Frederic S Mishkin: The Federal Reserve's tools for responding to
financial disruptions
Speech by Mr Frederic S Mishkin, Member of the Board of Governors of the US Federal
Reserve System, at the Tuck Global Capital Markets Conference, Tuck School of Business,
Dartmouth College, Hanover, New Hampshire, 15 February 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
Since the onset of financial market strains late last summer, the Federal Reserve has been
acting in a decisive, timely, and flexible manner in fostering the objectives of price stability
and maximum employment. In particular, the Federal Reserve's actions have been aimed at
supporting market liquidity, mitigating the downside risks to economic activity, and promoting
moderate growth over time.
In my remarks here, I would like to explain how the Federal Reserve has used four different
tools to accomplish these objectives.1 I will first examine three tools for supporting market
liquidity - namely, open market operations, the discount window, and the newly developed
Term Auction Facility. Then I will discuss some important principles for adjusting the target
federal funds rate, which is the primary tool for addressing the macroeconomic implications
of a financial market disruption. As usual, my remarks reflect only my own views and are not
intended to reflect those of the Federal Open Market Committee (FOMC) or of anyone else
associated with the Federal Reserve System.2
Supporting market liquidity
As I pointed out in a speech last October, one of the fundamental reasons that the Federal
Reserve was established in 1913 was to ensure the provision of ample liquidity during
financial market disruptions (Mishkin, 2007a). In fact, my own academic research has
examined the recurring financial crises that occurred prior to the founding of the Fed
(Mishkin, 1991). These crises exhibited a consistent pattern of very sharp upward spikes in
interest rates, reflecting a surge in demand for liquidity without any corresponding change in
supply, and these interest rate fluctuations were associated with significant adverse
consequences on the broader economy.
In contrast, during more recent episodes of financial market turmoil, as in October 1987 and
the fall of 1998, the Federal Reserve has contributed to the stability of short-term funding
markets by boosting the supply of liquidity in line with changes in demand. In each case, the
Federal Reserve's actions were successful in preventing sharp upward spikes in short-term
interest rates and in insulating the macroeconomy from these financial market developments.
Moreover, those episodes have highlighted the extent to which the provision of liquidity in an
environment of heightened uncertainty can play an important role in allowing financial
institutions to make more-accurate judgments about the solvency and creditworthiness of
prospective borrowers (Mishkin, 2007a).
In that context, I would now like to describe the three tools that the Federal Reserve has
used over the past six months in providing liquidity to the financial system.
Tool #1: Open market operations
Open market operations are the most powerful and often-used tool for keeping the federal
funds rate close to the target rate set by the FOMC.3 In principle, the Federal Reserve could
influence the federal funds rate by purchasing or selling any type of asset, but in practice,
most assets are not traded readily enough to serve this purpose. For open market operations
to work effectively, the Federal Reserve must be able to engage in these transactions
quickly, at its own convenience, in whatever volume may be needed to keep the federal
funds rate near the target rate. Moreover, it is appropriate for such operations to be
conducted using securities that are traded in a broad and highly active market, thereby
ensuring that these transactions do not generate distortions or disruptions in that market.
Thus, with the broadest and most active of all U.S. financial markets, Treasury securities are
ideal for conducting open market operations.
In early August 2007, depository institutions faced the possibility that emerging pressures in
financial markets could have significant effects on their balance sheets, and this uncertainty
generated a considerable increase in demand for short-term funds. On August 10, the
Federal Reserve underscored its commitment to providing ample liquidity to facilitate the
orderly functioning of financial markets, stating: "The Federal Reserve will provide reserves
as necessary through open market operations to promote trading in the federal funds market
at rates close to the Federal Open Market Committee's target rate" (Board of Governors,
2007a).
As is clear in chart 1, the Federal Reserve was generally successful in keeping the federal
funds rate from spiking above the target rate; indeed, the effective federal funds rate was
somewhat below the target rate at times. Nonetheless, the volatility of the federal funds rate
in recent months reflects the extent to which daily changes in demand for reserve balances
have been unusually difficult to predict.4
Tool #2: Overnight lending through the discount window
The Federal Reserve's second tool for supplying liquidity during a financial disruption is to
provide fully collateralized overnight loans directly to commercial banks and other depository
institutions, which I will refer to collectively as banks. The Federal Reserve extends this credit
through the discount window - that is, the lending facility at each of the regional Federal
Reserve Banks. (The phrase "discount window" harks back to the good old days when loans
were provided by a human being sitting behind a bank window.)
