Donald L Kohn: Monetary policy in the financial crisis
Speech by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal
Reserve System, at the Conference in Honor of Dewey Daane, Nashville, Tennessee,
18 April 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
In response to the financial turmoil and economic weakness of the past 18 months, the
Federal Reserve has taken unprecedented steps in conducting monetary policy. Not only
have we reduced our target federal funds rate aggressively, essentially to zero, but we have
also made credit available to institutions and markets in which we had not previously
intervened. To varying degrees, similar actions have been taken by other central banks
around the world. For Dewey's class each January, I have been describing my take on the
framework for making monetary policy. I thought a natural extension of that role and a way of
honoring Dewey and his abiding interest in policymaking would be to talk about how the
crisis has and has not affected that framework. Chairman Bernanke has done that already in
several speeches, but participants in this conference might find my perspective useful. In
providing it, I will try to address some of the questions people have raised about our policy
actions.1
Although our actions have been unprecedented, the framework in which I have been
considering them remains, at its most fundamental level, the same as the one I have been
describing to Dewey's classes over the years. Our objective is to promote maximum
sustainable employment and stable prices over time. These goals are enshrined in law, and
they also make sense in economic theory and practice. Central banks are uniquely suited to
promoting price stability, and they contribute to maximum employment and growth over time
by eliminating the uncertainties and distortions of high and unstable inflation. The goal of
maximum employment also is critical: A balance between aggregate demand and potential
supply is needed to maintain price stability; in addition, significant fluctuations in output
impose costs on our economy, add to uncertainty, and impede planning and growth. Our
monetary policy actions in the crisis have been aimed at fostering both broad objectives.2
We achieve our objectives by influencing financial conditions - the cost and availability of
credit as well as asset prices. Changes in financial conditions, in turn, affect spending and
thus the balance between aggregate demand and potential supply. And how close we are to
maximum employment is a basic ongoing determinant of inflation, with slack reducing
inflation and overly high resource utilization increasing it. The other major determinant is
inflation expectations: If expectations are not anchored - if they vary in response to our
actions or to persistent gaps between actual and potential output - inflation itself will follow.
Historically, we've achieved needed adjustments in financial conditions by moving our federal
funds rate target, and we have done that by adjusting the supply of bank reserves through
open market operations in the government securities market. In well-functioning financial
markets, changes in actual and expected targets for the federal funds rate are arbitraged
through the financial system to affect the cost of credit and the price of assets. Many factors
affect these markets, and the relationship of our actions to financial conditions is very loose,
but, on balance, we have been able to use our control of the federal funds rate to make the
adjustments to financial conditions needed to foster our objectives for prices and
employment.
From the time that the financial market turmoil emerged in force in August 2007, however,
we could see that the relationship of the federal funds rate to financial conditions, and hence
to spending, was especially disrupted, with any given federal funds rate implying much
tighter conditions than usual. Banks became quite uncertain about the losses they might
have to absorb on mortgages and other lending, about the losses their counterparties might
also suffer, and about the extent to which their liquidity was at risk from having to support
offbalance-sheet entities or from experiencing a withdrawal by their own lenders. This
uncertainty made banks much more cautious about extending credit to each other and to
households and businesses. As financial disruption continued and the economy weakened,
lenders generally became much more uncertain about the financial condition of borrowers,
sparking a strong preference for safe and liquid assets like Treasury bills. Trading liquidity in
many markets dried up, the usual arbitrage among markets broke down, and spreads
widened - often by more than seemed justified by the underlying deterioration in the
economy and the ability of borrowers to repay. The tightening of financial conditions, in turn,
further restrained aggregate demand and economic activity. This adverse feedback loop
between financial conditions and the economy has been a prominent feature of the
recession.
The Federal Reserve took a two-pronged approach to countering the effects of financial
stringency on the economy: We used our conventional policy tools, and we initiated a range
of unconventional policy actions to support the extension of credit. In the first category, we
cut the federal funds rate target and did so aggressively after the economy began to weaken
substantially in late 2007. By December of last year, we had reduced the target to a range of
0 to 1/4 percent. Lowering the federal funds rate helped offset a portion of the effects of
financial disruption on credit conditions for households and businesses. And policy easing
should have helped the flow of credit by reducing some of the concerns about the effects of a
weaker economy on repayment prospects.
But reducing the federal funds rate has not seemed sufficient, and so we also have taken
actions to ease conditions in credit markets more directly - what Chairman Bernanke has
referred to as "credit easing." In many respects, these actions have been extensions of our
traditional methods of operation, though they have taken us into new territory in which we
have used the tools in very new ways.
