THE FEDERAL RESERVE AND THE FINANCIAL CRISIS

Lecture 2: The Federal Reserve after World War II

1. Early Challenges 2. The Great Moderation 3. Origins of the Recent Crisis

What Is the Mission of a Central Bank?

Macroeconomic stability - All central banks use monetary policy to strive for low and stable inflation; most a so use monetary policy to try to promote stable growth in output and employment. Financial stability - Central banks try to ensure that the nation's financial system functions properly; importantly, they try to prevent or mitigate financia panics or crises.

Fed-Treasury Accord of 1951

During World War II and subsequently, the Fed was pressed by the Treasury to keep longer-term interest rates low to allow the government debt accrued during the war to be financed more cheaply. Keeping interest rates low even as the economy was growing strongly risked economic overheating and inflation.

 In 1951, the Treasury agreed to end the arrangement and let the Fed set interest rates independently as needed to achieve economic stability. The Fed has remained independent since 1951, conducting monetary policy to foster economic stability without responding to short-term political pressures.

The Fed in the 1950s and Early 1960s

Between World War II and the recent financial crisis, macroeconomic stability was the predominant concern of central banks. During most of the 1950s and Chairman, 1951-1970 early 1960s, the Federal [quote]"Inflation is a thief in Reserve followed a "lean the night and if we against the wind" monetary don't act promptly and policy that sought to keep decisively we will both inflation and economic always be behind." growth reasonably stable.
[end of quote.]

The Great Inflation: Monetary Policy from the Mid-1960s to 1979

Inflation

Starting in the mid1960s, monetary policy was too easy. This stance led to a surge in inflation and inflation expectations. Inflation peaked at about 13 percent.

[For the accessible version of this figure, please see the accompanying HTML.]

The Great Inflation: Why Was Monetary Policy Too Easy?

Monetary policymakers were too optimistic about how "hot" the economy could run without generating inflation pressures. When inflation began to rise, monetary policymakers responded too slowly.

 Exacerbating factors included

- oil and food price shocks - fiscal policies (such as spending for the Vietnam War) that stretched economic capacity - Nixon's wage-price controls that artificially held down inflation for a time

Central Banking in an Evolving Economy

These experiences illustrate how central banks have to struggle with an evolving economy and imperfect knowledge.
[imageof]Arthur Burns Chairman, 1970-1978

world the opportunities for making mistakes are legion."[end of quote].

The Volcker Disinflation

To subdue double-digit inflation, Chairman Volcker announced, in October 1979, a dramatic break in the way that monetary policy would operate. In practice, the new approach to monetary policy involved high interest rates (tight money) to slow the economy and fight inflation.
[quote]

[imageof]Paul Volcker Chairman, 1979-1987

"To break the [inflation]

c y c l e , ... w e m u s t credible and

have

disciplined

m o n e t a r yp o l i c y . " [ e n dofquote].

Inflation in the 1980s

Inflation

In the years after the new disciplined monetary policy began, inflation fell markedly. When Chairman Volcker left his post in 1987, the inflation rate was around 3 to 4 percent.

[For the accessible version of this figure, please see the accompanying HTML.]

The 1981-1982 Recession

Unemployment Rate

The high interest rates needed to bring down inflation were costly. In the sharp recession during 1981 and 1982, unemployment peaked at nearly 11 percent.

[For the accessible version of this figure, please see the accompanying HTML.]

The Great Moderation

During the Great Inflation of the 1970s, both output and inflation were highly volatile. Following the Volcker disinflation, from the mid1980s through 2007 (primarily Chairman Greenspan's term), both output and inflation were much less volatile. This was the period of "The Great Moderation."

Chairman, 1987-2006
[quote] " . . . g r e a t e r h a s a n e n v i r o n m e n t o f

e c o n o m i c k e y t o

s t a b i l i t y

b e e n

i m p r e s s i v e s t a n d a r d s e c o n o m i c e v i d e n t i n

g r o w t h o f l i v i n g

i n

t h e

a n d s o

w e l f a r e t h e

U n i t e d

S t a t e s . "[endofquote.]

The Variability of Real GDP Growth

Real GDP Growth
[For the accessible version of this figure, please see the accompanying HTML.]

The Variability of Inflation

CPI Inflation
[For the accessible version of this figure, please see the accompanying HTML.]

Understanding the Great Moderation

Improved monetary policy after 1979 contributed to the Great Moderation. In particular, low and stable inflation promoted broader economic stability. Structural change (such as better inventory management) and simple good luck may also have contributed.

 Financial stresses occurred (for example, the 1987 stock market crash), but they did not cause major economic damage. - One exception was a boom and bust in the stock prices of "dot-com" companies that touched off a mild recession in 2001. Because of the relative tranquility during this period, monetary policy generally received greater emphasis than financial stability policies.

Prelude to the Financial Crisis: The Housing Bubble

From the late 1990s until early 2006, house prices soared 130 percent. Meanwhile, mortgage lending standards deteriorated.
Prices of Existing Single-Family Houses
[For the accessible version of this figure, please see the accompanying HTML.]

