What did the Federal Reserve do during the financial crisis
The Federal Reserve System — America's central bank — is the main policymaking institution charged with fighting recessions. It is also one of several institutions charged with regulating banks and ensuring the stability of the financial system. Consequently, starting in 2008 and continuing for several subsequent years, the Fed was on the front lines of combating interconnected crises in the banking system and the real economy.
In its war on the crisis, the Fed has deployed a wide range of tools including the traditional tricks of monetary policy plus a range of unconventional measures. It's been in the public eye as never before, and been subjected to an unprecedented level of political criticism.
The Fed's main tactics were:
- Interest rate cuts
- Targeted assistance to ailing financial institutions
- Quantitative easing (or Large-Scale Asset Purchases)
- Forward guidance about interest rates
Despite the Fed's efforts, unemployment remained quite elevated for years after the onset of the crisis. As a result, the central bank found itself charged with both excessive complacency and excessive activism.
Who is making all these decisions?
The Federal Reserve system has a complicated governance structure, arising for a mix of historical and political reasons over the course of several decades. But the most important figure in Fed decision-making is the chair. That's Janet Yellen right now, but for most of the crisis years, the person in charge was Ben Bernanke, a former Princeton professor and George W. Bush administration official.
Alongside the chair there is a vice chair (Yellen's job before she became chair, currently vacant) and five other members of the Federal Reserve Board of Governors (now two of these five seats are vacant, and a third one will be soon when Jeremy Stein's already announced resignation takes effect). While governors serve 14-year terms (staggered every two years, though in practice governors often don't serve this long), chairmanship terms are four years long. However, chairs are often re-nominated and re-confirmed. William McChesney Martin, who served just shy of 19 years, from 1951 until 1970, was the longest tenured Fed chair, with Alan Greenspan close behind, serving roughly 18.5 years from 1987 through 2006.
Alongside the Board of Governors there are twelve regional Federal Reserve banks:
Each of the 12 reserve banks is responsible for a particular geographic region, or district. In addition, there are 24 more Fed branch banks in other cities that help the regional banks carry out their duties, like distributing currency and lending money to commercial banks. In addition, they conduct economic research and release indicators on a variety of topics and make it their business to understand and report on their regional economies. One key report that shows off this regional knowledge is the beige book, which is published eight times per year and collects the regional banks' qualitative assessments of economic conditions in their regions. Every regional Fed has its own president.
The big monetary policy decisions are made by the Federal Open Market Committee, which meets eight times a year in Washington, DC. The FOMC is composed of the Board of Governors, plus the president of the New York Fed, plus three of the other 11 regional bank presidents on a rotating basis.
What did the Fed do in the early stages of the crisis?
Starting in late 2007, the Fed began responding to rising unemployment with the main tool of traditional monetary policy: interest rate cuts.
The way this works is that the Fed boosts the economy by reducing the interest rate that banks pay each other for overnight loans, the federal funds rate. The idea is that cuts to the federal funds rate lead to lower interest rates throughout the economy. Those low rates spur businesses to make new investments, spur people to buy houses or invest in renovations, and spur purchases of major durable goods like cars. When the economy is depressed and has lots of excess capacity — unemployed workers, vacant offices and storefronts, idle factories — all that extra spending leads to an increase in employment and economic output.
But if the economy isn't depressed, more spending simply leads to more inflation. When inflation gets out of control the Fed raises the federal funds rate, leading to higher interest rates and less spending throughout the economy.
Starting in September 2007, the Fed began steadily reducing interest rates until June 2008. At that point even though the economic situation was still deteriorating, the threat of rising inflation — driven by high prices for energy and agricultural commodities — caused them to pause the process of rate cuts. At the June meeting, the August meeting, and even the September 2008 meeting held the day after Lehman Brothers went bankrupt, the Fed held its policy rate steady at 2 percent.
The economic situation deteriorated precipitously in the following months, and by mid-December 2008 the Federal Funds Rate had reached nearly 0 percent and could go no lower.
Why can't interest rates go below zero?
The main reason is the existence of cash. In the normal course of events, cash — paper currency and coins — is a small element of the money supply and an even smaller share of overall transactions. Mostly people get paid via direct deposit, make large purchases with credit or debit cards, mail checks, or use online bill pay services for recurring payment, etc. This is largely a question of convenience, but it also reflects the fact that money in a bank account pays interest while cash does not.
