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Contents Introduction Traditional Tools Open Market Operations and the Federal Funds Rate The Discount Window New Tools Term Auction Facility Term Securities Lending Facility What is a Primary Dealer? Primary Dealer Credit Facility Emergency Authority Under Section 13(3) of the Federal Reserve Act Swap Lines with Foreign Central Banks Intervention in the Commercial Paper Market Payment of Interest on Bank Reserves The Fed's Role in the JPMorgan Chase Acquisition of Bear Stearns Loan to American International Group (AIG) Policy Issues Cost to the Treasury How Much Can the Fed Lend? Will the Fed Run Out of Money? Why the Fed's Actions Have Not Successfully Restored Financial Normalcy? Lender of Last Resort, Systemic Risk, and Moral Hazard Effects on the Allocation of Capital Liquidity Trap? Stagflation? Concluding Thoughts
On August 9, 2007, liquidity abruptly dried up for many financial firms and securities markets. Suddenly some firms were able to borrow and investors were able to sell certain securities only at prohibitive rates and prices, if at all. The "liquidity crunch" was most extreme for firms and securities with links to subprime mortgages, but it also spread rapidly into seemingly unrelated areas. (1) The Federal Reserve (Fed) was drawn into the liquidity crunch from the start. On August 9, it injected unusually large quantities of reserves into the banking system to prevent the federal funds rate from exceeding its target.
It has been observed that the most unusual aspect of the current turmoil is its persistence for more than a year. As financial turmoil has persisted in the intervening months, the Fed has aggressively reduced the federal funds rate and the discount rate in an attempt to calm the waters. When this proved not to be enough, the Fed greatly expanded its direct lending to the financial sector through several new lending programs, some of which can be seen as adaptations of traditional tools and others which can be seen as more fundamental departures from the status quo. (2) Most controversially, in March 2008, the Fed was involved in the "bailout" of the investment bank Bear Stearns, which was not a member bank of the Federal Reserve system (because it was not a depository institution), and, therefore, not part of the regulatory regime that accompanies membership. (3) In August, Fannie Mae and Freddie Mac, the housing government-sponsored enterprises (GSEs) were taken into conservatorship by the government. (4) In September, the investment bank Lehman Brothers filed for bankruptcy (it did not receive emergency government assistance) and the financial firm American International Group (AIG), which was also not a member bank, received a credit line from the Fed in order to meet its obligations. Lending to non-members requires emergency statutory authority that had not previously been used in more than 70 years. (5)
One of the original purposes of the Federal Reserve Act, enacted in 1913, was to prevent recurrence of financial panics. To that end, the Fed has been given broad authority over monetary policy and the payments system, including the issuance of federal reserve notes as the national currency. As with any statutory delegations of authority, the Fed's actions are subject to congressional oversight. Although the Fed has broad authority to independently execute monetary policy on a day-to-day basis, questions have arisen as to whether the unusual events of recent months raise fundamental issues about the Fed's role, and what role Congress should play in assessing those issues. This report reviews the Fed's actions since August 2007 and analyzes the policy issues raised by those actions.
The Fed, the nation's central bank, was established in 1913 by the Federal Reserve Act (38 Stat. 251). Today, its primary duty is the execution of monetary policy through open market operations to fulfill its mandate to promote stable economic growth and low and stable price inflation. Besides the conduct of monetary policy, the Federal Reserve has a number of other duties: it regulates financial institutions, issues paper currency, clears checks, collects economic data, and carries out economic research. Prominent in the current debate is one particular responsibility: to act as a lender of last resort to the financial system when capital cannot be raised in private markets in order to prevent financial panics. The next two sections explain the Fed's traditional tools, open market operations and discount window lending, and summarizes its recent use of those tools.
Open Market Operations and the Federal Funds Rate
Open market operations are carried out through the purchase and sale of U.S. Treasury securities in the secondary market in order to alter the reserves of the banking system. (6) By altering bank reserves, the Fed can influence short-term interest rates, and hence overall credit conditions. The Fed's target for open market operations is the federal funds rate, the rate at which banks lend to one another on an overnight basis. The federal funds rate is market determined, meaning the rate fluctuates as supply and demand for bank reserves change. The Fed announces a target for the federal funds rate and pushes the market rate toward the target by altering the supply of reserves in the market through the purchase and sale of Treasury securities. (7) More reserves increase the liquidity in the banking system and, in theory, should make banks more willing to lend, spreading greater liquidity throughout the financial system.
When the Fed wants to stimulate economic activity, it lowers the federal funds target, which is referred to as expansionary policy. Lower interest rates stimulate economic activity by stimulating interest-sensitive spending, which includes physical capital investment (e.g., plant and equipment) by firms, residential investment (housing construction), and consumer durable spending (e.g, automobiles and appliances) by households. Lower rates would also be expected to lead to a lower value of the dollar, all else equal. A lower dollar would stimulate exports and the output of U.S. import-competing firms. To reduce spending in the economy (called contractionary policy), the Fed raises interest rates, and the process works in reverse.
