On Maiden Lane

The Pligh Federal Reserve In the summer of 1931, as the economy descended deeper into depression, Irving Fisher pressed Eugene Meyer, a Federal Reserve Board Governor, to expand the money supply in order to stop the economy from deteriorating further. A recent drop in the level of demand deposits had alarmed Fisher, who believed the economy would continue to wane if the Fed failed to intervene. When Fisher explained this to Governor Meyer, Meyer asked, What did you call the figure? Meyer had no idea what demand deposits were. Fisher repeated his explanation once more, arguing that further a contraction in the money supply could devastate the economy. However, Meyer failed to see his point. As a result, the Fed did not act and the economy continued its free-fall. As Fisher later described, He was like a chauffeur going blindfolded and running into the curb because he could not see the direction in which he was driving. There is little question that monetary policy has evolved since this time - Chairman Bernanke is undoubtedly well aware of the Fed's historic missteps. Nevertheless, the recent crisis has demonstrated that the Fed has yet to perfect its policy. As traditional responses proved inadequate to curtail financial turmoil over the past three years, the Fed has been forced to rethink and reevaluate its response to financial turmoil. Central to this policy reformulation was a group of unprecedented liquidity initiatives, designed to stabilize financial markets and support the economy. As the crisis unfolded, the Fed, and particularly its New York branch, which sits on Maiden Lane in Manhattan, rapidly planned and unrolled liquidity facilities as weaknesses in different parts of the financial sector became more apparent. Yet, despite these efforts, and fiscal stimulus from the Ob ama administration, unemployment remains unnervingly high. Making matters worse, in the process of implementing these extraordinary efforts, the Fed has drawn the ire of both Congress and the public for stretching its powers beyond their ordinary scope. Its recent decision to purchase $600 billion of long-term Treasuries (popularly referred to as quantitative easing 2 or QE2) has even drawn criticism from beyond America's borders; Russia, Brazil, and China have all roundly condemned the Fed's plan. Some of the criticism the Fed has received is well-deserved. Arguably, the Fed kept rates too low for too long, which helped fuel the rise in housing prices and also failed to carefully monitor the financial system at a time when it was becoming increasingly fragile. Therefore, the Fed must certainly reassess its role in the economy, and in particular, must decide how it will effectively monitor the financial system and provide oversight. As Michael Woodford, professor of economics at Columbia University, describes, going forward central banks will be less casual saying the system will take care of itself. But other aspects of the criticism the Fed has received have been off the mark. Despite its imperfections, the Fed has come a long way since the days of Fisher and Meyer. During the crisis, the Fed was often the only body equipped to adequately respond to the languishing economy, and unlike when Meyer rebuffed Fisher's plea to intervene, the Fed took aggressive, innovative actions to halt - or at least slow - the descent into catastrophe. Response to the Crisis The Fed's initial response to the crisis largely escaped criticism; though it was aggressive, when the markets first experienced turmoil in July 2007, the response closely adhered to the precedent it had established over the previous decades. Since the end of stagflation in the 1980s, the Fed has relied on targeting short-term interest rates to either stimulate or rein in the economy. And, until the turn of the century, the Fed's policy on these short-term rates closely followed a Taylor Rule, a monetary policy rule-of- thumb that provides an optimal target for the fed funds rate based on inflation and output. …