Donald L Kohn: Federal Reserve's policy actions during the financial
crisis and lessons for the future
Speech by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the Federal
Reserve System, at the Carleton University, Ottawa, 13 May 2010.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
The financial and economic crisis that started in 2007 tested central banks as they had not
been tested for many decades. We needed to take swift and decisive action to limit the
damage to the economy from the spreading distress in financial markets. Because the
financial distress was so deep and pervasive and because it took place in financial markets
whose structure had evolved dramatically, our actions also needed to be innovative if they
were to have a chance of being effective. Many central banks made substantial changes to
traditional policy tools as the crisis unfolded. But the epicenter of the financial shock was in
U.S. mortgage markets, with severe effects on many of our financial institutions, and our
financial markets had perhaps evolved more than many others. As a consequence, no
central bank innovated more dramatically than the Federal Reserve.
We traditionally have provided backup liquidity to sound depository institutions. But in the
crisis, to support financial markets, we had to provide liquidity to nonbank financial
institutions as well. Just as we were forced to adapt and innovate in meeting our liquidity
provision responsibilities, we also needed to adapt and innovate in the conduct of monetary
policy. Very early in the crisis, it became evident that lowering short-term policy rates alone
would not be sufficient to counter the adverse shock to the U.S. economy and financial
system. We needed to go further - much further, in fact - to ease financial conditions and
thus encourage spending and support employment. We took steps to reinforce public
understanding of our inflation objective to prevent the development of deflationary
expectations; we provided guidance on the possible future course of our policy interest rate;
and we purchased large amounts of longer-term securities, and in the process created
unprecedented volumes of bank reserves. Now, careful planning is under way to remove that
stimulus at the appropriate time. My discussion today will focus on innovations in both our
role as liquidity provider and in our monetary policy tools: their motivation, their effectiveness,
and their lessons for the future.1
The Federal Reserve's liquidity tools
Before the crisis, the implementation of monetary policy was fairly straightforward, and our
approach minimized its footprint on financial markets. The Federal Reserve adjusted the
liquidity it provided to the banking system through daily operations with a relatively small set
of broker-dealers against a very narrow set of collateral - Treasury and agency securities.
These transactions had the effect of changing the aggregate quantity of reserve balances
that banks held at the Federal Reserve, and that liquidity was distributed by interbank
funding markets through the banking system in the United States and around the world. In
addition, the Federal Reserve stood ready to lend directly to commercial banks and other
depository institutions at the "discount window," where, at their discretion, banks could
borrow overnight at an above-market rate against a broad range of collateral when they had
a need for very short-term funding. Ordinarily, however, little credit was extended through the
discount window. Banks were able to obtain their funding and reserves in the open market
and generally turned to the window only to cover very short-term liquidity shortfalls arising
from operational glitches or transitory marketwide supply shortfalls, as opposed to more
fundamental funding problems.
During the financial crisis, however, market participants became highly uncertain about the
financial strength of their counterparties, the future value of assets (including any collateral
they might be lending against), and how their own needs for capital and liquidity might
evolve. They fled to the safest and most liquid assets, and as a result, interbank markets
stopped functioning as an effective means to distribute liquidity, increasing the importance of
direct lending through the discount window. At the same time, however, banks became
extremely reluctant to borrow from the Federal Reserve for fear that their borrowing would
become known and thus cast doubt on their financial condition. Importantly, the crisis also
involved major disruptions of important funding markets for other institutions. Commercial
paper markets no longer channeled funds to lenders or to nonfinancial businesses,
investment banks encountered difficulties borrowing even on a short-term and secured basis
as lenders began to have doubts about some of the underlying collateral, banks overseas
could not rely on the foreign currency swap market to fund their dollar assets beyond the
very shortest terms, investors pulled out from money market mutual funds, and most
securitization markets shut down. These disruptions to financing markets posed the same
threats to the availability of credit to households and businesses that runs on banks created
in the more bank-centric financial system of the 1800s and most of the 1900s. As a result,
intermediaries unable to fund themselves were forced to sell assets, driving down prices and
exacerbating the crisis; moreover, they were unwilling to assume the risks necessary to
make markets in the debt and securitization instruments that were critical channels
supporting household and business borrowing - and households and businesses unable to
borrow were thus unable to spend, thereby deepening the recession.
