selling Treasury
securities from its portfolio, with no effect on high-powered money or on thesize of its balance sheet.
To date, the Fed has extended over 1.3 trillion dollars of credit tobanks and non-bank financial institutions, to special purpose entities tofinance the acquisition of commercial paper, and to purchase mortgagebacked securities. The Fed financed around 800 billion dollars of its massive
extension of credit with newly-created bank reserves. In this sense, one cansay that 800 billion dollars of its unprecedented credit initiative was a
combination monetary and credit policy. An additional 250 billion dollarsof credit extended by the Fed, funded by the sale of a like amount ofTreasury securities, was pure credit policy. The remaining 300 billion
dollars of credit extended by the Fed utilized a like amount of new Treasury
deposits. Since the Treasury financed those deposits by issuing debt, thisportion of Fed asset acquisition was pure credit policy, too.
The Fed acquired the authority to pay interest on reserves in theautumn of 2008. It has utilized interest on reserves since then to free interest
rate policy from monetary policy. This interest-on-reserves regime works asfollows. The Fed buys enough securities with newly-created bank reserves todrive the federal funds rate down to the zero bound.6 Simultaneously, theFed pays interest on reserves at the intended (overnight) federal funds rate,
5

Most Treasuries have been purchased outright, but a small fraction is held under repurchase agreements
for liquidity purposes.
6
Goodfriend (2002), and Keister, Martin, and McAndrews (2008).

4

say 2%. Banks don’t lend federal funds below 2% since they earn 2%
overnight by holding reserves at the Fed. The overnight federal funds ratewould not trade much above 2% either, as long as the Fed nearly satiates themarket for reserves.
Evidence from the 1930s, the last time interest rate policy hit the zerobound in the United States, indicates that short-term interest rates fell toaround 25 basis points once excess reserves rose above 10 percent ofdeposits.7 In other words, the reserves market was nearly satiated with arelatively modest volume of reserves. The Fed would be free to expand
bank reserves beyond that threshold for reasons other than targeting thefederal funds rate. In other words, an interest-on-reserves regime would
allow the Fed to pursue monetary policy independently of interest rate policy.
Of course, Fed credit policy funded with Treasury deposits or with sales ofTreasury securities from the Fed’s portfolio could be pursued independentlyof both interest rate policy and monetary policy.
2. Fiscal Aspects of Monetary, Credit, and Interest Rate Policy
For a given payment of interest on reserves, at zero or otherwise, puremonetary policy involves fiscal policy in two ways. First, monetary policy
influences the spread between the federal funds rate and interest paid on
reserves by varying the marginal liquidity services yield on reserves. For
instance, by draining reserves from the banking system the central bankraises the marginal liquidity services yield, which requires a higher interest
opportunity cost of holding reserves in equilibrium, and hence a higher
spread between the federal funds rate and interest paid on reserves. In effect,monetary policy raises the federal funds rate relative to interest paid on
reserves by increasing the scarcity of reserves which, in turn, taxes reserves
by paying below market interest on reserves.
Second, the Fed collects the tax as interest on the Treasury securities
that it purchases in the process of supplying bank reserves and non-interest
bearing currency. Treasury securities so purchased are “retired” from thegovernment’s point of view, since the Fed returns to the Treasury interest
paid on these securities. The monetized Treasury securities represent theseigniorage from the creation of high-powered money. Importantly, byadhering to a “Treasuries only” asset acquisition policy, the Fed passes all
the tax revenue from monetary policy through to the Treasury.

7

Morrison (1966), page 44.

5Fed credit initiatives described above employ fiscal policy to improveflows in credit markets. When the Fed substitutes credit to the private sector
or another government entity for a Treasury security in its portfolio, the Fed
can no longer return to the Treasury the interest it had received on the
Treasury security that it held. In other words, when the Fed sells a Treasury
security to make a loan, it’s as if the Treasury issued new debt to finance theloan. Credit policy executed by the Fed is really debt-financed fiscal policy.
Fed loans may perform well, throwing off interest payments by a margin
appropriate for the risk above interest paid by the Treasury to fund the loan.
Nevertheless, Fed credit policy is risky, and inherently involves contentious
questions of fiscal policy.
Fed credit policy “works” by exploiting the creditworthiness of thegovernment to acquire funds at a riskless rate of interest in order to makethose funds available to financial institutions and other borrowers that
otherwise would have to pay a much higher risk premium to borrow, if they
can borrow at all under the circumstances. Collateralized Fed credit policy isrisky not only because the borrower might default, but also because thecollateral might prove to be worth less than the loan in the event of aborrower default. In effect, Fed credit policy works by interposing the US
Treasury between lenders and borrowers in order to improve credit flows. In
doing so, however, the Fed essentially makes a fiscal policy decision to put
taxpayer funds at risk. In the event of a default, if the collateral is unable tobe sold at a price sufficient to restore the initial value of Treasury securities
on the Fed’s balance sheet that was used to fund the credit initiative, then theflow of Fed remittances to the Treasury will be smaller after the loan isunwound. The Treasury will have to make up the shortfall somehow, namely,
by lowering expenditures, raising current taxes, or borrowing more andraising future taxes to finance the increased interest on the floating debt or to
retire the debt.
Even Fed lending that is collateralized fully and subject to a negligiblerisk of loss exposes taxpayers to losses if the borrower fails subsequently.
For instance, Fed emergency lending (that finances the withdrawal ofuninsured claimants of a financial institution that fails subsequently) strips
that institution of collateral that would otherwise be available to cover thecost of insured deposits or other government guarantees. Thus, even if the
Fed succeeds in lending only against good collateral so as not to takeappreciable credit risk itself, last resort lending to depositories andemergency credit extended to other financial institutions that have federal
guarantees have the capacity to impose significant losses on taxpayers.