Beginning early in the turmoil, we eased the terms on which we lent to depository institutions
(our traditional borrowers) quite dramatically. We lowered the interest rate on discount
window loans, increased their maturity, and, to reduce the stigma of borrowing from the
window, auctioned credit. We cooperated with foreign central banks through currency swaps
to make dollar funding available to banks operating abroad. Later, for the first time since the
1930s, we extended credit to nondepository institutions, granting discount window access to
primary dealers when it became evident that constraints on their access to liquidity
threatened broader financial stability and economic activity.3 Given the increasing reliance on
securities markets to intermediate credit in our financial system, these dealers had become
more central to maintaining the flow of credit from savers to borrowers. Last fall, when a run
on money market mutual funds was severely constricting their purchases of commercial
paper, an important source of credit to many businesses, we supported the funds, their
customers, and their borrowers by making credit available that allowed funds to meet heavy
redemption requests and also provided credit directly to borrowers in the commercial paper
market.
Our objectives in these programs are consistent with central banks' classic function as
lenders of last resort. We are encouraging the continued provision of private-sector funding
to intermediaries by assuring their creditors that sound intermediaries have a sure source of
liquidity to repay debts. When, despite this encouragement, private lenders have such a
strong preference for safety and liquidity that credit is not forthcoming, we lend, often at a
penalty rate relative to normally functioning markets; that lending is intended to prevent
disorderly and disruptive failures and fire sales of illiquid assets, which would drive asset
prices lower, intensify the disruption of credit flows, and deepen the pullback in spending.
Most recently, in collaboration with the Treasury, we have begun supplying liquidity to
purchasers of securitized credit. Under this program, private investors absorb credit risk up to
a certain level, and the Treasury takes on the bulk of the credit risk above that level. The
Federal Reserve's residual credit risk is designed to be quite small. The asset-backed
securities market that this program supports had become a key vehicle over the past couple
of decades for financing credit extended to households and businesses, but its functioning
deteriorated rapidly over the second half of last year, with issuance tailing off almost
completely. The availability of credit from the Federal Reserve and the insurance against
severe downside risks from the Treasury should buoy demand for securitized debt and thus
help bolster the flow of credit to households and businesses.
A shortage of funding has not been the only factor impeding the extension of credit. Lenders
have been concerned about counterparty risk and about conserving their own capital against
unforeseeable events. We can't deal with those concerns through our lending because we do
not take appreciable credit risk. But confidence about access to funding has been a part of
the problem, as reflected in the evaporation of trading in term maturities in a wide range of
wholesale funding markets and the elevated spreads paid by even very safe borrowers. The
limited availability of credit to sound borrowers, even when secured by what had been seen
as good collateral, has been a source of instability and constraint on credit flows. Central
banks can address such a shortage because they can remain unaffected by panicky flights to
liquidity and safety. Their willingness to extend collateralized lending in size against a broad
range of assets can replace flows of private credit that are normally uncollateralized.
Another aspect of our efforts to affect financial conditions has been the extension of our open
market operations to large-scale purchases of agency mortgage-backed securities (MBS),
agency debt, and longer-term Treasury debt. We initially announced our intention to
undertake large-scale asset purchases last November, when the federal funds rate began to
approach its zero lower bound and we needed to begin applying stimulus through other
channels as the economic contraction deepened. These purchases are intended to reduce
intermediate- and longer-term interest rates on mortgages and other credit to households
and businesses; those rates influence decisions about investments in long-lived assets like
houses, consumer durable goods, and business capital. In ordinary circumstances, the
typically quite modest volume of central bank purchases and sales of such assets has only
small and temporary effects on their yields. However, the extremely large volume of
purchases now underway does appear to have substantially lowered yields. The decline in
yields reflects "preferred habitat" behavior, meaning that there is not perfect arbitrage
between the yields on longer-term assets and current and expected short-term interest rates.
These preferences are likely to be especially strong in current circumstances, so that
longterm asset prices rise and yields fall as the Federal Reserve acquires a significant portion of
the outstanding stock of securities held by the public.
Against this general background, let me address some questions about our operations.
Have they been effective?
Yes, I believe they have helped ease financial conditions, though they can't address all the
problems in financial markets. And the situation in financial markets and the economy would
have been far worse if the Federal Reserve hadn't taken the actions we did in supplying
liquidity as well as lowering our federal funds rate target.
Clearly, sharp decreases in the federal funds rate target have shown up directly in other
short-term interest rates. Our commercial paper facilities helped stabilize money market
mutual funds and have steadied the commercial paper market and lowered rates for
highquality issuers. And the announcements of our purchases of MBS and Treasury bonds have
reduced mortgage and other long-term interest rates appreciably - by some estimates as
many as 100 basis points.
