A Brief History of the Fed and the Financial Crisis Part II: QE I and II

Here is Part I.

This post I'm going to talk about Quantitative Easing, which the Fed pursued with two different programs over the course of the last 2 1/2 years.

Quantitative Easing 1 (QEI):

Here are two other useful timelines that were written when the second round of quantitative easing (QEII) was expected:

Calculated Risk: A QE1 Timeline
WeeklyBasis: Quantitative Easing 101

Now, the model we use in class of the fed funds market predicts that once the Fed is on the flat part of the reserve demand curve (i.e. at the rate where the Fed pays interest on reserves) there is nothing left for the fed to do vis-1a-vis interest rates. If the Fed did not pay interest on reserves then the "floor" on the Fed funds rate would be at 0% because no bank will loan money at a rate lower than zero ( a negative interest rate) because then you are paying someone to borrow from you. In either case this is know as the "liquidity trap". By December of 2008 the Fed was fully "caught" in the liquidity trap.

The Fed however was not necessarily out of bullets. I'm going to repeat figure 1 from part 1:

Figure 1 (from part 1)

Again, you will notice that the fed funds rate has a very direct effect on short term rates but less of an obvious or direct effect on longer rates. Since there was clearly a problem brewing in the mortgage/housing industry the Fed set about trying to solve the problem directly. In November of 2008 the Fed announced that it would buy $600 billion in "agency backed" (top of the line?) mortgages starting in January of 2009. As the WeekBasis post above points out, before the fed bought any mortgages mortgages rates dropped by 1% in anticipation of the purchase.

Figure 2

Figure 2 shows the interest on prime mortgages. There is a very clear decline in the interest rates of mortgages. There was also a very clear decline in AAA corporate bonds and 10 year treasury bonds which are close subsitutes for mortgages (important for QEII).

It's important to understand what is going on here. The Fed is simply preforming open market purchases--which means increasing the money supply--but instead of buyin short term treasury bonds the fed is simply buying longer terms private instruments. That is to say, there is (literally) no law that says that the Fed's only focus should be on the single fed funds interest rate. Since the fed funds rate had essentially become useless as an instrument of monetary policy the Fed went directly to the source of the problem and changed mortgages rates directly. It bought down mortgages rates in an attempt to make it cheaper and easier for people to buy and/or (probably more importantly) refinance their homes.

In March the Fed announced the would purchase a total of $1.2 trillion in "agency backed" (guaranteed by Fannie and Freddie) mortgages.

QEII

The Fed had finished its mortgages purchases by March 2010. In late August Bernanke started talking about a second round of quantitative easing. In early November the Fed officially announced that it would purchase another $600 billion ($75 a month) in securities. However, QEII is slightly different that QEI. While QEI was a direct purchase of mortgages QEII is a program to purchase 10-year treasury bonds. Why? Well, the interest rate on 30-year mortgages is actually based on 10-year treasury bonds. The average mortgages is held for 10 years so fixed rate "conforming" mortgages rates are based on the 10-year treasury rate with a risk premium. That is why they track so closely to the 10-year treasury bond in figure 2.

However, it looks at least from the above graph that QEII has not had the kind of pronounced effect as QEI, at least not on mortgage rates. If anything it looks like the expectation of QEII was most of its effect. Mortgages rates went slightly lower at the end of 2010. However, the QEII effect may also be beyond an interest rate decrease. The Fed forcasting that it QEII will create 700k jobs. It is after all still increasing the money supply.

QEII is expected to end (without a commitment of more money by the Fed) in June of this year.

A Brief History of the Fed and the Financial Crisis Part I: The Federal Funds Market and the Alphabet Soup of Programs.

Lets start out by establishing what it is the Fed actually does. It is a kind of short hand for commentators to say "The Fed is lowering/raising interest rates". More careful reporters and commentators will call the federal funds (fed funds) rate what it is or call it a policy rate.

Anyway, Figure 1 shows the relationship between the fed funds rate and a couple other rates.

Figure 1: Fed Funds and Selected Rates

Figure 1 should give you an idea of the kind of effect the federal funds rate has on "interest rates" over all. It is obvious that the rate on 3-month treasury bonds tracks the fed funds rates very closely. As well, the "prime rate"--the rate at which large banks lend to their best customers-- tracks the fed funds rate very closely but has a very clear risk/liquidity premium.

The effect of the fed funds rate is less obvious for the other rates. There seems to be a general pull downwards on 10-year yields, AAA bonds, and mortgages at least until the financial meltdown. You'll also notice that these three things move together pretty closely. That will be more important in part II.