6

The interest-on-reserves regime utilizes a fiscal policy instrument
granted to the central bank, the authority to pay interest on reserves, toimprove the efficiency of interest rate policy and free monetary policy topursue other objectives. The interest-on-reserves regime would nearly
eliminate the tax on reserves. An abundance of costless, safe reserves would
displace costly and risky private credit in the payments system. The savings
would be passed to interest on bank deposits, inducing the public to
substitute money balances for shopping time in making transactions. The
availability of low opportunity-cost bank reserves would enable the central
bank to limit the extension of its own credit in support of the payments
system. Moreover, by eliminating the tax on reserves, the interest-onreserves regime would secure the central bank’s control of short-term
interest rates, since banks would no longer have an incentive to substituteaway from central bank reserves in the provision of transactions services.
As indicated above, the advantages of the interest-on-reserves regime
could be achieved at a relatively low threshold of aggregate reserves todeposits. At that minimum, the central bank would likely have little problem
financing the payment of interest on reserves out of interest earned on its
securities in as much as all but a relatively small portion of its securities will
have been purchased with non-interest bearing currency. Moreover, theinterest-on-reserves regime could be run in conjunction with pure monetary
policy, that is, with a “Treasuries only” asset acquisition policy.
Switching to the interest-on-reserves regime would have two effects
on the government’s revenue from money creation. There would be a loss oftransfers to the government associated with interest paid to banks onpreexisting reserve balances. However, interest paid on the increase inreserves would be self-financing on average over time since interest rate
spreads between longer-term Treasuries and overnight deposits at the central
bank should normally exhibit term premia reflected in the Treasury yield
curve. In fact, the interest-on-reserves regime would likely yield a netincrease in seigniorage over time, since preexisting reserve balances are sosmall.
3. Monetary Policy at the Zero Bound and Interest on Reservesin the Exit Strategy
Monetary policy expansion at the zero bound can be effective if the
public is confident that the central bank will expand bank reserves by asmuch and for as long as needed to act against the downturn. The credibilityof aggressive monetary stimulus, however, depends on the public’s belief
7that the central bank is confident of its independence to exit promptly andaggressively from the zero bound if need be to contain inflation. This section
explains the leverage that monetary policy can utilize to stimulate economic
activity at the zero bound, and the leverage that interest on reserves can exert
to exit from the zero bound, regardless of the size of the central bank’sbalance sheet.
Monetary Policy at the Zero Bound on Interest Rate Policy
To appreciate the power of monetary policy to stimulate economic
activity at the zero bound, we must distinguish between narrow and broadliquidity services. Narrow liquidity services are provided by the medium of
exchange allowing banks and the public to economize on transactions costs.
When short-term nominal interest rates are near zero, there is little
opportunity cost of holding currency, bank reserves, and transactions
deposits. Banks and the public enlarge their holdings of transactionsbalances, and the demand for narrow liquidity services of money is nearlysatiated.
The demand for broad liquidity services is evident in the large stockof time deposits and certificates of deposit, money market mutual fundshares, and short-term government securities willingly and routinely held by
the public in relation to consumption and income in the United States, eventhough the short-term real rate of interest on such financial assets has
averaged around 1 to 2 percent.8 For instance, in 2005 the US public heldaround one year’s GDP, then about 12.5 trillion dollars, in M3 plus shortterm Treasuries.
Broad liquidity services are not exhausted when the interbank interest
rate hits the zero bound. In fact, the hallmark of the credit turmoil has been
the “flight to safety,” an increased demand to hold wealth in such financial
assets.
The demand for broad liquidity provides the leverage for monetary
policy to stimulate the economy even after the interbank interest rate hits thezero bound.9 At the zero bound, high-powered money and short-term
Treasury securities provide identical (broad) liquidity services because
narrow liquidity services are satiated. Hence, to exert monetary (as distinct
from credit) policy stimulus at the zero bound, a central bank must inject
reserves by purchasing illiquid assets such as long-term Treasury bonds.
8
9

Campbell (1999), page 1233.
This following draws on Goodfriend (2000).