The primary credit facility is the main program under which the Federal Reserve extends
loans to depository institutions.5 Under this program, each loan is extended for very short
terms (usually overnight) to a depository institution in sound financial condition, and the
interest rate on such loans is referred to as the "discount rate." Since 2003, the discount rate
has been set above the usual level of short-term market interest rates, and during normal
times this rate has been maintained at 100 basis points (1 percentage point) above the
federal funds rate target.
As a tool for providing liquidity to the financial system, the discount window is distinct from
open market operations in two important respects. First, open market operations influence
the supply of short-term funds to the market as a whole, whereas loans through the discount
window are made directly to individual institutions with particular needs for liquidity. Second,
open market operations are conducted using U.S. Treasury and agency securities, whereas
loans through the discount window can be made against a much wider range of collateral.
In its August 10 announcement, the Federal Reserve reaffirmed that it stood ready to provide
liquidity not only through open market operations but also via discount lending by stating: "As
always, the discount window is available as a source of funding" (Board of Governors,
2007a). By August 17, the Federal Reserve had determined that the significant strains in
short-term money markets warranted further accommodation in the provision of liquidity
through the discount window; thus, the spread between the discount rate and the target
federal funds rate was reduced to 50 basis points, rather than the customary 100 basis
points, and the lower spread has been maintained since then (Board of Governors, 2007b).
In addition, the Federal Reserve adjusted its practices to facilitate the provision of discount
window financing at terms of up to thirty days, renewable at the request of the borrower.
These changes were aimed at assuring banks of the availability of a backstop source of
liquidity. Banks subsequently borrowed only moderate amounts at the discount window but
some institutions placed additional amounts of collateral with the Federal Reserve Banks,
suggesting that these institutions perceived the discount window as a potentially significant
source of liquidity under some contingencies.
Nonetheless, the discount window has two notable limitations as a tool for easing strains in
money markets. First, a bank may be reluctant to borrow from the discount window, worrying
that such borrowing might come to light and lead market participants and other institutions to
draw adverse inferences about the bank's financial condition. This so-called stigma problem
may largely account for the extent to which discount window borrowing has generally
remained at moderate levels in recent months.
Second, lending through the discount window can pose challenges for keeping the
federal funds rate close to its target, especially during periods of financial market disruption.
The Federal Reserve's open market desk - that is, the staff at the Federal Reserve Bank of
New York who actually conduct open market operations on a daily basis - must take into
account the fact that loans made through the discount window add reserves to the banking
system, and thus, all else equal, could tend to push the federal funds rate below the target
set by the FOMC. In ordinary circumstances, these borrowings are relatively small and
predictable, and this influence can be offset using open market operations to drain a
corresponding quantity of reserves from the system. But in times of financial market strains,
these borrowings can become larger and more difficult to predict.
Tool #3: The new Term Auction Facility
Despite the Federal Reserve's provision of liquidity through open market operations and the
discount window, strains in term funding markets persisted and became particularly elevated
in early December in response to year-end pressures. The magnitude of these strains can be
gauged using the spread between Libor - that is, the London interbank offered rate - and the
overnight indexed swap (OIS) rate at the same maturity, because the OIS rate reflects the
average overnight interbank rate expected over that maturity but is not subject to pressures
associated with credit and liquidity risks to the same degree as Libor.
As shown in chart 2, the one-month and three-month Libor-OIS spreads were at low levels
through the month of July but increased markedly in August and early September at the
onset of the financial market turmoil.6 The one-month spread declined during the fall but rose
sharply again toward the end of the year. In association with these wider spreads, liquidity in
term bank funding markets deteriorated substantially.
To address these pressures, the Federal Reserve introduced a new policy tool called the
Term Auction Facility (TAF).7 With this tool, the Federal Reserve auctions a pre-announced
quantity of credit to eligible borrowers for a term substantially longer than overnight; thus far,
each auction has involved a term of one month. As with primary credit, a depository
institution is eligible to participate in a TAF auction if the bank is judged to be in generally
sound financial condition, and a wide variety of collateral can be used to secure the loan. The
minimum bid rate for each auction is established at the OIS rate corresponding to the
maturity of the credit being auctioned.