Figure2: The Federal Funds Market

Here we have the federal funds market during the 21st century. The Federal funds rate being graphed here is the effective federal Funds rate not the target rate. You can get a pretty clear idea of what the target rate is from the effective rate. However we have also a little bit of added information. Notice the two big downward spikes. The first is at the very beginning of the graph (Jan 1, 2000) and the other is around the end of the year in 2001 (9/11/2001 to be exact).

Those two spikes represent huge injections of reserves into the fed funds market. The first was an intervention by the Fed to help prevent problems from the Y2K bug that never materialized. The other is of course in response to the massive disruption to the financial system when lower Manhattan was shut down for several days.

Figure 2 also tells the story of the Federal Reserve's role in the Financial crisis. We see a very, very sharp drop in the Federal Funds rate in 2001. In January of 2001 the Fed cut the fed funds rate from 6% to 5.50%. By the end of 2001 the rate was 1.25%. In Nov 2002 the Fed cut the rate all the way down to .75%. In 2003 the Fed raised rates to 2% and then keeps rates at that level until mid 2004 when it gradually starts (best illustrated by the step pattern in the discount rate) to increase interest rates to a peak of 6.25% in mid 2006.

Those low rates from 2001 to mid 2004 along with the quantity of reserves needed to keep rates that low many people say is a big part of the creation of the housing bubble. Initially, of course, the low rates were intended to juice the economy during the 2001 recession but critics say the Fed kept rates down too long.

I'm actually somewhat agnostic about the Fed's role. They must have had something to do with the housing bubble, but I'm not sure low rates were a sufficient condition. The giant increase in global savings during this period (it basically doubled)--as far as I'm concerned--is the central player in the housing bubble. Maybe we can think of the Fed as the yeast and the global savings glut as the flour. You can make bread without yeast, but it' won't rise. Of course, there are like a million other ways to blame the Fed beyond interest rate policy, such as thier role as a regulator and their refusal to use their ability to jawbone markets.

Also included this graph is the discount rate which, as we discussed in class is supposed to be a kind of "cap" on the federal funds rate. You'll notice several upward spikes. Lets zoom in a little bit:

Figure 3: Fed Funds Market Jan 2007 to March 2011

In late 2008 there are two significant spikes above the discount rate. This is indicative of the beginning of a financial panic. Banks are all scrambling to increase their excess reserves either "just in case" or because they legitimately need them. However some financial institutions may not have wanted to seem as though they needed discount loans and so borrowed at a rate above the discount rate from other banks, not the Fed. The expansion of discount loans through 2008 like the expansion of the fed balance sheet in general is really remarkable. The Fed had already increased its discount loans by about 1800% through 2007, from 27 million to $48.7 billion. From the 4th quarter of 2007 to its peak in 2009q1 the Fed increased the borrowed monetary base to $536.3 billion, an over 100% increase. All told, of course, the Fed increased its direct lending to the financial system by 20,000%!

This is a good place to talk about some of the unprecedented things the Fed did to try to stem the financial panic. It is important to point out that much of the lending the Fed did was not necessarily about maintain the target fed funds rate but was rather the fed fulfilling it's role as "lender of last resort". Credit markets in a financial panic seize up and banks and other financial institutions find it difficult or impossible to find funding. The Fed then steps in to make sure financial institutions can stay afloat. As well, the Fed greases the wheels of the financial system to get it running again.

A portion of the increase in discount loans I'm talking about were not loans to banks per se but were rather loans to money market mutual funds through banks. The Fed instituted a loan program (AMLF) in which they loaned money to banks so that they could buy commercial paper (corporate bills) from these mutual funds. This was intended to keep the commercial paper market operating in a time when no one wanted to loan money to anyone (especially financial companies) .

Not reflected in the loans above were a variety of programs such as the Term Auction Liquidity Facility or TALF. TALF loans were loans in which the collateral is an AAA rated asset backed securities (ABS). ABS of course tipped off the crisis through mortgage backed securities, but the ABS market is much bigger than just mortgages. ABSes finance credit cards, student loans, car loans and other things. Asset backed securities are fundamental to the "shadow banking system" the segment of the financial system that does many of the things banks do (make loans) but aren't actually banks. This market was also in a state of panic which was the justification for the TALF. Related (and a much bigger program) was the Commercial Paper Funding Facility (CPFF) which was similar to AMLF, but much much bigger.