8

Increasing the stock of broadly liquid financial assets acts on a number ofmargins to stimulate economic activity at the zero bound.
First, expanding the stock of broad money brings down the “marginal
broad liquidity services yield” and activates the portfolio rebalancing
channel. An injection of broad liquidity that drives down its implicit yield
induces banks and the public to hold assets that are less liquid but have ahigher explicit rate of return. Equilibrium prices of nonmonetary assets arebid up to restore the required return differential. Second, higher asset prices
raise collateral values and the net worth of households and firms, andthereby help bring elevated credit spreads back down. Higher asset prices
and reduced credit spreads, in turn, stimulate desired consumption out ofcurrent income and help revive investment.
Third, the public might utilize reserves injected into the economy torepay bank loans. In this case, the injection of reserves would not act directly
to increase the stock of broad liquidity. But the reserve injection would be
expansionary nevertheless, in addition to enabling the public to pay off bankloans without shrinking the aggregate money stock. The reserve injection
would increase the ratio of reserves to deposits; and it would free up banking
resources that had been engaged in managing and monitoring the loans thatwere paid off. Both effects would reduce the equilibrium external financepremium and encourage the extension of new loans by reducing riskweighted assets and improving risk-weighted capital ratios, and by making
available organizational banking resources to manage new lending. Not only
would the banking system be better positioned to extend loans to those stillin need of credit, in so doing it would expand the stock of aggregate bankdeposits and broad liquidity.
Two additional implementation problems would have to be overcome
to make monetary stimulus effective at the zero bound. Ordinarily, relatively
small changes in bank reserves suffice to manage interest rate policy. We
saw above, however, that monetary policy exerts its stimulus through a large“monetary aggregate” at the zero bound. Hence, a large, sustained increasein bank reserves in the trillions of dollars likely is necessary for monetary
policy stimulus to have much effect through the three broad-liquidity
channels of monetary transmission outlined above. Moreover, theeffectiveness of even such a large expansion of bank reserves against thecontraction would depend on the public’s belief in the central bank’s
willingness to expand reserves by as much and for as long as needed to act
against the contraction. The required expansion of bank reserves would be
credible only if the public also believed that the central bank could exit the9zero bound on interest rate policy promptly and aggressively if need be toact against inflation, regardless of the size of its balance sheet.
Interest on Reserves in the Exit Strategy
In principle, the authority to pay interest on reserves obtained in thefall of 2008 should give the Fed the operational independence to raise thefederal funds rate against inflation if the economy turns up sharply or if
inflation or inflation expectations begin to rise—even with trillions ofdollars of bank reserves on its balance sheet financing long term Treasuries
and credit programs that cannot be unwound promptly.
However, credible operational independence for the Fed to exit thezero bound also needs the support of financial independence. The question
is: can the Fed be sure to have sufficient interest income to financeindependently whatever interest must be paid on reserves as the economy
emerges from the zero bound, or might the Fed need additional fiscal
support from the Treasury? This question should be addressed even thoughnearly 1 trillion dollars of non-interest bearing currency provides the Fedwith a large cushion of net interest income.
Financial independence need not be a problem if the Fed manages
stabilization policy well in the current turmoil so as to maintain long term
Treasury rates in the vicinity of a sustainable 5 percent yield, a 3 percent real
yield plus a 2 percent inflation premium consistent with the Fed’s apparent
inflation target.10 If short rates remain below long rates as interest rate policy
exits from the zero bound so that the yield curve remains upward sloping,then Fed net interest income could remain comfortably positive.
However, a cash flow problem could arise if the Fed is either
insufficiently preemptive against deflation or insufficiently preemptive
against inflation. If the Fed acts too slowly against deflation, it could suffer
negative cash flow problems as interest rates normalize if it bought longbonds to act against the contraction and deflation after long rates had fallen
well below their steady state levels. If the Fed acts too slowly against
inflation, negative cash flow problems could arise if the Fed has to raiseinterest on reserves far above long term interest rates to stabilize inflation.
To make fully credible the Fed’s operational independence to useinterest on reserves to exit the zero bound, the Treasury should guarantee theFed’s financial independence to pay interest on reserves. This the Treasury
could do by allowing the Fed to retain net interest income to build up
10

Board of Governors of the Federal Reserve System (2009), page 39.