These liquidity pressures were evident in nearly every major country, and every central bank
had to adapt its liquidity facilities to some degree in addressing these strains. At the Federal
Reserve, we had to adapt somewhat more than most, partly because the scope of our
activities prior to the crisis was fairly narrow - particularly relative to the expanding scope of
intermediation outside the banking sector - and partly because the effect of the crisis was
heaviest on dollar funding markets. Initially, to make credit more available to banks, we
reduced the spread of the discount rate over the target federal funds rate, lengthened the
maximum maturity of loans to banks from overnight to 90 days, and provided discount
window credit through regular auctions in an effort to overcome banks' reluctance to borrow
at the window due to concerns about the "stigma" of borrowing from the Federal Reserve.
We also lent dollars to other central banks so that they could provide dollar liquidity to banks
in their jurisdictions, thus easing pressures on U.S. money markets. As the crisis intensified,
however, the Federal Reserve recognized that lending to banks alone would not be sufficient
to address the severe strains affecting many participants in short-term financing markets.
Ultimately, the Federal Reserve responded to the crisis by creating a range of emergency
liquidity facilities to meet the funding needs of key nonbank market participants, including
primary securities dealers, money market mutual funds, and other users of short-term
funding markets, including purchasers of securitized loans.2
Why couldn't the Federal Reserve maintain its routine lending practices and rely on lending
to commercial banks, which in turn lend to nonbank firms? The reason is that financial
markets have evolved substantially in recent decades - and, in retrospect, by more than we
had recognized prior to the crisis. The task of intermediating between investors and
borrowers has shifted over time from banks - which take deposits and make loans - to
securities markets - where borrowers and savers meet more directly, albeit with the
assistance of investment banks that help borrowers issue securities and then make markets
in those securities. An important aspect of the shift has been the growth of securitization, in
which loans that might in the past have remained on the books of banks are instead
converted into securities and sold to investors in global capital markets. Serious deficiencies
with these securitizations, the associated derivative instruments, and the structures that
evolved to hold securitized debt were at the heart of the financial crisis. Among other things,
the structures exposed the banking system to risks that neither participants in financial
markets nor regulators fully appreciated. Banks became dependent on liquid markets to
distribute the loans they had originated. And some parts of the securitized loans were sold to
off-balance-sheet entities in which long-term assets were funded by short-term borrowing
with implicit or explicit liquidity guarantees provided by the banks. Securitization markets
essentially collapsed when banks became unwilling to increase their exposure to such risks
during the crisis, when the liquidity guarantees were invoked, and when other lenders in
securitization markets became unwilling to supply credit.
Although the Federal Reserve's lending actions during the crisis were innovative and to
some degree unprecedented, they were based on sound legal and economic foundations.
Our lending to nonbank institutions was grounded in clear authority found in section 13(3) of
the Federal Reserve Act permitting a five-member majority of the Federal Reserve Board to
authorize a Reserve Bank to lend to individuals, partnerships, or corporations in "unusual
and exigent circumstances." These actions also generally adhered to Walter Bagehot's
dictum, a time-honored central banking principle for countering a financial panic: Lend early
and freely to solvent institutions at a penalty rate and against good collateral.3 Central banks
are uniquely equipped to carry out this mission. They regularly lend to commercial banks
against a wide variety of collateral and have the infrastructure to value and perfect their
interest in the underlying collateral. During a panic, market functioning is typically severely
impaired, with investors fleeing toward the safest and most liquid assets, and the resulting
lack of liquidity, even for sound banks with sound assets, can result in funding pressures for
financial institutions and others. By lending to solvent institutions against illiquid collateral,
central banks effectively step in to assume the liquidity risk of such assets - that is, the risk
that assets can only be sold in the near term at fire sale prices. And their ability to substitute
for private-sector intermediation in a panic is unlimited since they create reserves. For the
most part, the Federal Reserve priced these facilities to be attractive when markets were
disrupted but not economical to potential borrowers as market functioning improved.