Finally, there are the Maiden Lane programs (I, II and III). Essentially, these are "shell" companies the Fed created in order to buy assets from Bear Sterns and AIG. The Fed bought some of the uglier holdings of Bear Sterns to make the sale to JP Morgan Chase more attractive (Maiden Lane I) and the Fed bought a bunch of AIG's Mortgage Back Securities (MBS) in order to give AIG the cash needed to meet their obligations (Maiden Lane II). This was over and above the $85 billion line of credit the Fed set up for AIG. Finally, Maiden Lane III was another LLC set up by the Fed (partially owned by AIG). Maiden Lane III was created to buy up the Collateralized Debt Obligations (CDO) that several banks had take out insurance policies (Credit Default Swaps, or CDOs) on. As the value of the CDOs fell, AIG was obligated to pay these banks the difference between the market value of the CDOs and "par" (what the banks paid for them) value. AIG had already paid about $35 billion (mostly out of the $85 billion the Fed had lent them), the purchase of the CDOs from the banks by the Fed made up another $29 billion or so.

Now during 2008 the Fed isn't only making loans. The Fed is also rapidly slashing the federal funds rate. The Fed had begun cutting interest rates in September of 2007 (from it's peak of 5.25%), in response to what became the recession that started in December of 2007. Just real quick: I want to point out that the financial crisis was the result of the recession not it's cause, though it certainly made the recession worse. Anyway, in January of 2008 the Fed took the dramatic step of cutting the fed funds rate by .75%, there were several other cuts from January to March but on March 18th in the wake of the Bear Sterns collapse the Fed made another dramatic cut of 75 basis points off the fed funds rate. Long story short, from September 2007 to December 2008 the Fed cut the fed funds rate from 5.25% to a "target" of 0 to 25 basis points.

About this this target of 0 to 25 basis points: Importantly missing from Figure 2 is the interest rate the fed pays on deposits by banks at the Fed. When first instituted in October of 2008 the Fed made a distinction between what it would pay for required reserves and for excess reserves but later started paying 25 basis points on all reserves. Now, it may not be obvious from figure 3, but the fed funds rate has actually been below 25 basis points (roughly speaking around 15 basis points). Using the model of the market for reserves in class we came to the conclusion that no one would lend at less than 25 basis points. However, in the real fed funds market there are non-banks that buy and sell reserves (most notably Fannie Mae and Freddie Mac). These non-banks do not have deposits at the Fed though they make overnight loans and they are apparently willing to lend reserves at around 15 basis points.

I'm going to break this post up into two posts:

Part II: Quantitative easing.

How I would deal with the European debt crisis.

If I were Emperor of Europe here is what I would do: I would have the European Central Bank (ECB) implicitly guarantee Greek debt by offering to buy Greek debt at some particular interest rate and then pay for the purchase of Greek debt by issuing a "Eurozone Bond" backed by the full faith and credit of all the countries in the Eurozone.

The buying of Greek debt would not be inflationary since the ECB would effectively be sterilizing the purchase of Greek debt with the issuance of Eurozone debt. It would also relieve the fiscal pressure on the countries who are putting up government funds to help shore up the Eurozone. These countries could still--in partnership with the ECB--exercise control and impose all the austerity conditions they want.

This would also help push the Euro ever so slightly toward its full potential as a competitor currency of the dollar since it would finally create a true Eurozone debt instrument. Obviously, though, the market would not be very large or liquid but perhaps this market could be opened up to other countries. While the EU does not seem overly concerned with the problem of moral hazard it would be relatively easy to limit countries from taking advantage of this market if the EU actually started to enforce their rules governing debt to gdp ratios.

I am double minded about what interest rate to charge the Greeks. A penalty rate seems appropriate, but obviously that may only make it more difficult for Greece to pay down it's debts. At any rate, some kind of risk premium above what the ECB would get on the Eurozone instrument seems appropriate and would be profitable for the ECB. And if the Greeks finally do default? Well, then the Germans can put their real money to work.

Perhaps unfortunately, I do not run Europe and the ECB seems like a profoundly conservative and unimaginative institution. That may be a necessary thing in Europe, it may also be a major liability for Europe to have monetary policy nonexistent at the national level and unhelpful at the supra-national level. While the ECB has been engaged in what the Wall Street Journal calls a "stealth bailout" of Europeans banks holding Greek debt they may do well to push things further. Legal and political realities notwithstanding.

Bankling: The History of the Gold Standard: 25 Great Web Sites to Research Its Rise and Fall

This is a pretty good list of websites:

The History of the Gold Standard: 25 Great Web Sites to Research Its Rise and Fall

The lecture is largely based on this article in particular By Lawrence H. Officer

Delong Op-Ed: Sympathy for Greenspan

Sympathy for Greenspan

J. Bradford DeLong

29 June 2009

In the circles in which I travel, there is near-universal consensus that America’s monetary authorities made three serious mistakes that contributed to and exacerbated the financial crisis.