10

“surplus capital.” The Fed would hold its cushion of surplus capital in shortterm Treasury securities to be sold if need be to offset a negative cash flow
problem. By allowing the Fed to build up capital this way, the Treasury
would be undertaking a fiscal policy action to utilize tax revenue to buy backshort term government debt. Debt in the Fed capital account would be retired
from the Treasury’s point of view because the Fed would return the interest
to the Treasury. Under this arrangement, however, the Fed would have theindependence to sell the short term Treasuries in its capital account to help
finance interest on reserves, and any other operational expenses, if that were
to become necessary.
4. Fiscal Aspects of Five Federal Reserve Initiatives
This section describes five Fed initiatives in the credit turmoil: theTerm Auction Facility, lending to facilitate the acquisition of Bear Stearns
by JP Morgan Chase, Fed support for AIG, emergency authority to pay
interest on reserves, and the joint statement by the Treasury and the Fed on
the role of the Fed in preserving financial and monetary stability. The
descriptions highlight the role that fiscal policy plays in each of these
initiatives, and how at times the fiscal aspects of these initiatives createdproblems for the Fed and for the effectiveness of its interventions to stabilize
the economy.
The Term Auction Facility
In December 2007, the Fed approved the establishment of the Term
Auction Facility (TAF) under which the Fed auctions term loans against awide variety of collateral to depository institutions judged to be in soundcondition.11 Since January 2009 the minimum bid rate has been interest paidon reserves. TAF loans are provided for 28- and 84-day terms. Roughly 400
billion dollars of TAF loans were outstanding in April 2009.
In the taxonomy of this paper, the TAF program was established as apure credit policy in as much as the Fed financed TAF loans with funds
acquired by selling Treasury securities from its portfolio, with no effect on
aggregate bank reserves.
The TAF worked as follows. The credit turmoil was marked by an
unprecedented elevation in rates at which banks could borrow in the federal
funds market. Banks recognized a substantial credit risk in lending to each11

Armantier, Olivier, Sandy Krieger, and James McAndrews (2008).

11

other given that federal funds lending is generally unsecured. Even if
collateral were taken, the ability to liquidate it could be impaired severely ina widespread default. These factors reflected the substantial broad-liquidity
premium on reserve balances at the Fed. Banks reacted by shortening thematurity at which they were willing to lend, and charging a substantial term
premium for interbank lending at longer horizons such as one and threemonths. Bank positions in the federal funds market can be highly persistent.
For instance, big banks tend to be borrowers of federal funds and smallerbanks lenders. When the credit turmoil hit, those banks that were persistentborrowers of federal funds endured a sharp persistent jump in their funding
costs.
Persistent borrowers of federal funds would bid most aggressively for
TAF term credit. By substituting TAF credit for more expensive federal
funds borrowed they could lower their borrowing costs. Persistent lenders offederal funds in the interbank market could sell their excess reserves to the
Fed in exchange for Treasury securities sold by the Fed to fund its TAF
loans.
Since the TAF program had no effect on total bank reserves, and little
if any effect on the balance of supply and demand in the federal funds
market, and little effect on the creditworthiness of borrowing banks, it
should not have been expected to have much sustained effect on themarginal federal funds rate paid by persistent interbank borrowers. The Fed
says that the TAF program was designed to increase the access of depository
institutions to funding in order to support the ability of such institutions tomeet the credit needs of their customers.12 Whether or not the TAF program
has had much effect on the marginal federal funds rate, the TAF program
can be understood to have reduced funding costs of those banks caught witha persistent short-term funding shortfall.
Understood this way, the TAF program provides infra-marginal relief
on funding costs for persistent borrowers of federal funds. To the extent thatinterest the Fed earns on TAF credit exceeds interest on the Treasury
securities sold to fund it, and TAF credit is virtually riskless for the Fed
because it has a secure collateral interest if the borrowing bank fails, theTAF may provide that relief at little cost to the Fed.
It cannot be said, however, that the TAF provides interest savings tobanks at little risk to the taxpayer. As discussed in Section 2 above, even
Fed lending that is collateralized fully exposes taxpayers to losses if theborrower fails subsequently. If TAF credit finances uninsured or unsecured
12

Board of Governors of the Federal Reserve System (2009), page 47.

12lenders to a bank that fails while the loan is outstanding, then the TAF will
have stripped the bank of collateral that would be available otherwise tocover the cost of insured deposits or other government guarantees. Thus, theFed must be careful when extending one to three month term credit throughthe TAF to make sure that bank receiving TAF credit will remain solvent
over the term of the loan.
Lending to Facilitate the Acquisition of Bear Stearns
by JP Morgan Chase
In mid-March 2008 Bear Stearns was pushed to the brink of failure
after losing the confidence of investors and its access to short-term funding.
The Fed judged that a disorderly failure of Bear Stearns would havethreatened overall financial stability, and after talking with the Treasury and
SEC, the Fed determined that it would invoke emergency authority toprovide special financing to facilitate the acquisition of Bear Stearns by JP
Morgan Chase. 13 In June, when the acquisition was completed, the Fed
extended roughly 29 billion dollars to the limited liability company Maiden
Lane I, which was formed to facilitate the transaction by acquiring a variety
of mortgage obligations, derivatives, and hedging products from Bear
Stearns.
The point of this discussion is not to question the Fed’s decision toprovide financial support for the acquisition of Bear Stearns by JP Morgan
Chase. What matters for our purposes is that the Fed’s financial support
went well beyond ordinary lending to depository institutions. Institutions
ordinarily eligible to borrow at the Fed discount window are depositories
that hold balances at the Fed. Investment banks were not in this group.
Hence, the Fed had to invoke emergency powers to lend in support of theacquisition.
As a central bank the Fed usually provides loans against goodcollateral to institutions deemed to be in sound financial condition. The Fedwent beyond these two conditions in this case. It lent to a limited liability
company Maiden Lane I formed for the purpose of acquiring certain assets
of Bear Stearns. Maiden Lane I was funded by a 29 billion dollar loan fromthe Fed and a 1 billion dollar loan from JP Morgan Chase. The first 1 billion
dollar loss was to be borne by JPMC, any further loss up to 29 billion was tobe borne by the Fed. And any realized gains beyond the 30 billion initialfinancing, which could occur because of revaluing the underlying assets,
13

See Geithner (2008).

