IV. Extraordinary Monetary Stimulus

The Key Elements of the Crisis

The financial crisis of 2007-2008 started in the United States in August 2007. Banks were at the center of the crisis which eventually led to the largest recession since the great depression.

• Banks were put under stress from three sources:

· A Widespread Fall in Asset Prices: The so-called “housing bubble” burst and house prices rapidly switched from rising to falling. Sub-prime mortgage defaults occurred and these assets as well as derivatives based on these assets lost value. Banks suffered losses which reduced their equity.

· A Significant Currency Drain: Depositors started to withdrawal their deposits at money market mutual funds. This process created concern among banks that similar withdrawals would occur and that bank runs might start.

· A Run on the Bank: One bank in the United Kingdom, Northern Rock, experienced a bank run. In the United States, massive withdrawals of deposits from money market mutual funds occurred. Banks’ desired reserves increased so banks increased their reserves by calling in loans.

· The widespread fall in asset prices threatened banks’ solvency; the currency drain threatened their liquidity; and, the potential run on the bank threatened both solvency and liquidity.

• Banks’ efforts to shore up their balance sheet severely decreased the supply of loans and commercial paper, so these markets essentially closed. Because the loanable funds market is worldwide, these problems immediately spread throughout the world.
• The drastic decrease in the supply of loanable funds started to affect the real economy.

The Policy Actions

• Policy actions responding to the crisis were slowly implemented until by November 2008 eight groups of policies were in place:

· Open Market Operations: The Fed undertook massive open market operations to give banks more liquidity. The federal funds rate was lowered, in December to between 0.00 and 0.25 percent.

· Extension of Deposit Insurance: Deposit insurance was extended to other institutions, such as money market funds. This policy was aimed at preventing runs.

· Term Auction Credit; Primary Dealer and Other Broker Credit; and Asset-backed Commercial Paper Money Market Mutual Fund Liquidity Facility: These are three separate policies but all have similar effects: The Fed accepted significantly riskier assets from a wider range of depository institutions than before in exchange for assets or reserves. These policies allowed depository institutions to swap risky assets for safer assets or reserves.

· Troubled Asset Relief Program (TARP 1): The TARP is conducted by the U.S. Treasury not the Fed. The TARP was funded with $700 billion of government debt. As first envisioned, the plan was for the U.S. government to buy troubled assets from depository institutions and replace them with U.S. government securities. But this process was more difficult than thought and its overall value was questioned.

· Troubled Asset Relief Program (TARP 2): Because of the difficulties of the TARP 1 and concern about its effectiveness, the TARP was modified to the TARP 2, in which the U.S. government took direct equity stakes in major depository institutions. This action directly increased these firms’ equity and reserves. In December of 2008 some of the TARP funds were used to assist major automakers.

· Fair Value Accounting: The accounting standard that required depository institutions to value their assets at their current market value was relaxed and they were permitted, in rare occasions, to use a model to value the assets. The effect of this policy was to try to keep depository institutions’ (accounting measure of their) equity higher.

Persistently Slow Recovery

• Despite extraordinary efforts by monetary and fiscal policy, the U.S. economy at the end of 2010 still had slow growth and high unemployment, with the unemployment rate near 10 percent.
• Critics argue that the Fed did more harm than good by creating uncertainty with its policies. They argued that the Fed should create greater clarity about its monetary policy strategy.

Policy Strategies and Clarity

Two alternative decision-making strategies have been proposed. Both strive to create greater openness and certainty about the Fed’s monetary policy.

Inflation Rate Targeting

• Inflation rate targeting is a monetary policy strategy in which the central bank makes a public commitment to achieve an explicit inflation target and to explain how its policy actions will achieve that target. Other countries (England, New Zealand, Canada, Sweden, and the EU) have successfully used inflation targeting rules to keep their inflation rate low.

Taylor Rule

• The Taylor rule uses a formula to set the target federal funds rate. The Taylor rule sets the federal funds rate (FFR) at the equilibrium real interest rate, assumed to be 2 percent, plus amounts based on the inflation rate (INF) and the output gap (GAP) according to:

FFR = 2 + INF + 0.5(INF - 2) + 0.5GAP

John Taylor says that the Fed has come close to following this rule but if it had followed it precisely the economy would have performed better.

Why Rules?

• Rules are important because rules enable households and firms to form more accurate inflation expectations. Markets work best when inflation expectations are most accurate and rules allow accuracy in inflationary expectations.

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