Key Challenges Facing Federal Reserve Policymakers

College Fed Challenge OrientationFederal Reserve Bank of New York

Raymond W StoneStone & McCarthy Research Associates

June 16, 2008

Taylor Rule—Fed Buying “Insurance” Against “Adverse Feedback Loop”

T aylor Rule ( funds ra te based on Core PCE Defla tor)

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7.00Funds Rate

Taylor Est imate

Insurance Against Def lat ion- >

Insurance Against "Adverse Feedback Loop"- >

“Adverse Feedback Loop”

• A situation in which a tightening of credit conditions could depress investment and consumer spending, which, in turn, could feed back to a further tightening of credit conditions.

Price of Insurance—The Possible De-anchoring of “Inflation Expectations”

Weak Dollar, Higher Import Prices: Risk to Inflation

Credit Crisis: Strains in Term Interbank Funding

Bank Funding Strains—More Restrictive Credit Availability to Households and Businesses

Credit Crisis Response: Adding to the Fed’s Tool-Kit

• Changes to Discount Window Policy (lower spread over Funds target, longer borrowing terms)

• Term Auction Facility (TAF)

• Single Tranche 28-Day RPs

• Term Security Lending Facility (TSLF)

• Primary Dealer Credit Facility (PDCF)

FRBNY Summary Table http://www.newyorkfed.org/markets/Forms_of_Fed_Lending.pdf

Fed’s Role in Facilitating Acquisition of Bear

Stearns By JP Morgan Chase • Why?

• Moral Hazard Debate

• Good Idea or Bad Idea?

Geithner’s Defense of Fed Actions with Regard to Bear Stearns

• We did this with great reluctance, and only because it was the only feasible option available to avert default, and because we did not believe we had the ability to contain the damage that would have been caused by default.

• Our actions were guided by the same general principles that have governed Fed action in crises over the years. There was an acute risk to the stability of the system; we were not confident that the damage could be contained through other means; we acted only to help facilitate an orderly resolution, not to preserve the institution itself; and the management of the firm and the equity holders of the institution involved suffered very substantial consequences.

Bear Stearn’s Ultimate Impact on Fed’s Balance Sheet

Credit Crisis Innovations and the Fed’s Balance Sheet

Chgs Federa l Reserve Balance Sheet ( De c 5 , 2 0 0 7 to June 4 , 2 0 0 8 )

Weekly averages ($blns)

asset s liabilt ies

- $292.8 Outr ights $0.6 Re se r v e Ba la nce s

$67.3 RPs

$150.0 TAF Cr e dit $5.3 Cur r e ncy in Cir cula t ion

$8.3 PDCF Cr e dit - $0.1 Tr e a sur y De posits

$15.7 Othe r Discount Adv a nce s

$3.0 Re v e r se RPs ( For e ign Of f icia l)

$0.0 Re v e r se RPs ( De a le r s)

- $0.5 Floa t

$62.9 Othe r FR Asse ts (including SWAP drawings) $2.0 All Othe r Lia bilit ie s & Ca pita l

$10.8 Tota l Re se r v e Ba nk Cr e dit

$0.0 Gold stock $10.3 Fa ctor s Absor bing Re se r v e s

$0.0 Special Drawing Rights

$0.0 Treasury Currency Outstanding

$10.8 Tota l Fa ctor s Supply ing Re se r v e s $10.8 Tota l Lia bilit ie s & Ca pita l

Changing Composition of Reserve Bank Credit—Fed Assets

Constraints on the Fed’s Balance Sheet

• Size of System Open Market Account—Could the Fed run out of Treasury Securities?

• Collateralization of Federal Reserve Notes (relaxed by amendments to Federal Reserve Act)

Had the Federal Reserve Act Not Been Amended in 1999, The Fed Wouldn’t Have Been Able to Address the Credit Crisis Effectively

Possible Solutions to Balance Sheet Constraints

• Paying Interest on Bank Reserves

• Fed Issuing Debt to Fund Expansion of SOMA

• Changes in Treasury Cash Management Practices

Paying Interest on Bank Reserves: Impact on Sweep Accounts and Required Reserves, as well as demand for Excess Reserves

Demand for Excess Reserves increases due to interest on Reserve balances.

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f . S S'u . .n . . d .s . .

. .r . .a . .t funds target . .e . - - - - - > .

. .. .

. .. .

Balance Sheet . .increased by . D'magnitude of Dshif t in theSupply Curve

reserves

The Goodfriend Approach

We Can Reduce Risk In the Financial System(Op-Ed article FT 6/8/2008)

Timothy Geithner, President FRBNYhttp://www.ft.com/cms/s/0/807c8a64-355a-11dd-998d-0000779fd2ac.html

(1) Increase the shock absorbers held in normal times against bad macroeconomic and financial outcomes….more exacting expectations on capital, liquidity and risk management for the largest institutions that play a central role in intermediation and market functioning.

(2) Improve the capacity of the financial infrastructure to withstand default by a big institution.

(3) Supervision has to ensure that counterparty credit risk management in the supervised institutions limits the risk of a rise in overall leverage outside the regulated institutions that could threaten the stability of the financial system.

Geithner Continued

• Streamline and simplify the US regulatory framework…The institutions that play a central role in money and funding markets – including the main globally active banks and investment banks – need to operate under a unified framework that provides a stronger form of consolidated supervision, with

appropriate requirements for capital and liquidity. • A stronger capacity to respond to crises. The Fed has put in place a

number of innovative new facilities that have helped ease liquidity strains. We plan to leave these in place until conditions in money and credit markets have improved substantially. Some of these could become a permanent part of our instruments. Some might be best reserved for the type of acute market illiquidity experienced in this crisis.