Central banks across the world, including Europe, Japan, and the United States acted quickly to restore liquidity to the financial system following August 9, 2007. On a normal day, the Fed might need to buy or sell a couple billion dollars of Treasury securities in order to keep the federal funds rate within a few one- hundredths of a percent of its target. Suddenly on August 9, the federal funds rate approached 6%, and the Fed was forced to purchase $24 billion of Treasury securities in order to add enough liquidity to bring the federal funds rate back down to its target of 5.25%. On August 10, the Fed needed to purchase an additional $38 billion to keep the rate at its target, and issued a statement that began, "The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial markets." The European Central Bank provided 156 billion euros ($215 billion) of liquidity to markets on August 9 and 10. Normalcy soon returned to the federal funds market, although other parts of the financial system remained illiquid. The Fed took similar actions on March 7, 2008, when it announced that it would be injecting up to $100 billion in liquidity for at least 28 days through open market operations. It took similar actions again in September 2008.
How should the Fed's actions be characterized? The Fed's actions cannot be classified as a policy change since it left the federal funds target rate unchanged in the August case for over a month. (8) Nor can it be considered unusual that the Fed bought Treasury securities to keep the federal funds rate at its target--the Fed does this on a daily basis. What was unusual about the incidents was the magnitude of liquidity the Fed needed to add to keep the rate near its target.
On September 18, 2007, the Fed reduced the federal funds target rate by 0.5 percentage points to 4.75%, stating that the change was "intended to forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets ... " Since then, the Fed has aggressively lowered interest rates several times. The Fed decides whether to change its target for the federal funds rate at meetings scheduled every six weeks. In normal conditions, the Fed would typically leave the target unchanged or change it by 0.25 percentage points. From September to March, the Fed lowered the target at each regularly scheduled meeting, by an increment larger than 0.25 percentage points at most of these meetings. It also lowered the target by 0.75 percentage points at an unscheduled meeting on January 21, 2008.
As the financial turmoil persisted, the Fed became more concerned about rising inflationary pressures. Although financial conditions had not returned to normal, the Fed kept the federal funds rate steady from April 30, 2008, until October 9, 2008, when it again reduced the federal funds rate, this time by 0.5 percentage points, to 1.5%. Unusually, this rate reduction was coordinated with several foreign central banks.
The Discount Window
The Fed can also provide liquidity to member banks (depository institutions that are members of the Federal Reserve system) directly through discount window lending. (9) Discount window lending dates back to the early days of the Fed, and was originally the Fed's main policy tool. (The Fed's main policy tool shifted from the discount window to open market operations several decades ago.) Loans made at the discount window are backed by collateral in excess of the loan value. A wide array of assets can be used as collateral, but they must generally have a high credit rating. Most discount window lending is done on an overnight basis. Unlike the federal funds rate, the Fed sets the discount rate directly through fiat.
During normal market conditions, the Fed has discouraged banks from borrowing at the discount window on a routine basis, believing that banks should be able to meet their normal reserve needs through the market. Thus, the discount window has played a secondary role in policymaking to open market operations. In 2003, the Fed made that policy explicit in its pricing by changing the discount rate from 0.5 percentage points below to 1 percentage point above the federal funds rate. A majority of member banks do not access the discount window in any given year. Since the beginning of the financial turmoil, the Fed has reduced the spread between the federal funds rate and the discount rate, although it has kept the spread positive.
On August 17, 2007, the Fed took further actions to restore calm to financial markets when it reduced the discount rate from 6.25% to 5.75%. Since then, the discount rate has been lowered several times, typically at the same time as the federal funds rate. Discount window lending (in the primary credit category) increased from a daily average of $45 million outstanding in July 2007 to $1,345 million in September 2007. Lending continued to increase to more than $10 billion outstanding per day from May 2008, but was superseded in economic significance by the creation of the Term Auction Facility in December 2007 (discussed below).
The Fed's traditional tools are aimed at the commercial banking system, but current financial turmoil has occurred outside of the banking system as well. The inability of traditional tools to calm financial markets since August 2007 has led the Fed to develop several new tools to fill perceived gaps between open market operations and the discount window.
Term Auction Facility
A stigma is thought to be attached to borrowing from the discount window. In good times, discount window lending has traditionally been discouraged on the grounds that banks should meet their reserve requirements through the marketplace (the federal funds market) rather than the Fed. Borrowing from the Fed was therefore seen as a sign of weakness, as it implied that market participants were unwilling to lend to the bank because of fears of insolvency. In the current turmoil, this perception of weakness could be particularly damaging since a bank could be undermined by a run based on unfounded, but self-fulfilling fears. Ironically, this means that although the Fed encourages discount window borrowing so that banks can avoid liquidity problems, banks are hesitant to turn to the Fed because of fears that doing so would spark a crisis of confidence. As a result, the Fed found the discount window a relatively ineffective way to deal with liquidity problems in the current turmoil. It created the supplementary Term Auction Facility (TAF) in response. (10)
Discount window lending is initiated at the behest of the requesting institution--the Fed has no control over how many requests for loans it receives. The TAF allows the Fed to determine the amount of reserves it wishes to lend out to banks, based on market conditions. The auction process determines the rate at which those funds will be lent, with all …