13

would accrue to the Fed. This arrangement meant that the Fed had all of theupside of the asset valuations and all but a small fraction of the downside bylending to Maiden Lane I. In effect, the Fed “purchased” the assets, a variety
of risky mortgage obligations, derivatives, and hedging products acquired
from Bear Stearns.
The Fed financed its loan to Maiden Lane I with funds from the saleof Treasury securities. Hence, in terms of the terminology presented in thispaper, the loan to Maiden Lane I was a pure credit policy which, in turn,amounted to a debt-financed fiscal policy purchase of a pool of risky private
financial assets. The Fed effectively acknowledged this in two ways. First,
the Fed brought Maiden Lane onto its balance sheet and recognized
implicitly that its loan to Maiden Lane amounted to a purchase of the assets
in Maiden Lane.14 Second, the Fed received a letter from the Treasury saying“if any loss arises out of the special facility extended by the FRBNY to
JPMCB, the loss will be treated by the FRBNY as an expense that may
reduce the net earnings transferred by the FRBNY to the Treasury generalfund.”15
In April 2008, Paul Volcker described the Fed’s lending to facilitate
the acquisition of Bear Stearns by JP Morgan Chase as follows:
Simply stated, the bright new financial system—for all its talented
participants, for all its rich rewards—has failed the test of the market
place. To meet the challenge, the Federal Reserve judged it necessary
to take actions that extend to the very edge of its lawful and implied
powers, transcending certain long embedded central banking
principles and practices. The extension of lending directly to nonbanking financial institutions—while under the authority of nominally“temporary” emergency powers—will surely be interpreted as animplied promise of similar actions in times of future turmoil. Whatappears to be in substance a direct transfer of mortgage and mortgagebacked securities of questionable pedigree from an investment bank to
the Federal Reserve seems to test the time honored central bankmantra in time of crisis—“lend freely at high rates against goodcollateral”—to the point of no return.16

14

See Board of Governors of the Federal Reserve System statistical release H.4.1 from July 3 andSeptember 10, 2008, and 1A Memorandum Items, September 10, 2008.
15
Paulson (2008).
16
Volcker (2008), page 2.

14

In retrospect, Volcker’s remarks can be seen as a kind of “lifepreserver” thrown to the Fed. Without judging whether the Fed’s actions
were called for under the circumstances, but describing the Fed as having
acted at the “very edge of its lawful and implied powers,” Volcker’s remarks
could have prompted the Fed back in April to get the Treasury and Congress
to appropriate financial resources to stabilize the financial system, shouldthose resources be needed as the credit turmoil ran its course. Instead, thefiscal authorities were not then so involved, and the Fed remained exposed
to having its balance sheet utilized as an “off budget” arm of fiscal policy.
Federal Reserve Support for AIG
Events surrounding the deterioration of financial conditions in theautumn of 2008 illustrate the consequences of allowing the Fed’s balance
sheet to be the front line of fiscal support for the financial system. On
September 7 the Treasury and the Federal Housing Finance Agency
announced they would place Fannie Mae and Freddie Mac into
conservatorship. Shortly thereafter, Lehman Brothers came under pressure
as short-term secured funding was withdrawn from the investment bank, andLehman filed for bankruptcy on Monday, September 15th. The financial
condition of American International Group (AIG), a large, complex
insurance conglomerate, also deteriorated rapidly and on Tuesday,
September 16th with the full support of the Treasury, the Fed announced an
85 billion dollar loan to AIG to support the firm whose failure it judged
would have significant adverse effects on the economy. A full-scalefinancial panic developed on Wednesday, September 17th after a majormoney market mutual fund “broke the buck” prompting widespread
withdrawals from prime money funds and forcing the liquidation of theircommercial paper holdings. The “flight to safety” pushed the 3-month
Treasury bill yield to zero on September 17th.
The Fed’s financial support for AIG was criticized immediately bysome important members of Congress as a questionable commitment of
taxpayer funds, in effect, a “bridge too far.”17 At that point, and in light ofthe ongoing panic in financial markets, Fed Chairman Bernanke had little
choice but to call Treasury Secretary Paulson and tell him that the Fed had
been stretched to its limits and couldn’t do anymore. Although Paulson
apparently had been resisting such a move for months, Bernanke said it was

17Blackstone and Yoest (2008), and Andrews, de la Merced, and Walsh (2008).