The introduction of the TAF was announced on December 12 in conjunction with related
announcements by the Bank of Canada, the Bank of England, the European Central Bank,
and the Swiss National Bank (Board of Governors, 2007c).8 The first two auctions were held
on December 17 and 20, for amounts of $20 billion each, and were very well subscribed: A
large number of banks participated in each auction, and the total value of bids was about
three times as large as the amount of credit auctioned. The resulting interest rate in both
cases was about 50 basis points above the minimum bid rate but well below the one-month
Libor rate prevailing in financial markets at that time. In recent weeks, the Federal Reserve
has conducted three more auctions (most recently, last Monday) for amounts of $30 billion
each. The spread over the minimum bid rate was about 7 basis points for the January 14
auction, 2 basis points for the January 28 auction, and 15 basis points for the February 11
auction; these spreads were much lower than in December, apparently reflecting some
subsequent easing in the pressures on banks' access to term funding.
The TAF appears to have been quite successful in overcoming the two problems with
conventional discount window lending. Thus far, the TAF appears to have been largely free
of the stigma associated with borrowing at the discount window, as indicated by the large
number of bidders and the total value of bids submitted.9 Furthermore, because the Federal
Reserve was able to predetermine the amounts to be auctioned, the open market desk has
faced minimal uncertainty about the effects of the operation on bank reserves; hence, the
TAF has not hampered the Federal Reserve's ability to keep the effective federal funds rate
close to its target.
Isolating the impact of the TAF on financial markets is not easy, particularly given other
recent market developments and the evolution of expectations regarding the federal funds
rate. Nonetheless, the interest rates in term markets provide some evidence that the TAF
may have had significant beneficial effects on financial markets. As can be seen in chart 2,
term funding rates have dropped substantially relative to OIS rates: The one-month spread
exceeded 100 basis points in early December but has dropped below 30 basis points in
recent weeks - though still above the low level that prevailed before the onset of the financial
disruption last August.
Monetary policy response to macroeconomic developments
Although the TAF and other liquidity-related actions appear to have had positive effects, such
policy responses cannot fully address fundamental concerns about credit quality and
valuation or relax the balance sheet pressures on financial institutions. Thus, these
measures cannot eliminate the effects of the financial market turmoil that have the potential
to lower aggregate spending and cause a contraction in economic activity. Moreover, as I
have previously emphasized, macroeconomic risk refers to the elevated probability that a
financial disruption could lead to an adverse feedback loop in which economic activity
declines, leading to even greater uncertainty about asset values that worsens the financial
disruption and generates a further deterioration in macroeconomic activity (Mishkin, 2007c,
2008). Monetary policy - that is, the management of the target federal funds rate - is the
Federal Reserve's best tool for influencing the course of economic activity and mitigating the
degree of macroeconomic risk.
Tool #4: Changing the federal funds rate target to respond to macroeconomic risk
In the speech on risk management that I gave last month, I outlined a systematic approach
for coping with financial market disruptions (Mishkin, 2008). In this approach, policy needs to
respond aggressively when a large financial shock becomes evident, and the degree of
policy inertia in such circumstances may well be markedly lower than in more-routine
circumstances. By cutting the target federal funds rate to offset the negative effects of
financial turmoil on aggregate economic activity, monetary policy can reduce the likelihood
that a financial disruption might set off an adverse feedback loop. The resulting reduction in
uncertainty can then make it easier for the markets to collect the information that facilitates
price discovery, thereby hastening the return of normal market functioning.
To achieve this result most effectively, monetary policy needs to be timely, decisive, and
flexible. First, timely action is crucial when an episode of financial instability becomes
sufficiently severe to threaten the core macroeconomic objectives of the central bank. In
such circumstances, waiting too long to ease monetary policy by lowering the federal funds
rate could adversely affect the confidence of households and firms and thereby contribute to
further deterioration of the macroeconomy; waiting too long might also increase the overall
amount of easing that would eventually be needed.
Second, policymakers should be prepared to take decisive action in response to financial
disruptions. In such circumstances, although the most likely outcome - referred to as the
modal forecast - for the economy may be fairly benign, there may be a significant risk of
more-severe adverse outcomes. In such circumstances, the central bank may prefer to take
out insurance by easing the stance of policy further than if the distribution of probable
outcomes were perceived as fairly symmetric and more tightly clustered around the modal
forecast.
policy flexibility
Third, is crucial throughout the evolution of a financial market disruption.