This consensus is almost always qualified by declarations that the United States has been well served by its Federal Reserve chairmen since at least Paul Volcker’s tenure, and that those of us who have not sat in that seat know that we would have made worse mistakes. Nevertheless, the consensus is that US policymakers erred when:

· the decision was made to eschew principles-based regulation and allow the shadow banking sector to grow with respect to its leverage and its compensation schemes, in the belief that the government’s guarantee of the commercial banking system was enough to keep us out of trouble;

· the Fed and the Treasury decided, once we were in trouble, to nationalise AIG and pay its bills rather than to support its counterparties, which allowed financiers to pretend that their strategies were fundamentally sound;

· the Fed and the Treasury decided to let Lehman Brothers go into uncontrolled bankruptcy in order to try to teach financiers that having an ill-capitalised counterparty was not without risk, and that people should not expect the government to come to their 
rescue automatically.

There is, however, a lively debate about whether there was a fourth big mistake: Alan Greenspan’s decision in 2001-2004 to push and keep nominal interest rates on US Treasury securities very low in order to try to keep the economy near full employment. In other words, should Greenspan have kept interest rates higher and triggered a recession in order to avert the growth of a housing bubble? If we push interest rates up, Greenspan thought, millions of Americans would become unemployed, to no one’s benefit. If interest rates were allowed to fall, these extra workers would be employed building houses and making things to sell to all the people whose incomes come from the construction sector.

Full employment is better than high unemployment if it can be accomplished without inflation, Greenspan thought. If a bubble develops, and if the bubble does not deflate but collapses, threatening to cause a depression, the Fed would have the policy tools to short-circuit that chain. In hindsight, Greenspan was wrong. But the question is: was the bet that Greenspan made a favourable one?

Whenever in the future the US finds itself in a situation like 2003, should it try to keep the economy near full employment even at some risk of a 
developing bubble?

I am genuinely unsure as to which side I come down on in this debate. Central bankers have long recognised that it is imprudent to lower interest rates in pursuit of full employment if the consequence is an inflationary spiral. Some days I think that, in the future, central bankers must also recognise that it is imprudent to lower interest rates in pursuit of full employment when doing so risks causing an asset price bubble.

What I do know is that the way the issue is usually posed is wrong. People claim that Greenspan’s Fed “aggressively pushed interest rates below a natural level.” But what is the natural level? In the 1920’s, Swedish economist Knut Wicksell defined it as the interest rate at which, economy-wide, desired investment equals desired savings, implying no upward pressure on consumer prices, resource prices, or wages as aggregate demand outruns supply, and no downward pressure on these prices as supply exceeds demand.

On Wicksell’s definition — the best, and, in fact, the only definition I know of — the market interest rate was, if anything, above the natural interest rate in the early 2000’s: the threat was deflation, not accelerating inflation. The natural interest rate was low because, as the Fed’s current chairman Ben Bernanke explained at the time, the world had a global savings glut (or, rather, a global investment deficiency).

You can argue that Greenspan’s policies in the early 2000’s were wrong. But you cannot argue that he aggressively pushed the interest rate below its natural level. Rather, Greenspan’s mistake — if it was a mistake — was his failure to overrule the market and aggressively push the interest rate up above its natural rate, which would have deepened and prolonged the recession that 
started in 2001.

But today is one of those days when I don’t think that Greenspan’s failure to raise interest rates above the natural rate to generate high unemployment and avert the growth of a mortgage-finance bubble was a mistake. There were plenty of other mistakes that generated the catastrophe that faces us today.

J. Bradford DeLong, a former Assistant US Treasury Secretary in the Clinton administration, is Professor of Economics at the University of California at Berkeley

In Cooperation With Project Syndicate

Economist's View: Should We Pop Bubbles?

Should We Pop Bubbles?

June 30, 2009

This may help Brad DeLong settle his inner conflict over whether Greenspan made an error by not moving interest rates to limit the housing boom. Guillermo Calvo and Rudy Loo-Kung argue that the benefits of bubbles almost always outweigh their costs (and thus there's no need for regulation to prevent them).

I think the authors are correct to point out that distributional issues are omitted from the analysis. Also, the assumption that social welfare depends only upon consumption is important as it rules out any utility costs associated with losing a home, a job, changing schools, etc. over and above the loss of consumption. In addition, using the aggregate consumption level of a composite commodity to index social welfare doesn't capture the costs associated with producing the subotimal mix of goods (e.g. too much housing, not enough of other goods), all that matters is the total quantity that is produced and consumed. Finally, I was surprised that the downturn and upturn phases of the cycle were assumed to be of equal length as I thought a slower return to normal growth (as compared to the downturn) - something that would increase the costs of the collapse - was the normal scenario:

Should we rush to further regulate financial institutions?, by Guillermo Calvo and Rudy Loo-Kung, Vox EU:

‘Tis better to have loved and lost,
Than never to have loved at all.
Tennyson, 1850.