15

time for the Treasury secretary to go to Congress to seek funds and authority
for a broader rescue of the financial system.18
On Thursday eve, September 18th, Paulson and Bernanke made theircase to the congressional leadership—that the Congress should authorize alarge expenditure of public funds to help stabilize the financial system. By
that weekend, Congress and Paulson had agreed on the outlines of the700
billion dollar Troubled Asset Relief Program (TARP).19
The problem was that in order to get Congress to appropriate thefunds, Bernanke then had to argue that otherwise the US economy was at
risk of a severe contraction, if not another Great Depression. When theHouse of Representatives rejected the initial TARP bill on Tuesday,
September 30th, stocks plunged.20 To overcome resistance to funding the
TARP program, Bernanke continued to argue that the legislation was needed
to prevent a severe contraction. By the time the legislation passed on Friday,
October 3rd, the public was thoroughly frightened. Equity markets in the
United States fell by over 30 percent in the four weeks to October 10th. Risk
spreads rose dramatically throughout the credit markets as never before in
the credit turmoil. High-yield corporate bond spreads over comparable offthe-run Treasuries spiked briefly to 16 percentage points and remained
above 10 percentage points, well above their previous peak in the credit
turmoil of 6 percentage points.
Getting the fiscal authorities to appropriate the TARP funds proved
catastrophic. The political fighting involved in persuading Congress toauthorize funding for TARP, in conjunction with other aspects of the ad hoc
fiscal response to the financial turmoil, precipitated the collapse ofconfidence that gave rise to the severe contraction of spending andemployment in the fourth quarter of 2008 that we continue to endure.
Emergency Authority to Pay Interest on Reserves
The Financial Services Regulatory Relief Act of 2006 gave the Fed
the authority starting in October 2011 to pay interest on reserves for the firsttime in its history. In May 2008 Bernanke asked that Congress give the Fed
immediate authority to pay interest on reserves. Using authority granted
under the Emergency Economic Stabilization Act of 2008, the Fedannounced on October 6 that it would begin paying interest on required andexcess reserve balances. The payment of interest on reserves was intended to18

See the Wall Street Journal article written by Hilsenrath, Solomon, and Paletta (2008).
The Economist (2008).
20
See the headline in the New York Times September 30, 2008.
19

16

assist in maintaining the federal funds rate close to the target set by the
FOMC by creating a floor under interbank market rates. Initially, the rate
paid on excess reserves was set as a spread below the targeted federal funds
rate. Later, with the federal funds rate trading consistently below the target
rate, the spreads were eliminated. Interest on reserves helped set a floor
under the federal funds rate as the Fed created nearly a trillion dollars ofreserves to help finance its credit initiatives in the fourth quarter of 2008.
Interest on reserves became less important when the federal funds rate target
was reduced to ¼ percent in mid-December.
Nevertheless, the Fed’s authority to pay interest on reserves is timely
and valuable because, in principle, it gives the Fed the operational capacity
to exit credibly from the zero bound without first drawing down the stock ofbank reserves. Unfortunately, in practice, the fact that the federal funds rate
has fallen somewhat below the rate of interest paid on reserves indicates thatsome financial institutions holding balances at the Fed that trade in federal
funds market are not authorized to receive interest on those balances. The
Fed should act promptly to secure the power of interest on reserves to exit
the zero bound by seeking additional legislation if necessary so that (1) all
institutions with balances at the Fed eligible to trade federal funds canreceive interest that the Fed pays on reserves, and (2) the Fed can retaininterest income to build up surplus capital sufficient to finance the payment
of interest on reserves in addition to its operating expenses, as needed.
Joint Statement by the Treasury and the Fed on Preserving Financial andMonetary Stability
The joint statement issued on March 23, 2009 by the Department of
the Treasury and the Federal Reserve “The Role of the Federal Reserve in
Preserving Financial and Monetary Stability” indicates that the authorities
recognize that overall financial policy is well-served by clarifying therelationship between the Treasury and the Fed.21 The two institutions agree
1) to cooperate in preventing and managing financial crises, 2) that the Fed
alone is responsible for monetary policy and that its monetary policy
independence is critical for the long-term economic welfare of the nation, 3)that the Fed should use all its tools in cooperation with the Treasury andother agencies to improve the functioning of credit markets, help prevent the
failure of systemically important institutions, and to foster financial stability,
21

Jeffrey Lacker and Charles Plosser, presidents of the Federal Reserve Banks of Richmond andPhiladelpha, respectively, recently called for clarifying the relationship between the Fed and the Treasury.
See Lacker (2009) and Plosser (2009).