Inflationary House Price Psychology

Rising house prices and weakening mortgage standards fed off each other: - Rising house prices created an expectation that housing was a "can't lose" investment. - Lax underwriting and the availability of exotic mortgages drove up demand for housing, raising prices further.

Deterioration of Mortgage Quality

Prior to the early 2000s, homebuyers typically made a significant down payment and documented their finances in detail. But as house prices rose, many lenders began offering mortgages to less-qualified borrowers (nonprime mortgages) that required little or no down payment and little or no documentation.

The Deterioration of Mortgage Quality

Nonprime Mortgage Originations ( A s a s h a r e of total o r i g i n a t i o n s )
[For the accessible version of this figure, please see the accompanying HTML.]

P e r c e n t of N o n p r i m e L o a n s with L o w o r No D o c u m e n t a t i o n
[For the accessible version of this figure, please see the accompanying HTML.]

The House Price Bubble Bursts

House price increases made housing less affordable. Mortgage payments as a share of income rose sharply. Eventually, rising costs of homeownership began to damp housing demand.
Mortgage Debt S e r v i c e Ratio
[For the accessible version of this figure, please see the accompanying HTML.]

 Declining demand for houses led to a drop in house prices beginning in early 2006. Since then, house prices have fallen more than 30 percent.

P r i c e s of E x i s t i n g S i n g l e - F a m i l y H o u s e s
[For the accessible version of this figure, please see the accompanying HTML.]

The Aftermath of the House Price Bust

Mortgages with Negative Equity

As house prices fell, borrowersespecially those who had made little or no down paymentincreasingly went "underwater" (owed more on their mortgages than their houses were worth).

[For the accessible version of this figure, please see the accompanying HTML.]

Mortgage D e l i n q u e n c i e s

Mortgage delinquencies and foreclosures surged.

[For the accessible version of this figure, please see the accompanying HTML.]

 Banks and other holders of mortgage-related securities suffered sizable lossesa key trigger of the crisis.

How a Housing Bust Became a Financial Crisis: Triggers versus Vulnerabilities

It is important to distinguish between triggers and vulnerabilities: - The decline in house prices and the associated mortgage losses were key triggers of the crisis. - The effects of those triggers were amplified by vulnerabilities in the economy and financial system.

Private-Sector Vulnerabilities
Perhaps lulled into complacency during the Great Moderation, borrowers and lenders took on too much debt (leverage). Banks and other financial institutions failed to adequately monitor and manage the risks they were taking (for example, exposures to subprime mortgages).

 Firms relied excessively on short-term funding, such as commercial paper. The increased use of exotic financial instruments concentrated risk.

 Gaps in the regulatory structure left important firms without strong supervision (for example, AIG). There were failures of regulation and supervision, including consumer protection. Insufficient attention was paid to the stability of the financial system as a whole.

The Role of Monetary Policy

Some have argued that the Fed's low interest rate monetary policy in the early 2000s contributed to the housing bubble, which in turn was a trigger of the crisis.

 Most evidence suggests otherwise: - International comparisons: For example, the United Kingdom had a house price boom during the 2000s despite tighter monetary policy than the United States. - Size of the bubble: Changes in mortgage rates during the boom years seemed far too small to account for the magnitude of house price increases.

- Timing of the bubble: House prices began to pick up (late 1990s) before monetary policy began easing and rose sharply after monetary policy began tightening (2004). Economists continue to debate this issue.

References on Monetary Policy Role

Kenneth Kuttner (forthcoming). "Low Interest Rates and Housing Bubbles: Still No Smoking Gun," in Douglas Evanoff, ed., The Role of Central Banks in Financial Stability: How Has it Changed? Hackensack, N.J.: World Scientific.

Jane Dokko and others (2011). "Monetary Policy and the Housing Bubble," Economic Policy, vol. 26 (April), pp. 237-87. Carmen Reinhart and Vincent Reinhart (2011). "Pride Goes before a Fall: Federal Reserve Policy and Asset Markets," NBER Working Paper Series 16815. Cambridge, Mass.: National Bureau of Economic Research, February. Ben S. Bernanke (2010). "Monetary Policy and the Housing Bubble," speech delivered at the Annual Meeting of the American Economic Association, Atlanta, Ga., January 3, [Link]/newsevents/speech/[Link].

Economic Consequences of the Crisis

F i n a n c i a l S t r e s s Index

Financial stress skyrocketed. (Note: Shaded areas represent periods of recession.)

[For the accessible version of this figure, please see the accompanying HTML.]

S A P 500 C o m p o s i t e Index
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The stock market plunged.

Single-Family Housing Starts

[For the accessible version of this figure, please see the accompanying HTML.]

Home construction continued its sharp decline.

U n e m p l o y m e n t Rate

The unemployment rate rose sharply.

[For the accessible version of this figure, please see the accompanying HTML.]

 The next two lectures examine the unfolding of the crisis and the recession and describe the policy response: - Lecture 3 describes the financial stability policy responses to the crisis and recession by the Fed and others. - Lecture 4 discusses monetary policy responses to the recession, the sluggish recovery, post-crisis changes in financial regulation, and the implications of the crisis for central bank practice.
t

THE FEDERAL RESERVE AND THE FINANCIAL CRISIS