In times of systemic financial distress, hunting for culprits becomes a popular sport. The Madoffs of this world are easy targets because crisis makes crookery harder to conceal. While there is no question that crooks should be sent to jail, increasing financial regulation is a different issue and requires careful analysis. Rushing to impose tighter regulations may hamper recovery and growth. Empirical evidence strongly supports the view that growth and financial development go hand in hand (Demirgüç-Kunt and Levine 2008). Although it is much harder to establish that financial development causes growth, few would doubt that, at least temporarily, financial deregulation could promote higher growth. A genuine concern, however, is that the financial sector is prone to crises, which are typically associated with serious effects on output and employment.

We cannot reach definite conclusions about the desirability of risky financial arrangements in a short column. Our objective is much more modest. We examine the welfare implications of financial deregulations that result in higher growth but end in tears and perform the exercise in the context of a benchmark case in which consumption is the ultimate source of welfare, ignoring possibly relevant behavioural finance and political economy considerations. We base our analysis on estimates of the costs of financial crises in emerging market economies (since the 1980s), a cauldron of financial crises in the last thirty years. Our results support deregulation even under those dire circumstances.¹

A model of growth, collapse, and welfare

More specifically, suppose that financial deregulation is implemented at time 0 and that, as a result, consumption grows at rate g^H (where H stands for “high”); after T periods, there is a crisis that produces a (symmetric) collapse-recovery recession phase in consumption, resembling those observed in the 1990s’ Emerging Economies crises (see Figure 1) . That is, we assume that, starting at time T consumption decreases for a while and then begins to recover. The recession phase takes DT periods. During the first half of this phase, i.e., for DT/2 periods after time T, consumption declines at the rate g*; and then, for the next DT/2 periods, consumption resumes growth at the same rate g*. By construction, at time T + DT (end of the recession phase) consumption reaches its pre-crisis level (i.e., the level prevailing at time T). Afterwards, we assume that consumption grows at a lower rate g^L (where L stands for “low”). We assume that g^L is also the growth rate that would prevail if no financial deregulation had been implemented. Thus, this corresponds to a financial deregulation experiment in which when crisis hits authorities get cold feet and meekly go back to the old, low-growth, financial system forever. This extremely pessimistic scenario will allow us to make a stronger case for deregulation.

Figure 1. Consumption paths under alternative regimes for the average emerging economy

Note: The consumption path associated with financial innovation shows the calibrated collapse-recovery phase for the average emerging economy and the calculated break-even T using a degree of risk aversion (σ) equal to 4.

To calibrate DT and g*, we focus on average output collapse and recovery patterns (the recession phase) observed in emerging markets during times of systemic financial turmoil throughout the period 1980-2004, discussed in Calvo, Izquierdo and Talvi (2006).² More specifically, we set DT equal to the time that it took for average output to recover its pre-crisis level. The growth rate g* is calibrated to match accumulated output loss, which is defined as the sum of the differences between the pre-crisis peak GDP and observed GDP within the recession phase. This procedure suggests setting g* = 3.11% per year and DT = 3.43 years.

Moreover, we set g^H equal to the average GDP growth rate observed in emerging markets during 1992-97, a period in which many countries opened up to capital inflows. The low growth rate g^L is set equal to the average growth rate observed in the previous ten years (1982-91). This leads us to set g^H = 4.7% and g^L = 2.7% per year.³

We focus on the following question: How long should the bonanza or high-growth period T last for financial deregulation to be socially desirable? To answer that question, we examine the benchmark case in which welfare can be expressed as the present discounted value of a utility index which depends on aggregate consumption.⁴

We define the break-even T as the number of bonanza years that would make deregulation welfare equivalent to not deregulating at all and generating low growth, g^L, at all times. If the bonanza period exceeds break-even T, then financial deregulation is preferable to doing nothing, even though it results in a painful crisis. Table 1 and Figure 1 summarise the results (parameter σ is the coefficient of relative risk aversion).⁵

Table 1

Emerging market episodes lasted 5 to 6 years on average, implying that the experiments were socially beneficial despite ending in large recessions. Admittedly, the boom-bust episodes are not identical across economies. To test for robustness, we perform the same exercise for two polar episodes in Latin American, namely, Argentina’s and Chile’s, for which the bonanza period was 4 and 13 years, respectively.⁶ In both cases, results point in favour of financial liberalisation for σ = 4. However, in the case of Argentina (and σ=1), the methodology yields borderline results (Chile passes the test with flying colours).⁷

Two points are worth making: (1) support for deregulation is stronger if the coefficient of relative risk aversion is more realistically set at 4, and (2) break-even T is the same if one assumes that the cycle is repeated as many times as desired (high growth-bust-high growth), and only after the last cycle the economy resumes low growth.⁸ This is more realistic because emerging markets returned to exhibiting high growth during 2003-2007.