Importantly, lending against good collateral to solvent institutions supplies liquidity, not
capital, to the financial system. To be sure, limiting a panic mitigates the erosion of asset
prices and hence capital, but central banks are not the appropriate authorities to supply
capital directly; if government capital is necessary to promote financial stability, then that is a
fiscal function. This division of responsibilities presented challenges in the crisis. The
securitization markets were impaired by both a lack of liquid funding and by concerns about
the value of the underlying loans, and broad-based concerns about the integrity of the
securitization process. To restart these markets, the Federal Reserve worked with the
Treasury in establishing the Term Asset-Backed Securities Loan Facility (TALF): The Federal
Reserve supplied the liquid funding, while the Treasury assumed the credit risk. The issue of
the appropriate role of the central bank and fiscal authority was present in other contexts as
well. We were well aware that we were possibly assuming a risk of loss when we lent to
stabilize the systemically important firms of Bear Stearns and American International Group
(AIG). Unfortunately, at the time, alternative mechanisms were not available and we lent with
the explicit support of the Secretary of the Treasury, including a letter from him
acknowledging the risks.
An important task before us now is to assess the effectiveness of these actions. Not
surprisingly, rigorous studies that evaluate the extent to which the emergency liquidity
facilities contributed to improved financial conditions are just beginning to emerge.
Nonetheless, market reactions to the announcement of the emergency facilities, anecdotal
evidence, and a number of the studies we do have suggest that the facilities forestalled
potentially much worse outcomes and encouraged improvements. For example, some
assetbacked securities (ABS) spreads, such as those for consumer ABS and commercial
mortgage-backed securities, narrowed significantly following the creation of the TALF, and
activity in ABS markets has picked up. While the overall improvement in the economic
outlook has no doubt contributed to the improvement in ABS markets, it does appear that the
TALF helped to buoy the availability of credit to firms and households and thus supported
economic activity. Indeed, following the kick-start from the TALF, a number of these markets
are now operating without any governmental backing. Another example is the reduction in
pressures in U.S. dollar funding markets (as evidenced by the sharp narrowing of spreads
between Libor (London interbank offered rates) and OIS (overnight index swap) rates and
the decline in premiums paid for U.S. dollars in foreign exchange swap markets). These
developments followed the establishment of the Term Auction Facility (which auctioned
discount window credit to depository institutions) and also of liquidity swaps between the
Federal Reserve and foreign central banks, which enabled those banks to lend dollars to
commercial banks in their jurisdictions. Our willingness to lend in support of the commercial
paper and asset-backed commercial paper markets helped to stem the runs on money
market funds and other nonbank providers of short-term credit. Of note, usage of these
emergency liquidity facilities declined markedly as conditions in financial markets improved,
indicating that they were indeed priced at a penalty to more normal market conditions. They
were successfully closed, suggesting that market participants had not become overly reliant
on these programs and were able to regain access to funding markets. Except for the TALF
and the special Bear Stearns and AIG loans, all were repaid without any losses to the
Federal Reserve. The funding markets evidently remain somewhat vulnerable, however. Just
this week, with the reemergence of strains in U.S. dollar short-term funding markets in
Europe, the Federal Reserve reestablished temporary U.S. dollar liquidity swap facilities with
the Bank of Canada, the Bank of England, the European Central Bank, the Bank of Japan,
and the Swiss National Bank.4
Lessons for handling future liquidity disruptions
What lessons can be drawn from the Federal Reserve's experience in the financial crisis
when designing a toolbox for dealing with future systemic liquidity disruptions? First, the
crisis has demonstrated that, in a financial system so dependent on securities markets and
not just banks for the distribution of credit, our ability to preserve financial stability may be
enhanced by making sure the Federal Reserve has authority to lend against good collateral
to other classes of sound, regulated financial institutions that are central to our financial
markets - not on a routine basis, but when the absence of such lending would threaten
market functioning and economic stability. Thus, it would seem that authority similar to that
provided by section 13(3) will continue to be necessary.