174) that the Fed’s lender-of-last resort responsibilities involve lending against
collateral, secured to the satisfaction of the responsible Federal Reserve
Bank, 5) that the Fed should improve financial conditions broadly and not
aim to allocate credit narrowly, 6) that government decisions to allocate
credit are the province of the fiscal authorities, 7) that the use of the Fed’sbalance sheet in the pursuit of financial stability should not compromise its
independence on monetary policy, 8) that the Treasury should help the Fed
seek legislative action to provide additional tools to sterilize the effects of its
lending or security purchases on the supply of bank reserves, 9) that the two
institutions will work with Congress to develop a regime to allow thegovernment to address at an early stage the failure of a systemicallyimportant financial institution within a framework that spells out the roles of
the Fed and other government agencies, 10) that the Treasury will remove
from the Fed balance sheet the three Maiden Lane facilities.
The joint statement has much to recommend it. It establishes theprinciple that the boundary between the Fed and the Treasury must be
managed carefully so the two institutions can operate productively inmanaging financial stability. It reasserts the importance of the Fed’s
independence on monetary policy. And it implicitly recognizes the fiscal
nature of the Maiden Lane facilities and the Treasury’s responsibility for
them.
Nevertheless, the March 23rd joint statement does not specify clearly
the principles that one should use to clarify the boundary of responsibilities
between the two institutions. It is on this last point that the present essay
hopes to contribute by distinguishing among monetary, credit, and interest
rate policy.
5. An Accord for Federal Reserve Credit Policy
The 1951 “Accord” between the United States Treasury and theFederal Reserve was one of the most dramatic events in US financial history.
The Accord ended an arrangement dating from World War II in which the
Fed agreed to use its monetary policy powers to keep interest rates low tohelp finance the war effort. The Truman Treasury urged that the agreement
be extended to keep interest rates low in order to hold down the cost of thehuge Federal government debt accumulated during the war. Fed officials
argued that keeping interest rates low would require inflationary money
growth that would destabilize the economy and ultimately fail.22
22

See Hetzel (2001), and Stein (1969).

18

The so-called Accord was only one paragraph, but it famously
reasserted the principle of Fed independence so that monetary policy mightserve exclusively to stabilize inflation and the macroeconomic activity.
The Fed has long executed credit policy in addition to monetary
policy, usually as “lender of last resort” to depository institutions. Credit
policy is also subject to misuse for fiscal policy purposes. However, as longas Fed lending was relatively modest and temporary and confined todepository institutions deemed solvent, and the Fed took good collateralagainst its loans, the potential for fiscal misuse was limited by today’s
standards.23 So although the Fed has long needed an “Accord” for its credit
policy, a credit accord did not seem to be a pressing matter.24
The enormous expansion of Fed lending today—in scale, in reachbeyond depository institutions, and in acceptable collateral—demands anaccord for Fed credit policy to supplement the accord on monetary policy. A
credit accord should set guidelines for Fed credit policy so that pressure tomisuse Fed credit policy for fiscal purposes does not undermine the Fed’s
independence and impair the central bank’s power to stabilize financial
markets, inflation, and macroeconomic activity.
Federal Reserve Independence
The 1951 Accord restored the Fed’s instrument independence after thewartime interest rate peg. Thereafter, the Fed utilized monetary policy tomanage the federal funds rate to achieve its macroeconomic objectives.
Congress early on recognized that the Fed needed financial independence inorder to conduct monetary policy effectively. The Fed is exempted from thecongressional appropriations process in order to keep the political systemfrom abusing its money-creating powers. The central bank funds its
operations from interest earnings on its portfolio of securities. The Fed wasgiven wide latitude regarding the size and composition of its balance sheet toenable it to react quickly and independently to unanticipated short-run
developments in the economy. In the early 1980s under the strong,
independent leadership of Paul Volcker the Fed succeeded in establishing
low inflation as the nominal anchor for monetary policy. Thus, Fed
independence is today the institutional foundation for effective monetary
policy.

23
24

Schwartz (1992).
Goodfriend (1994).

19

Asset Acquisitions Should Sustain Federal Reserve Independence25
Congress bestowed financial independence on the Fed only because itis essential for the Fed to do its job effectively. A healthy democracy
requires full public disclosure and discussion of the expenditure of publicfunds. The congressional appropriations process enables Congress toevaluate competing budgetary programs and to establish priorities for the
allocation of public resources. Hence, the Fed—precisely because it isexempted from the appropriations process—should avoid, to the fullest
extent possible, taking actions that can properly be regarded as within theprovince of fiscal policy and the fiscal authorities.
When the Fed purchases Treasury securities, it lends to the Treasury.
Doing so leaves all the fiscal decisions to Congress and the Treasury andhence does not infringe on their fiscal policy prerogatives. Pure monetary
policy as described above—the acquisition of Treasury securities with newly
created bank reserves—respects the integrity of fiscal policy fully.
Federal Reserve credit policy as described above is another matter
entirely, because all financial securities other than Treasuries carry somecredit risk and all lending involves the Fed in potentially controversial
disputes regarding credit allocation. When the Fed extends credit to private
or other public entities, it is allocating credit to particular borrowers, andtherefore taking a fiscal action and invading the territory of the fiscal
authorities. As discussed in Section 2 above, and again with respect to theTAF, even fully collateralized lending that is riskless for the Fed may expose
taxpayers to losses if the borrower fails subsequently. Fed credit that
finances the exit of uninsured or unsecured lenders to a financial institutionthat fails while the loan is outstanding will have stripped the bank ofcollateral that could otherwise be available to cover the cost of insured
deposits or other government guarantees.
It is important to appreciate the difficulties to which the Fed exposes
itself in the pursuit of credit policy initiatives that go beyond traditional lastresort lending to depository institutions. The Fed must decide how widely to
expand its lending reach. Lending farther afield creates “an implied promiseof similar actions in times of future turmoil,” as Volcker put it, which the
Fed may then be inclined to accommodate.26 Fed involvement in one credit
class can drain lending from nearby credit channels. The Fed must determine
the relative pricing of its loans based on risk and collateral. The Fed must be
25
26This section draws directly from Broaddus and Goodfriend (2001).
Goodfriend and Lacker (1999) discuss this “limited commitment” problem in detail.