The analysis abstracts from the important issues of poverty and income distribution, which might alter our assessment of past deregulation episodes, but that does not make our analysis less relevant looking forward. For example, for the type of social welfare function considered here, if income distribution remains fairly constant, one would reach the same pro-deregulation conclusions even if one entirely focused on the welfare of the poor, à la Rawls. This shows that financial deregulation would be desirable under the Rawlsian criterion if one can find suitable social protection mechanisms, and that the effectiveness of those mechanisms should be explored as part of the grand design of new financial regulations – especially before enacting new regulations that would stifle the dynamism of the financial sector.

Conclusion

Our analysis in this column may help explain why policymakers are hesitant to prick the bubble when it starts – they may simply be trying to maximise social welfare and realise that a potential crisis is not strong enough reason to prevent the bubble from developing (Tennyson’s verses ringing in their ears?). Of course, no policymaker likes crises. When crises strike, much of the discussion focuses on how to avoid them or lessen their impact in the future. This is quite understandable. However, this does not insure that “they are not going to fall in love again.” Therefore, the policy debate should give equal time to discussing what to do when crises happen and to developing institutions that help to assuage their blow.

In closing, we would like to point out that even though this note gives some support to financial deregulation, it does not rule out the existence of financial arrangements that are far superior to the ones currently available. A case in point would be the creation of a global lender of last resort. Central banks have successfully filled that role at the local level and likely prevented many serious self-fulfilling banking crises in the last seventy years. However, there is no equivalent to a lender of last resort at the global level. Its absence was clearly felt in emerging markets in the aftermath of the Russian August 1998 crisis. Even the subprime crisis suffered from the absence of a fully effective lender of last resort. To be sure, central banks stepped up to the plate early on in the current episode, but their coverage was and still is quite limited. Many central financial institutions were left without a safety net, or the net was stretched out after they hit the ground. We feel that the issue of a global lender of last resort should be given more weight in the current debate (see Calvo 2009).

References

Baldacci, Emanuele , Luiz de Mello, and Gabriela Inchauste (2002) "Financial Crises, Poverty, and Income Distribution" IMF Working Paper 02/4.
Barro, Robert (2006) “Rare disaster and Asset Markets in the Twentieth Century”, Quarterly Journal of Economics, 121(3).
Calvo, Guillermo (2009) “Lender of Last Resort: Put it on the agenda!”, VoxEU column, 23 March
Calvo, Guillermo, Alejandro Izquierdo and Ernesto Talvi (2006) “Phoenix Miracles in Emerging Markets: Recovering Without Credit from Systemic Financial Crises,” National Bureau of Economic Research, Working Paper 1201, March.
Demirgüç-Kunt, Asli and Ross Levine (2008), “Finance, Financial Sector Policies, and Long-Run Growth,” Commission on Growth and Development, Working Paper No. 11, World Bank, Washington, DC
Rancière, Romain, Aaron Tornell and Frank Westermann (2008) “Systemic Crises and Growth,” Quarterly Journal of Economics, pp. 359-406.

[1] Our results, thus, give further support to the line of research advanced by Aaron Tornell and Frank Westermann since 2002, which is inspired by the conjecture that financial liberalisation may be socially desirable despite the booms and busts that it may generate. See Rancière, Tornell and Westermann (2008) and their recent VoxEU column.
[2] The paper focuses on episodes in which GDP peak-to-trough contraction is greater than the median fall in the sample. Note that including only the most severe collapses in the calibration constitutes a more difficult test for the case of financial deregulation.
[3] Countries included are those tracked by the J.P. Morgan’s EMBI Global Index: Argentina, Belize, Brazil, Bulgaria, Chile, China, Colombia, Côte d'Ivoire, Dominican Republic, Ecuador, Egypt, El Salvador, Gabon, Ghana, Hungary, Indonesia, Iraq, Jamaica, Lebanon, Malaysia, Mexico, Morocco, Pakistan, Panama, Peru, Philippines, Poland, Romania, South Africa, Sri Lanka, Thailand, Trinidad and Tobago, Tunisia, Turkey, Uruguay, Venezuela, and Vietnam.
[4] More concretely, we assume that the utility index exhibits constant relative risk aversion, σ, and the instantaneous rate of discount equals 3% per year.
[5] If parameters are calibrated on the basis of GDP per capita (instead of its level) yields similar results, due to the high correlation between the two series.
[6] In both cases, we set g^L to average GDP growth rates during 1951-1970. The parameter g^H is set to the average GDP growth rates during 1991-94 for Argentina and 1984-97 in the case of Chile; The values and DT and g* are calibrated to match the characteristics of the Argentine crisis of 2002 and the Chilean crisis of 1998.
[7] In an exercise in which the collapse in growth is modeled as a stochastic event with constant probability, following Barro (2006), we also find support for financial deregulation. In both cases, the break-even expected frequency of these events is lower than the ones observed in the data
[8] It follows that T will be the same if the cycle is repeated an infinite number of times.
[9] The empirical work of Baldacci, de Mello, and Inchauste (2002) suggests that the financial crises that struck developing countries between 1960 and 1998 had severe effects on poverty and, in some cases, income inequality.

