The Fed and the Financial CrisisJonathan CottenRoger KoneDavorin Kuljasevic

Outline• Feds role in causing the crisis

▫Monetary Policy• Feds reaction to the crisis

▫Lower Target Funds Rate▫Discount window/TAF▫Bailouts▫Lending Facilities▫Scap

• Critique and concerns▫Easy money, what should have happened▫Current Policy▫Concerns about Fed and Economy

Federal Reserves Role in Creating the CrisisMonetary PolicyOverview2001 – 20022003 – 20042005 - 2006

Overview of Monetary Policy2001 – 2006•Focus on federal funds target rate and

Taylor rule•Monetary policy lag of 12-18 months

Economic indicators:•GDP•Unemployment rate• Inflation•DJIA returns•Geo-political factors

Period 2001-2002: Recession•Mild recession in 2001•Negative or low GDP growth•Unemployment rate increased to 6% from

4.3%•DJIA dropped by 23% in 2002•9/11 & corporate scandals in 2002 Fed funds rate cut from 6.5% to 1.75% -

close to Taylor rule appropriate reaction

Period 2001-2002: Recession•November 2002 - Fed funds target

reduced to 1.25% from 1.75%•Two factors: 1) weak and “jobless”

recovery – actual data support it•2) fear of deflation – actual data don’t

support it inflation doubled in this period

Fed should have kept the target at 1.75%

Period 2003-2004: Recovery• June 2003 – Fed further reduced the fed funds

target to 1.00%• August 2003 – policy accommodative for a

“considerable period”• However, the economy was recovering rapidly• 1) GDP grew 1.6%, 3.2%, 6.9%, and 3.6% in

each respective quarter of 2003• 2) unemployment high, but under control• 3) DJIA up 30% in 2003• 4) Taylor rule suggested increase in the fed

funds target

Period 2003-2004: Recovery•Fed kept the fed funds target rate at

1.00% until Q2 2004 – too low for too long created excess liquidity

•Monetary policy lag – this excess liquidity had an impact on the economy in 2004 & 2005

Period 2005-2006: Boom

•The Fed began gradually increasing the target from mid-2004 until 2006

•Economic boom (stock market, housing market, GDP growth, drop in unemployment)

•Taylor rule suggested that the target should have been increased more sharply monetary policy was too easy in this period as well

Fed Funds Rate Relative to Taylor Rule

Federal Reserve Reaction to CrisisLowering Funds RateDiscount Window/TAFBailouts

Feds Reaction to the Crisis

•Lowered the Target Fed Funds Rate▫ Sep 18 07: A 1/2 point cut to 4.75%. ▫ Oct 31 07: A 1/4 point cut to 4.5%.▫ Dec 11 07: A 1/4 point cut to 4.25%.▫ Jan 22 08: A 3/4 point cut to 3.5%.▫ Jan 30 08: A 1/2 point cut to 3%.▫ Mar 18 08: A 3/4 point cut to 2.25%.▫ Apr 30 08: A 1/4 point cut to 2%. ▫ Oct 8 08: A 1/2 point cut to 1.5%.▫ Oct 29 08: A 1/2 point cut to 1%.

•Did this to facilitate lending to attempt to avoid potential liquidity crisis.

Target Federal Funds Rate

Discount Window/TAF• Fed begins urging banks to borrow from the

discount window in 2007, attempts to downplay the negative implications of borrowing from window

• Decreases prime rate to encourage borrowing• Creates Term Auction Facility in December

2008▫Allowed Fed to lend directly and on longer term▫Enabled Fed to control when, and how much,

liquidity supplied to market▫Negate stereotype

Bailouts• Bear Stearns

▫Provided 29 Billion in Financing to facilitate acquisition by JP Morgan

• Lehman Brothers Failure▫Allowed Lehman to fail in September 2008

• Fannie and Freddie▫Did not play major role, did authorize FBNY to

extend funding if needed• AIG

▫Loaned a total of 85 Billion to AIG in beginning in late 2008

Critique and ConcernsOur critique

Reasons given by the Fed for easy money policy between 2000 and 2003:

• Restoring confidence• Global imbalances

Our observation: failure to assume their supervisory and regulatory power

What should have been done:• On depository institutions: Increase the required reserve

requirements• On investment banks: Impose an explicit leverage ratio• On GSE’s: Prevent them from having access to low-interest loans

Critique and ConcernsOur critique

Reasons given by the Fed for easy money policy from 2007 until now:

• Loosen credit markets

Our observation: No effect

What should have been done:Increase the Fed funds rate target to reward

savings and discourage borrowing and risk taking

Critique and ConcernsOur concerns

Biggest Controversy!: Bailouts and lending actions of the Fed during the crisis

Concerns about the Fed:• Effectiveness of their monetary policy• Effectiveness of their regulatory and supervisory

power• Concerns about the fed being the principal liquidity

provider• Concerns about moral hazard the Fed engaged into

Critique and Concerns

Our concerns

Concerns about the economy:•Possible losses to be incurred by the Fed

in the future, and will affect the economy•Probable inflation spiral in the coming

years•Rise in unemployment

“Those who do not learn from history are doomed to repeat it”,George Santayana.

Our proposals:

•Move the current target of the Fed funds rate to a neutral stance

•Have legislation to limit the Fed powers•Audit the Fed without restrictions