Second, we recognize that holding open this possibility is not without cost. With credit
potentially available from the Federal Reserve, institutions would have insufficient incentives
to manage their liquidity to protect against unusual market events. Hence, emergency credit
should generally be available only to groups of institutions that are tightly regulated and
closely supervised to limit the moral hazard of permitting access to the discount window,
even when such access is not routinely granted. If the Federal Reserve did not directly
supervise the institutions that would potentially receive emergency discount window credit, it
would need an ongoing and collaborative relationship with the supervisor. The supervisor
should ensure that any institution with potential access to emergency discount window credit
maintained conservative liquidity policies. The supervisor would also provide critical insight
into the financial condition of the borrower and the quality of the available collateral and,
more generally, whether lending was necessary and appropriate. Most importantly, no such
institution should be considered too big or too interconnected to fail, and any losses should
be shouldered by shareholders and other providers of capital, by management, and, where
consistent with financial stability, by creditors as well.
Third, the United States needs a resolution facility for systemically important institutions that
meets the criteria I just enunciated. That authority must have access to liquidity to stabilize
situations where necessary, but the fiscal authorities, not the central bank, should be the
ones deciding whether to take on the credit risk of lending to troubled institutions in order to
forestall financial instability.
Fourth, transparency about unusual liquidity facilities is critical. The public appropriately
expects that when a central bank takes innovative actions - especially actions that might
appear to involve more risk than normal lending operations - then it will receive enough
information to judge whether the central bank has carried out the policy safely and fairly. The
required degree of transparency might well involve more-detailed types of reporting than for
normal, ongoing, lending facilities.
Finally, the problem of discount window stigma is real and serious. The intense caution that
banks displayed in managing their liquidity beginning in early August 2007 was partly a result
of their extreme reluctance to rely on standard discount mechanisms. Absent such
reluctance, conditions in interbank funding markets might have been significantly less
stressed, with less contagion to financial markets more generally. Central banks eventually
were able to partially circumvent this stigma by designing additional lending facilities for
depository institutions; but analyzing the problem, developing these programs, and gathering
the evidence to support a conclusion that they were necessary took valuable time. Going
forward, if measures are adopted that could further exacerbate the stigma of using central
bank lending facilities, the ability of central banks to perform their traditional functions to
stabilize the financial system in a panic may well be impaired.
Monetary policy and the zero bound
The Federal Reserve and other central banks reacted to the deepening crisis in the fall of
2008 not only by opening new emergency liquidity facilities, but also by reducing policy
interest rates to close to zero and taking other steps to ease financial conditions. Such rapid
and aggressive responses were expected to cushion the shock to the economy by reducing
the cost of borrowing for households and businesses, thereby encouraging them to keep
spending.
After short-term rates reached the effective zero bound in December 2008, the Federal
Reserve also acted to shape interest rate and inflation expectations through various
communications. At the March 2009 meeting, the Federal Open Market Committee (FOMC)
indicated that it viewed economic conditions as likely to warrant "exceptionally low" levels of
the federal funds rate for an "extended period." This language was intended to provide more
guidance than usual about the likely path of interest rates and to help financial markets form
more accurate expectations about policy in a highly uncertain economic and financial
environment. By noting that the federal funds rate was likely to remain at "exceptionally low"
levels for an "extended period," the FOMC likely was able to keep long-term interest rates
lower than would otherwise have been the case.
To provide the public with more context for understanding monetary policy decisions, Board
members and Reserve Bank presidents agreed in late 2007 to prepare more frequent
forecasts covering longer time spans and explain those forecasts. In January 2009, the
policymakers also added information about their views of the long-run levels to which
economic growth, inflation, and the unemployment rate were likely to converge over time.
The additional clarity about the long-run level for inflation, in particular, likely helped keep
inflation expectations anchored during the crisis. Had expectations followed inflation down,
real interest rates would have increased, restraining spending further. Had expectations risen
because of concern about the Federal Reserve's ability to unwind the unusual actions it was
taking, we might have needed to limit those actions and the resulting boost to spending.
Given the severity of the downturn, however, it soon became clear that lowering short-term
policy rates and attempting to shape expectations would not be sufficient alone to counter
the macroeconomic effects of the financial shocks. Indeed, once the Federal Reserve
reduced the federal funds rate to zero, no further conventional policy easing was possible.