During the onset of the episode, this flexibility may be evident from the decisive easing of
policy that is intended to forestall the contractionary effects of the disruption and provide
insurance against the downside risks to the macroeconomy. However, it is important to
recognize that financial markets can also turn around quickly, thereby reducing the drag on
the economy as well as the degree of macroeconomic risk. Therefore, the central bank
needs to monitor credit spreads and other incoming data for signs of financial market
recovery and should be prepared to take back the insurance once the recovery becomes
clearly established. Thus, at each stage of the episode, the appropriate monetary policy may
exhibit much less gradualism than would be typical in other circumstances.
A central bank must always be concerned with inflation as well as growth. As I have
emphasized in an earlier speech about inflation dynamics, the behavior of inflation is
significantly influenced by the public's expectations about where inflation is likely to head in
the long run (Mishkin, 2007a). Therefore, preemptive actions of the sort I have described
here would be counterproductive if these actions caused an increase in inflation expectations
and in the underlying rate of inflation; in other words, the flexibility to act preemptively against
a financial disruption presumes that inflation expectations are firmly anchored and unlikely to
rise during a period of temporary monetary easing. Indeed, as I have argued elsewhere, a
commitment to a strong nominal anchor is crucial for both aspects of the dual mandate, that
is, for achieving maximum employment as well as for keeping inflation low and stable
(Mishkin, 2007b). Policymakers therefore need to closely monitor information about
underlying inflation and longer-run inflation expectations, and the central bank must be ready
to hold steady or even raise the policy rate if the evidence clearly indicates a significant rise
in inflation expectations.
In my view, the Federal Reserve's recent monetary policy actions - reducing the target
federal funds rate by 1 percentage point last fall and by a further 1-1/4 percentage points in
January - have been consistent with these principles for coping with macroeconomic risk.
timely
First, we have been proceeding in a manner in countering developments that could
threaten economic or financial stability. In particular, the stance of monetary policy has been
eased promptly in response to the rapid deterioration in financial market conditions, which
had worsened the economic outlook and contributed to the emergence of pronounced
downside risks to economic growth and employment.
Second, I believe that the Federal Reserve has been acting and will continue to act
decisively, in the sense that our lowering of the federal funds rate target has reflected the
evolution of the balance of risks to the macroeconomy. The disruption in financial markets
poses a substantial downside risk to the outlook for economic growth, and adverse economic
or financial news has the potential to cause further strains. In that light, the Federal
Reserve's policy strategy is aimed at providing adequate insurance to help mitigate the risk
of more-severe macroeconomic outcomes.
Third, because we recognize that financial and economic conditions can change quickly, the
Federal Reserve is prepared to act flexibly in adjusting the federal funds rate in response to
incoming information. Because longer-run inflation expectations appear to have remained
reasonably well anchored, in my view, the easing of the stance of policy in response to
deteriorating financial conditions seems unlikely to have an adverse impact on the outlook for
inflation. Although I expect that inflation expectations will remain solidly anchored, we cannot
be complacent that this will always continue to be the case. Therefore, careful monitoring of
the incoming data on inflation and inflation expectations will continue to be necessary,
especially given the potential risks to price stability that are associated with the rapid
increase in energy prices and the depreciation of the dollar. Similarly, while the current
strains in financial markets are likely to persist for some time, there have been instances
when financial markets have turned around quickly, and we must be prepared for such a
possibility in this instance.
Conclusion
In recent months, the Federal Reserve has faced a more difficult policy environment as a
result of disruptions to the financial markets. We have attempted to address the resulting
challenges by using four tools. First, we have conducted open market operations to increase
the supply of reserves and keep demands for increased liquidity from causing sharp
increases in interest rates. Second, we have provided liquidity through the discount window
by lowering the spread between the discount rate and the federal funds rate. Third, we have
developed a new source of liquidity - the Term Auction Facility - to provide a fixed amount of
funds for a one-month term at a competitively determined interest rate. Finally, we have
lowered the target federal funds rate in a timely, decisive, and flexible manner to help
mitigate macroeconomic risk. Although financial disruptions present one of the most difficult
challenges that central banks can face, I believe that these measures have been appropriate
for achieving our macroeconomic objectives of promoting price stability and maximum
sustainable employment.
References
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