Our provision of liquidity to banks in the United States and, via currency swaps with other
central banks, abroad appears to have eased pressures in dollar funding markets, as
indicated by declines in spreads between the London interbank offered rate, or Libor, and the
overnight index swap rate. This easing has lowered rates for bank borrowers paying rates
tied to Libor and given banks better access to interbank liquidity to support lending and
market making. The extension of liquidity to primary dealers has been critical in providing
stability when private lenders have, from time to time, become reluctant to make even
secured loans to these counterparties. Our own sense, reinforced by many reports from
market participants, is that our willingness to extend credit to commercial and investment
banks prevented far worse market outcomes when flights to liquidity and safety intensified -
say, around the time of the problems of Bear Stearns and in the wake of multiple failures and
near-failures of financial firms in the second half of September. Private lenders have
demanded that intermediaries be much less leveraged. That development is healthy over the
long run, but when the transition is compressed by extreme risk aversion and market
participants are forced to delever through fire sales, the financial markets and economy
suffer. Our liquidity facilities allow for a more gradual and controlled process.
Are we allocating credit?
Our actions are aimed at increasing credit flows for the entire economy; we are not trying to
favor some sectors over others. However, an element of credit allocation is inherent in some
of our interventions. That element grows out of the very market characteristics that have
necessitated these interventions and have made such interventions effective. If markets were
highly liquid and investors and lenders were willing to take normal risks and arbitrage across
markets, financial conditions wouldn't have tightened so much, intensifying the economic
downturn, and adjustments in the federal funds rate could well have sufficed to stabilize the
economy. As we have been forced to attack overly tight financial conditions by extending our
discount window facilities to new intermediaries and certain markets and to extend open
market operations to agency debt and MBS, we have recognized that the resulting effects
can be uneven across markets and lenders. This outcome is not a comfortable one for the
central bank, and we have taken steps to minimize the extent of any credit allocation. We try
to limit our interventions to broad market segments or classes of intermediaries, and we
choose them based on judgments that improved functioning will reduce systemic instability or
have a material effect on credit flows and the economy and that our actions have high odds
of yielding improvements.
Are we taking credit risks that will end up being paid for by the taxpayer?
For the credit facilities that we make available to multiple firms, we are not taking significant
credit risk that might end up being absorbed by the taxpayer. For almost all the loans made
by the Federal Reserve, we look first to sound borrowers for repayment and then to
underlying collateral. Moreover, we lend less than the value of the collateral, with the size of
the "haircuts" depending on the riskiness of the collateral and on the availability of market
prices for the collateral. Some of our lending programs involve nonrecourse loans that look
primarily to the collateral rather than to the borrower for repayment in the event that the value
of the collateral falls below the amount loaned. In these circumstances, we insist on taking
only the very highest quality collateral, lend less than the face amount of the collateral, and
typically have other sources to absorb any losses that might nonetheless occur - for
example, Treasury capital for our lending against securitized loans.4
We have increased the amount of information that we publish about the collateral and other
steps we take to protect against credit losses. But, understandably, given the sharp increase
in loans to new institutions and markets, the public is naturally interested in our lending
practices, and we will be releasing even more information about what stands behind our
loans in coming weeks.
How will we gauge how much to do?
This is a difficult question without a ready answer, even under more normal circumstances
when we are focused on the federal funds rate, and it is an even harder judgment when, as
now, the federal funds rate is near zero and we are intervening in other ways to affect
financial conditions. We have some, albeit limited, ability to gauge the effects of large-scale
asset purchases on interest rates; the effects of liquidity facilities, like the Term
AssetBacked Securities Loan Facility and other programs, are even more difficult to assess and
predict. And with markets disrupted and confidence depressed, the relationship between a
particular constellation of interest rates and asset prices and future spending and inflation is
more uncertain than usual. We will continue to analyze these relationships in light our
experience and adjust our forecast of the evolution of the economy under various policy
alternatives, but we need to recognize that those forecasts could change appreciably and be
ready to adapt policy flexibly. That flexibility could entail doing more to ease credit if the
economy proves resistant to the monetary and fiscal stimulus now in train, or it could involve
reversing actions to forestall potential inflationary effects of past actions, as I will discuss in a
moment.
In gauging the effects of market interventions in the current crisis, one approach is to look to
the size of increases in the quantity of reserves and money to judge whether sufficient
liquidity is being provided to forestall deflation and support a turnaround in growth - an
approach often known as quantitative easing. The linkages between reserves and money
and between either reserves or money and nominal spending are highly variable and not
especially reliable under normal circumstances. And the relationships among these variables
become even more tenuous when so many short-term interest rates are pinned near zero
and monetary and some nonmonetary assets are near-perfect substitutes. In our approach to
policy, the amount of reserves has been a result of our market interventions rather than a
goal in itself. And, depending on the circumstances, declines in reserves may indicate that
markets are improving, not that policy is effectively tightening or failing to lean against
weaker demand. Still, we on the Federal Open Market Committee (FOMC) recognize that
high levels of Federal Reserve assets and resulting reserves are likely to be essential to
fostering recovery, and we have discussed whether some explicit objectives for growth in the
size of our balance sheet or for the quantity of the monetary base or reserves would provide
some assurance that policy is pointed in the right direction.