The Federal Reserve needed to use alternative methods to ease financial conditions and
encourage spending. Thus, to reduce longer-term interest rates, like those on mortgages, the
Federal Reserve initiated large-scale purchases of longer-term securities, specifically
Treasury securities, agency mortgage-backed securities (MBS), and agency debt. All told,
the Federal Reserve purchased $300 billion of Treasury securities, about $175 billion of
agency debt obligations, and $1.25 trillion of agency MBS. In the process, we ended up
supplying about $1.2 trillion of reserve balances to the banking system - a huge increase
from the normal level of about $15 billion over the few years just prior to the crisis.
How effective have these various steps been in reducing the cost of borrowing for
households and businesses while maintaining price stability? Central banks have lots of
experience guiding the economy by adjusting short-term policy rates and influencing
expectations about future policy rates, and the underlying theory and practice behind those
actions are well understood. The reduction of the policy interest rate to close to zero led to a
sharp decline in the cost of funds in money markets - especially when combined with the
creation of emergency liquidity facilities and the establishment of liquidity swaps with foreign
central banks that greatly narrowed spreads in short-term funding markets. Event studies at
the time of the release of the March 2009 FOMC statement (when the "extended period"
language was first introduced) indicate that the expected path of policy rates moved down
substantially. Market participants reportedly interpreted the characterization of the federal
funds rate as likely to remain low for "an extended period" as stronger than the "for some
time" language included in the previous statement.5 Nonetheless, the extended period
language has not prevented interest rates and market participants' expectations about the
timing of exit from the zero interest rate policy from reacting to incoming economic
information, though each repetition of the extended period language has appeared to affect
those expectations a little.
By contrast, the economic effects of purchasing large volumes of longer-term assets, and the
accompanying expansion of the reserve base in the banking system, are much less well
understood. One question involves the direct effects of the large-scale asset purchases
themselves. The theory behind the Federal Reserve's actions was fairly clear: Arbitrage
between short- and long-term markets is not perfect even when markets are functioning
smoothly, and arbitrage is especially impaired during panics when investors are putting an
unusually large premium on the liquidity and safety of short-term instruments. In these
circumstances, purchasing longer-term assets (and thus taking interest rate risk from the
market) pushes up the prices of the securities, thereby lowering their yields. But by how
much and for how long? Good studies of these sorts of actions also are sparse. Currently,
we are relying in large part on event studies analyzing how much interest rates declined
when purchases were announced in the United States or abroad. According to these studies,
spreads on mortgage-related assets fell sharply on November 25, 2008, when the Federal
Reserve announced that it would initiate a program to purchase agency debt and agency
MBS. A similar pattern for Treasury yields was observed following the release of the March
2009 FOMC statement, when purchases of longer-term Treasury securities were
announced.6 Effectiveness, however, is hard to quantify, partly because we are uncertain
about how, exactly, the purchases put downward pressure on interest rates. My presumption
has been that the effect comes mainly from the total amount we purchase relative to the total
stock of debt outstanding. However, others have argued that the market effect derives
importantly from the flow of our purchases relative to the amount of new issuance in the
market. Some evidence for the primacy of the stock channel has accumulated recently, as
the recent end of the MBS purchase program does not appear to have had significant
adverse effects in mortgage markets.
A second issue involves the effects of the large volume of reserves created as we purchased
assets. The Federal Reserve has funded its securities purchases by crediting the accounts
that banks hold with us. In explanations of our actions during the crisis, we have focused on
the effects of our purchases on the prices of the assets that we bought and on the spillover to
the prices of related assets, as I have just done. The huge quantity of bank reserves that
were created has been seen largely as a byproduct of the purchases that would be unlikely
to have a significant independent effect on financial markets and the economy. This view,
however, is not consistent with the simple models in many textbooks or the monetarist
tradition in monetary policy, which emphasizes a line of causation from reserves to the
money supply to economic activity and inflation. According to these theories, extra reserves
should induce banks to diversify into additional lending and purchases of securities, reducing
the cost of borrowing for households and businesses, and so should spark an increase in the
money supply and spending. To date, this channel does not seem to have been effective:
Interest rates on bank loans relative to the usual benchmarks remain elevated, the quantity
of bank loans is still falling, and money supply growth has been subdued. Banks' behavior
appears more consistent with the standard Keynesian model of the liquidity trap, in which
demand for reserves becomes perfectly elastic when short-term interest rates approach zero.