Posted by Mark Thoma on Tuesday, June 30, 2009 at 12:19 AM in Economics, Financial System, Regulation Permalink TrackBack (0) Comments (37)

Can the Federal Reserve Shrink the Money Stock Rapidly Now that It Can Pay Interest on Reserves?

DeLong/Pimco: Can the Federal Reserve Shrink the Money Stock Rapidly Now that It Can Pay Interest on Reserves?

[Links work]
Tyler Cowen asks:

Marginal Revolution: Paying interest on reserves, and why it should be easy to disarm future inflationary pressures. Do I believe it?

The correct answer is "maybe."

If inflationary pressure comes because banks and others regain their confidence and seek to move their excess reserve deposits into higher-yielding dollar denominated assets, then the Federal Reserve can fix that with a flick of its wrist by raising the interest rate on deposits.

If inflationary pressure comes because banks and others fear a large dollar depreciation and seek to move their excess reserve deposits into non-dollar denominated assets, then the Federal Reserve is helpless, and the situation is dire--unless the Federal Reserve has gotten the authority to issue bonds and has preemptively used that authority to mop up the excess liquidity.

Paul McCulley of PIMCO:

PIMCO - Global Central Bank Focus June 2009 Exit Strategy: Most rational investors accept the dual proposition that a Fed funds rate pinned against zero and near-$800 billion of excess reserves sloshing around the banking system are not enduringly sustainable. This is the case despite the fact that most – though a smaller most – applaud the Fed for engineering these outcomes, so as to cut off the fat tail risk of deflationary Armageddon. The consensus overwhelmingly holds that once that fat tail has been cut off and then killed, borrowing from Colin Powell’s famous description of America’s strategy for running Iraq out of Kuwait, it will be necessary for the Fed to exit its extraordinarily accommodative strategy, hiking the Fed funds rate and soaking up all those excess reserves. It’s hard to argue with the basic thrust of this exit thesis. Because it’s basically right!

I must admit, however, that I’m perplexed that so many pundits put so much emphasis on the importance of the Fed soaking up excess reserves, as if it is a necessary condition for hiking the Fed funds rate. It is not. To be sure, it used to be, before the Fed had the legal authority to pay interest on reserves, which Congress granted last fall. Before then, the only way the Fed could achieve a meaningfully positive Fed funds rate target was to constrain the supply of reserves relative to the banking system’s demand for reserves, essentially required reserves. If there were excessive excess reserves, then the Fed funds rate would fall below the Fed’s target, as banks with excess would be willing to lend them out in the Fed funds market below the Fed funds target, given that if they simply left them at the Fed, they would earn nothing. But now, the Fed pays interest on banks’ excess reserves (presently at an interest rate of 0.25%, the top of the Fed’s 0% – 0.25% target band for the Fed funds rate). Thus, logic says that banks with excess reserves will not lend them in the Fed funds market at a rate appreciably lower than the Fed pays, but simply leave them on deposit at the Fed. Accordingly, the rate that the Fed pays on excess reserves should now act as a proximate floor for the Fed funds rate, even if there are huge excess reserves in the system. Thus, by hiking the rate it pays on excess reserves, the Fed now has the ability to enforce a rising Fed funds rate target – even before it “unwinds” its bloated balance sheet....

The Federal Reserve’s approach to supporting credit markets is... credit easing... focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions.... [C]redit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing. To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally.... When markets are illiquid and private arbitrage is impaired by balance sheet constraints and other factors, as at present, one dollar of longer-term securities purchases is unlikely to have the same impact on financial markets and the economy as a dollar of lending to banks, which has in turn a different effect than a dollar of lending to support the commercial paper market.... [T]he stance of Fed policy in the current regime – in contrast to a QE regime – is not easily summarized by a single number....