This is a good reason to avoid stockpiling large quantities of cash as long as interest rates are positive. But if rates became negative, the situation would flip. It would make more sense to have stacks of hundred-dollar bills than to keep money in a bank account.
Trying to push rates negative, in other words, might lead to mass withdrawals of money from banks. That would worsen a financial crisis, and ultimately impose a huge efficiency cost on the economy through the collapse of convenient electronic payments system. Worst of all, once we completed the awkward transition to a cash economy, interest rates would still effectively be stuck at zero — cash pays neither positive nor negative interest — so nothing would be accomplished.
This problem is called the zero bound, and an economy that has lots of unemployment while at the zero bound is said to be in a liquidity trap.
What did the Fed try once interest rates hit zero?
With rates at zero, the Fed has been trying a series of unconventional monetary policy measures. Because they are unconventional, they tend to be more controversial both politically and academically. Because they are controversial, the Fed tends to be hesitant to deploy them on a massive scale, which arguably makes them less effective. But the questionable efficacy of these tactics further exacerbates public and professional doubts about them. It's a tough problem.
One of the main tools has been targeted assistance to financial institutions. The Fed (and policymakers outside the Fed) made the judgment that the collapse of Lehman Brothers showed that major bank failures were extremely costly. Consequently, the Fed encouraged Congress to pass the Troubled Asset Relief Program (TARP), a major bailout of the financial system. It also allowed the surviving standalone investment banks Goldman Sachs and Morgan Stanley to reclassify as bank holding companies for regulatory purposes, which gave them access to cheap overnight lending. Last, it launched an alphabet soup of special lending programs. The basic idea was to lend money very cheaply to every financial institution around to prevent additional bankruptcies.
Another tool has been quantitative easing, a term the Fed itself rejects. They call it Large-Scale Asset Purchases. Whatever you call it, it means buying up lots of longer-term debt issues by the federal government and Fannie Mae and Freddie Mac.
Last but not least they have used forward guidance about how long interest rates are likely to stay low. The idea is that if people believe that today's near-zero interest rates will persist for a long time, that will make them more likely to borrow and invest than if think today's low rates may vanish soon.
What is quantitative easing?
Quantitative easing is often regarded as a form of "printing money" but the Fed doesn't literally print anything. Paper money is printed by the Bureau of Printing and Engraving so that people who want to take money out of their bank accounts can get their hands on cash. But most money is electronic. And, yes, quantitative easing involves the Fed making new money. It then uses that money to buy bonds, injecting extra money into the banking system. As you can see below, the money supply used to increase at a slow but steady pace. During the crisis, it has instead shot up in several large irregular spurts associated with different rounds of QE:
What makes it quantitative is that when the Fed does QE it specifies a dollar quantity of assets that it wants to buy.
An alternative approach (call it qualitative easing, if you like) would be for the Fed to target a specific outcome it wants to see — conventional mortgage rates below X percent or whatever — and then commit to buying however many assets it takes to create that outcome.
Did all this QE create tons of inflation?
No. Inflation was very low during Ben Bernanke's tenure in office.
One reason for that is that even though lots of money has been created, much of it is simply parked at the Fed. Banks are required to hold reserves — that is, money that they don't lend out — as a regulatory matter. But lately they've been holding lots of extra reserve money:
This stockpiling of excess reserves may have happened in part because the Fed now pays interest on them.
Why did the Fed start paying interest on excess reserves?
Paying interest on excess reserves could be a useful way for the Fed to in effect suck money out of the economy if it becomes worried about inflation in the future. No investment on Earth is safer for banks than parking money at the Fed, so the higher you make that interest rate the more money banks will park. Money that is parked is not being loaned out and spent. So by inducing banks to park their money, the Fed can put the breaks on the economy and stop inflation.
That said, the Fed isn't currently trying to slow the economy down, so it isn't entirely clear why they think paying interest on excess reserves is a good idea. Such payments weren't legal until 2008, and the Fed says the current very low rate — just 0.25 percent — isn't a big deal. They pay them mostly in order to demonstrate that they can use this tool to fight future inflation.
Some critics believe that even though 0.25 percent interest is a small amount it is still large enough to somewhat slow economic activity.
Another line of criticism, associated with Paul Krugman's 1998 analysis of the Japanese economy, says that the real problem is something else. The Fed wants to reassure people that it has the ability to fight a potential future outbreak of inflation. But QE would be more potent if people were in fact afraid of a potential future outbreak of inflation. People worried that their money may lose value in the near future are more likely to run out and trade that cash for cars or refrigerators or houses and spur economic activity.