But the portfolio behavior of banks might shift as the economy and confidence recover, and
we will need to watch and study this channel carefully.
Another uncertainty deserving of additional examination involves the effect of large-scale
purchases of longer-term assets on inflation expectations. The more we buy, the more
reserves we will ultimately need to absorb, and the more assets we will ultimately need to
dispose of before the conduct of monetary policy, the behavior of interbank markets, and the
Federal Reserve's balance sheet can return completely to normal. As a consequence, these
types of purchases can increase inflation expectations among some observers who may see
a risk that we will not reduce reserves and raise interest rates in a timely fashion. So far,
longer-term inflation expectations have generally been well anchored over the past few years
of unusual Federal Reserve actions. However, many unsettled issues remain regarding the
linkage between central bank actions and inflation expectations, and concerns about the
effect of the size of our balance sheet are often heard in financial market commentary.
Lesson from conducting monetary policy in a crisis
It is certainly too soon to fully assess all the lessons learned concerning the conduct of
monetary policy during the crisis, but a few observations seem worth noting even at this early
stage.
First, commitments to maintain interest rates at a given level must be properly conditioned on
the evolution of the economy. If they are to achieve their objectives, central banks cannot
make unconditional interest rate commitments based only on a time dimension. The Bank of
Canada has recently illustrated that need by revising its time commitment based on changing
circumstances. To further clarify that the "extended period" language is conditional on the
evolution of the economy, the FOMC emphasized in the November 2009 statement that its
expectation that the federal funds rate is likely to remain at an "exceptionally low" level for an
"extended period" depended on the outlook for resource utilization, inflation, and inflation
expectations following the anticipated trajectories.
Second, as I previously pointed out, firmly anchored inflation expectations are essential to
successful monetary policy at any time. That's why central banks have not followed the
standard academic recommendation to set a higher inflation target - either temporarily or, as
has been recently suggested, over the longer run - to reduce the likelihood of hitting the zero
lower bound. Although I agree that hitting the zero bound presents challenges to monetary
policy, I do not believe central banks should raise their inflation targets. Central banks around
the world have been working for 30 years to get inflation down to levels where it can largely
be ignored by businesses and households when making decisions about the future.
Moreover, inflation expectations are well anchored at those low levels.
Increasing our inflation targets could result in more-variable inflation and worse economic
outcomes over time. Inflation expectations would necessarily have to become unanchored as
inflation moved up. I doubt households and businesses would immediately raise their
expectations to the new targets and that expectations would then be well anchored at the
new higher levels. Instead, I fear there could be a long learning process, just as when
inflation trended down over recent decades. Moreover, a higher inflation target might also
mean that inflation would be higher than can be ignored, and businesses and households
may take inflation more into account when writing contracts and making investments,
increasing the odds that otherwise transitory inflation would become more persistent.
For both these reasons, raising the longer-term objective for inflation could make
expectations more sensitive to recent realized inflation, to central bank actions, and to other
economic conditions. That greater sensitivity would reduce the ability of central banks to
buffer the economy from bad shocks. It could also lead to more-volatile inflation over the
longer run and therefore higher inflation risk premiums in nominal interest rates. It is notable
that while the theoretical economic arguments for raising inflation targets are well
understood, no major central bank has raised its target in response to the recent financial
crisis.
Third, it appears that large-scale asset purchases at the zero bound do help to ease financial
conditions. Our best judgment is that longer-term yields were reduced as a result of our asset
purchases. The lower rates on mortgages helped households that could refinance and
supported demand to help stabilize the housing market. Moreover, low rates on corporate
bonds contributed to a wave of longer-term business financing that has strengthened the
financial condition of firms that could access securities markets and contributed to the
turnaround in business investment.
Fourth, central banks also need to be mindful of the potential effects on inflation expectations
of the expansion of their balance sheet. Most policymakers do not tend to