20accountable for its credit allocations and the returns or losses on its loans or
security purchases. The public deserves transparency on Fed credit
extensions beyond ordinary lending to depository institutions. Yet,
congressional oversight opens the door to political interference in the Fed’s
lending choices. The Fed is exposed to congressional pressure to exploit thecentral bank’s off-budget status to circumvent the appropriations process.
Finally, the Fed and the government must cooperate on banking,financial, and payments system policy matters. This interdependence
exposes the Fed to political pressure to make undesirable concessions withrespect to its credit policy initiatives in return for support on other matters.
Worse, the Fed could be pressured to make concessions on monetary policy
to deflect pressure regarding credit policy.
Accord Principles for Federal Reserve Credit Policy
The above reasoning suggests that the following principles should
serve as the basis for a comprehensive Credit Policy Accord between the
Treasury and the Federal Reserve. To repeat, Congress bestows Fed
independence only because it is necessary for the Fed to do its job
effectively. Hence, the Fed should perform only those functions that must be
carried out in an independent central bank. The main idea is to preserve theFed’s independence to act flexibly and aggressively with monetary andinterest rate policy, and (limited) credit policy so that the Fed can maximize
its contribution to price stability, financial market stability, andmacroeconomic stability.
Principle 1: As a long run matter, a significant, sustained expansion of
Fed credit initiatives beyond, ordinary, temporary last resort lending todepository institutions is incompatible with Fed independence. The Fed
should adhere to a “Treasuries only” asset acquisition policy except foroccasional and limited discount window lending to depository institutions
deemed to be solvent.
Principle 2: The Treasury and the Fed should agree to cooperate, assoon as the current credit turmoil allows, to shrink the central bank’s lending
reach by letting Fed credit programs run off or by moving them from theFed’s balance sheet to be managed elsewhere. Any further expansion of Fed
credit programs in the current turmoil should be undertaken by agreementwith the Treasury to minimize the risk of committing to a course of actionthat proves subsequently to be ill-advised.
21

Principle 3: The Fed has employed monetary policy in the service ofcredit policy in the current emergency by creating around 800 billion dollars
of bank reserves to finance its credit initiatives, with the possibility of more
to come before the credit turmoil ends. The Treasury and the Fed should
cooperate to guarantee that the use of monetary policy for the fiscal purposeof funding credit policy does not undermine price stability.
Principle 4: To strengthen the nation’s commitment to price stability,
the Treasury and the Fed should agree on a low long run inflation objective.
Anchoring inflation expectations will improve the effectiveness of monetary
policy and hold down the inflation premium in long-term Treasury bondrates.
Principle 5: The Treasury should help the Fed, by seeking
congressional legislation if necessary, to secure the capacity of interest on
reserves to provide a fully credible exit strategy from the zero bound on
interest rate policy, regardless of the Fed’s credit policy commitments or thesize of its balance sheet. Specifically, the fiscal authorities should support
interest rate policy by (1) allowing every institution that holds balances at
the Fed and trades in the federal funds market to receive the rate of interest
that the Fed pays on the reserves of depository institutions, and (2) allowing
the Fed to retain interest income to build up surplus capital enough tofinance the payment of interest on reserves and any operating expenses inthe event of adverse cash flow problems.
Principle 6: The credibility and effectiveness of monetary policy to act
aggressively against deflation at the zero bound requires that the Fed and the
public are both confident that interest rate policy can exit the zero boundpromptly and aggressively against inflation if need be, whatever the Fed’s
credit policy commitments. The Treasury and the Fed should agree promptly
to cooperate according to the above principles so that the Fed can act
preemptively, flexibly, and aggressively against either rising inflation or adeepening contraction and deflation, if either demands Fed action.

22

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Armantier, O., S. Krieger, and J. McAndrews, “The Term Auction Facility,”
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Blackstone, B. and P. Yoest, “Bailouts Turn Up Heat on Fed Chief,” The
Wall Street Journal.com, September 18, 2008
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Campbell, J.Y., A.W. Lo, and A.C. MacKinlay, The Econometrics ofFinancial Markets, Princeton: Princeton University Press, 1997.
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Economist, “America’s Bail-out Plan: The Doctors’ Bill,” September 25,
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