What's forward guidance?
The idea behind forward guidance is that when people or companies are making decisions they don't just care about today's interest rates; they care about tomorrow's rates as well. So even if a central bank can't reduce rates below zero, it can communicate to people that rates will stay at zero for a long time.
Initially, the Fed tried to implement this by simply saying that rates would stay very low for a long time. This led to what current Council of Economic Advisors member Betsey Stevenson and her husband, the economist Justin Wolfers, called the Eeyore/Tigger problem. The Fed wanted to communicate the idea that persistent low rates meant people should run out and buy houses and cars (Tigger). But its statement could be interpreted as saying that the economy was going to stay depressed for a long time, forcing rates to stay low (Eeyore).
So they switched to a proposal initially made by Charles Evans, president of the Chicago Federal Reserve. Here the Fed promises to keep interest rates at zero even if inflation pops up into the 2 percent to 2.5 percent range, as long as unemployment stays over 6.5 percent. Normally the Fed would raise rates and try to slow the economy at the first sign of inflation above 2 percent. So this kind of guidance (often called the Evans Rule) was a form of extra reassurance that no rate hikes were coming in the near term.
The problem with the Evans Rule proved be that the unemployment rate was falling in part because many people dropped out of the labor force. Under the circumstances, the Fed didn't judge the near-6.5 percent rate to be a real sign of a strong labor market. The Fed could have simply switched the number to 5.5 percent or 5 percent, but they instead chose to drop any reference to any specific number.
Has the Fed's strategy worked?
It depends how you look at it and it depends on whom you ask.
Most economists and financial journalists have a very high opinion of the Bernanke-era Fed and its handling of the economic crisis. The conventional wisdom in these circles is that the world economy nearly tilted into a replay of the Great Depression, and that the Fed successfully avoided that cataclysmic scenario. Most people have seen a Fed that's more visibly active than ever before presiding over several years of slow growth and high unemployment.
As a substantive matter, this chart from Josh Lerner at the Oregon Office of Economic Analysis makes the case for Team Fed:
Compared to other countries that have experienced major financial crises, in other words, the United States has done well over the past several years.
The more skeptical case is this. The Fed has a "dual mandate" to try to create the maximum level of employment that's consistent with stable prices, defined as 2 percent inflation. During the crisis years, unemployment was very high while inflation has generally been below the 2 percent target. At times, relatively high unemployment may be the only way to avoid high inflation. But during the crisis years, the Fed never managed to generate enough demand to fulfill either side of its mandate.
Should we audit the Fed?
Republican Sen. Rand Paul introduced a 2013 bill known as the "Audit the Fed" bill, aimed at certain exemptions on the central bank's current audit system.
The Fed is already audited, both by the Government Accountability Office and independent outside auditors brought in by the bank's Office of the Inspector General. However, US law dictates that four Fed activities are exempt from auditing: transactions with foreign entities, decision-making information on monetary policy decisions, transactions directed by the FOMC, and discussions among Fed employees on all of these topics.
Some people, most of them on the far right but also including some idiosyncratic progressives, believe these exemptions should be removed, in the interest of transparency. Paul's bill would eliminate all of the current audit exemptions. Opponents, meanwhile, say these audits would threaten the Fed's independence by subjecting its operations to excessive congressional scrutiny.
What are the main criticisms of the Fed's approach to the crisis?
One longstanding line of criticism of the Federal Reserve holds that the idea of a pure fiat currency — currency that's just made up by a central bank and not backed by any precious metal — is an inherently bad idea. People who favor this way of thinking, notably including former presidential candidate Rep. Ron Paul, tend to believe we should "end the Fed" and return the United States to the gold standard. A related idea, occasionally pushed by Rep. Paul Ryan (R-WI), is that the US dollar should be backed by a broad basket of commodities rather than a particular metal such as gold.
More broadly, critics of the Fed's conduct during the crisis tend to fall into two camps. There are those who complain that the Fed's unconventional monetary policies have been excessively inflationary and there are those who complain that the Fed has not gone far enough.
The inflation critique is sufficiently prominent that many members of Congress have made noise about changing the Fed's mandate to a single-minded focus on price stability rather than a dual mandate on inflation and unemployment. But inflation has in fact been unusually low during this period, so the nature of the criticism is a little difficult to understand.