Will these policies lead to a future surge in inflation?
No, and the key to preventing inflation will be reversing the programs, reducing reserves, and
raising interest rates in a timely fashion. Our balance sheet has grown rapidly, the amount of
reserves has skyrocketed, and announced plans imply further huge increases in Federal
Reserve assets and bank reserves. Nonetheless, the size of our balance sheet will not
preclude our raising interest rates when that becomes appropriate for macroeconomic
stability. Many of the liquidity programs are authorized only while circumstances in the
economy and financial markets are "unusual and exigent," and such programs will be
terminated when conditions are no longer so adverse. Those programs and others have
been designed to be unattractive in normal market conditions and will naturally wind down as
markets improve.
However, our newly purchased Treasury securities and MBS will not mature or be repaid for
many years; the loans we are making to back the securitization market are for three years,
and their nonrecourse feature could leave us with assets thereafter. But we have a number
of tools we can use to absorb the resulting reserves and raise interest rates when the time
comes. We can sell the Treasury and agency debt either on an outright basis or temporarily
through reverse repurchase agreements, and we are developing the capability to do the
same with MBS. We are paying interest on excess reserves, which we can use to help
provide a floor for the federal funds rate, as it does for other central banks, even if declines in
lending or open market operations are not sufficient to bring reserves down to the desired
level. Finally, we are working with the Treasury to promote legislation that would further
enhance our toolkit for absorbing reserves.
Our work on the framework for exiting these programs is one indication that we are focused
on maintaining price stability over time even as we concentrate for now on promoting
economic recovery. Another such indication is our increased emphasis on defining the price
stability goal more clearly. Already the FOMC has extended its forecast horizon to indicate
where the Governors and Reserve Bank presidents would like to see inflation coming to rest
over time. And we are continuing to discuss within the Committee whether an explicit
numerical objective for inflation would be beneficial. Under current circumstances, those
benefits would include underscoring our understanding that our legislative mandate for
promoting price stability encompasses both preventing inflation from falling too low in the
near term and from rising too far as the economy recovers.
Have we compromised our independence?
No. Central banks all over the world and the legislatures that created them have recognized
that considerable independence from short-run political influences is essential for the
conduct of monetary policy that promotes economic growth and price stability. To be sure, in
the process of combating financial instability, we have needed to cooperate in
unprecedented ways with the Treasury. Our actions with the Treasury to support individual
systemically important institutions have sparked intense public and legislative interest. As
Chairman Bernanke has indicated, the absence of a regime for resolving systemically
important nonbank financial institutions has been a serious deficiency in the current crisis,
one that the Congress needs to remedy. Congress and the public, quite appropriately, want
to know more about lending programs that have greatly increased the scope and size of the
Federal Reserve's interventions in financial markets, and we will give them that information.
In addition, our country, like others, is undertaking a broad examination of what changes are
needed in our financial regulatory system. This examination will consider the role of the
Federal Reserve in the supervision and regulation of financial institutions and the advantages
and disadvantages of establishing a systemic risk authority.
It is natural and appropriate for our unusual actions in combating financial instability and
recession to come under intense scrutiny. However, increased attention to, and occasional
criticism of, our activities should not lead to a fundamental change in our place within our
democracy. And I believe it will not; the essential role for an independent monetary policy
authority pursuing economic growth and price stability remains widely appreciated and the
Federal Reserve has played that role well over the years. The recent joint statement of the
Treasury and the Federal Reserve included an agreement to pursue further tools to control
our balance sheet, indicating the Administration's recognition of the importance of our ability
to independently pursue our macroeconomic objectives.5
Conclusion
The Federal Reserve's actions over the past 20 months have been consistent with the
principles of central banking that have been developed over the course of centuries. But the
greatly increased complexity of our financial institutions and markets, as well as the virulence
of the financial crisis in choking off the flow of credit through a broad range of channels, has
meant that in applying these principles, the Federal Reserve and other central banks have
had to extend their reach and adopt new measures to preserve financial stability and to
counter the effects of financial turmoil on the economy. In my view, these actions have been
necessary, safe, and effective and will not lead to adverse aftereffects. But they have raised
a number of questions that I have addressed today. I expect to be back here in 10 years to
celebrate Dewey's 100th birthday, at which time you can hold me accountable for my
answers.