Yes, I know that many of your eyes are probably glazing over about now, given my (and Ben’s) wonkishness. I’m sorry about that, but this is really, really important stuff to understand, given the widespread yammering about the need for the Fed to have an exit strategy to de-create all the excess reserves it has created, as if they are intrinsically the kindling for an (eventual) rip-roaring inflationary fire. They are not.... [W]e can categorically say that the near-zero Fed funds rate is not, for the moment, fueling an inflationary pace of aggregate demand growth.... And neither is the Fed’s Credit Easing.... Yes, in the fullness of time, zero Fed funds could conceptually re-ignite borrowers’ and lenders’ mojo. Indeed, that’s precisely the Fed’s objective. And if and when that objective is achieved, the Fed funds rate will need to be hiked.... But right now, the least of my worries, and I think the Fed’s, too, is the prospect for an overheated economy, putting too many idled resources, both labor and industrial capacity, back to work too quickly... it would be delightful if that were our primary worry! But it isn’t....

Chairman Bernanke and a number of his colleagues have talked about all these various tools, stressing they have plenty of potential doors in their exit strategy. And indeed they do, even though simply hiking the rate the Fed pays on excess reserves is the cleanest way to hike the Fed funds rate...

Fed press Release: Paying interest on Reserves

Press Release

Release Date: October 6, 2008

For release at 8:15 a.m. EDT

The Federal Reserve Board on Monday announced that it will begin to pay interest on depository institutions' required and excess reserve balances. The payment of interest on excess reserve balances will give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.

Consistent with this increased scope, the Federal Reserve also announced today additional actions to strengthen its support of term lending markets. Specifically, the Federal Reserve is substantially increasing the size of the Term Auction Facility (TAF) auctions, beginning with today's auction of 84-day funds. These auctions allow depository institutions to borrow from the Federal Reserve for a fixed term against the same collateral that is accepted at the discount window; the rate is established in the auction, subject to a minimum set by the Federal Reserve.

In addition, the Federal Reserve and the Treasury Department are consulting with market participants on ways to provide additional support for term unsecured funding markets.

Together these actions should encourage term lending across a range of financial markets in a manner that eases pressures and promotes the ability of firms and households to obtain credit. The Federal Reserve stands ready to take additional measures as necessary to foster liquid money market conditions.

Interest on Reserves
The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008.

Employing the accelerated authority, the Board has approved a rule to amend its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve balances (that is, balances held to satisfy depository institutions' reserve requirements) and on excess balances (balances held in excess of required reserve balances and clearing balances).

The interest rate paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee over each reserve maintenance period less 10 basis points. Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector.

The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points. Paying interest on excess balances should help to establish a lower bound on the federal funds rate. The formula for the interest rate on excess balances may be adjusted subsequently in light of experience and evolving market conditions. The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System's macroeconomic objectives of maximum employment and price stability.

The Board also approved other related revisions to Regulation D to prescribe the treatment of balances maintained by pass-through correspondents under the new rule and to eliminate transitional adjustments for reserve requirements in the event of a merger or consolidation. In addition, the Board approved associated minor changes to the method for calculating earnings credits under its clearing balance policy and the method for recovering float costs.

The revisions to Regulation D and the other changes will take effect on Thursday, October 9, 2008. The Board recognizes that depository institutions may choose to adjust their typical liquidity management practices in light of the payment of interest on required reserve balances and excess balances; the primary credit program and other Federal Reserve liquidity facilities are available to help institutions meet temporary funding requirements.

The Board’s notice of its actions regarding the amendments to Regulation D and associated changes is attached. While the action is effective immediately, the Board will accept public comments until November 21, 2008, and the proposal will be published in the Federal Register shortly. The Board will adjust the rule as appropriate in light of comments.

Substantial Further Increases in Term Auction Facility Auctions
The sizes of both 28-day and 84-day Term Auction Facility (TAF) auctions will be boosted to $150 billion each, effective with the 84-day auction to be conducted Monday. These increases will eventually bring the amounts outstanding under the regular TAF program to $600 billion. In addition, the sizes of the two forward TAF auctions to be conducted in November to extend credit over year end have been increased to $150 billion each, so that $900 billion of TAF credit will potentially be outstanding over year end.

Exemption to Allow Limited Bank Purchases of Assets from Money Market Mutual Funds
The Board on Monday published a letter granting a request by a depository institution for an exemption from the limits on transactions with affiliates under section 23A of the Federal Reserve Act and the Board's Regulation W to allow the institution to purchase assets from affiliated money market mutual funds under certain circumstances. The Board is open to considering similar requests from depository institutions under simlar circumstances.

http://www.federalreserve.gov/monetarypolicy/20081006a.htm