The other line of criticism notes that the combination of low inflation and high unemployment violates both of the Fed's mandates. These critics say that the Fed should engage in some more aggressive action to stimulate the economy.
What more could the Fed have done?
If the Federal Reserve had been interested in pursuing a more stimulative monetary policy, it had several possible options at its disposal.
One option was simply to do more quantitative easing. Former Fed official and current Peterson Institute fellow Joseph Gagnon is a proponent of this approach. And the basic logic is simple. If the Fed thinks QE boosts demand, and if inflation is low and unemployment is high, then the Fed should keep doing more and more QE until either unemployment is low or inflation is high.
Another option would be to completely abandon the current inflation targeting regime in favor of something called NGDP targeting. Nominal GDP is the country's total volume of economic output before adjusting for inflation. Here the Fed would say that there's a certain amount of nominal spending that it would like to see happen, and it is indifferent whether that takes the form of more real growth or simply higher prices.
The idea is that this would compel people and businesses to get their money out of cash and ultra-safe government debt and put it to work in real investment instead. If the NGDP target is credible, then either the economy will grow a lot in the next couple of years, in which case you'll want to invest to take advantage of the opportunity, or else the economy will see a lot of inflation in the next couple of years, in which case you'll want to invest to get into higher-yield investments. This approach has been endorsed by the prominent academic monetary economist Michael Woodford, by former Obama economic advisor Christina Romer, and by Goldman Sachs chief economist Jan Hatzius. But in many ways its most influential proponent has been the economist and blogger Scott Sumner, whose relentless advocacy has won many adherents.
Last, the Fed could have attempted something known as "helicopter drops" by creating new money that's placed directly in the hands of people or governments rather than into the banking system.
What's this about dropping money from helicopters?
Back before he was Federal Reserve chair and before the economic crisis struck the United States, Ben Bernanke delivered several well-known talks and papers on the subject of monetary policy in Japan. His theme was to deny that there was nothing the Bank of Japan could do at the zero bound, arguing that a determined central bank could always reflate a depressed economy.
As an outlandish example, he said that if things got really desperate you could always print up more money and throw it out of helicopters.
That is, of course, not very practical, but the terms "helicopter drop" and "helicopter money" have entered the lexicon as meaning central bank efforts to bypass the financial system and inject money directly into the economy. One way to do this would be for the federal government to enact a large temporary tax cut, and then have the Fed make up the lost revenue by printing new money (or the electronic equivalent) and giving it to the Treasury. Alternatively, the money could be given to state governments so as to allow for different politicians to try putting it to use in different ways.
In practice there are some questions as to whether it would actually be legal for the Fed to do these things. But it's certainly logistically possible, and if Congress wanted monetary policy to be conducted this way it could always change the law.
Why doesn't the Fed do more to stimulate the economy?
While the Fed's unconventional monetary policies are frequently criticized on the theory that they are inflationary, few people on the Federal Reserve's central staff seem to believe this. Inflation concerns are present in a few of the regional banks — most notably the Dallas, Richmond, and Philadelphia Feds — but the main concern in Washington is something else. Instead, Federal Reserve Governor Jeremy Stein (who'll be stepping down in May) has forcefully made the case that excessively aggressive quantitative easing undermines the stability of the financial system.
QE, in other words, might lead financial institutions to take excessive risks and possibly lead to new banking crises.
This view is associated particularly with Stein, who's been its main official exponent. But according to minutes released from Fed monetary policy meetings, these stability concerns have been widely discussed by policymakers.
Are these worries warranted? Empirical research presented by Gabriel Chodorow-Reich at the spring 2014 Brookings Papers on Economic Activity conference indicated that they are not, and that in fact QE may be making financial institutions safer.
Where can I read more about this?
Monetary economics is the subject of very robust discussion.
Blogs from Scott Sumner and David Glasner are highly focused on monetary policy from a pro-stimulus perspective. From a very different viewpoint, Stephen Williamson's blog is also extremely interesting and focused on these issues. More general-purpose economic blogs such as Marginal Revolution or Brad DeLong's site also frequently discuss relevant issues, as does the Economist's Free Exchange.
If you want to dive deeper, the question of central banking in the crisis has also been the subject of several excellent books. David Wessel's In Fed We Trust: Ben Bernanke's War on the Great Panic is an excellent near-realtime account of events in the United States, while Neil Irwin's The Alchemists: Three Central Bankers and a World on Fire places American monetary policy in a more global perspective.