Central bankers are conservative people. They take great care in implementing policy; they speak precisely; they explain changes completely; and they study the environment trying to pinpoint where the next disaster looms. Good monetary policy is marked by its predictability, but when the world changes, policymakers change with it. If a crisis hits and the tools at hand are not up to the job, then central bank officials can and will improvise. In August 2007, the world changed and the traditional instruments of monetary policy were not up to the task.
For some time now, there has been a consensus among monetary economists on the fundamentals of policy design. These agreed upon principles of best practice extend from central bank design to operational policy: central banks should be independent but have clearly defined policy objectives for which they are held accountable; policymakers’ operational instrument should be an interest rate; and officials need to be transparent and clear in communicating what they are doing and why they are doing it. Furthermore, there is agreement that the central bank is the right institution to monitor and protect the stability of the financial system as a whole.
An important part of the consensus has been that central banks should provide short-term liquidity to solvent financial institutions that are in need. But, as events in 2007 and 2008 have shown, not all liquidity is created equal. And critically, the consensus model used by monetary economists to understand central bank policy offers no immediate way to organise thinking about this sort of problem.
By the beginning of 2007, the stage was set for a crisis: Prices of homes in the U.S. were at unprecedented levels and borrowing by the owners (as a fraction of the inflation adjusted value) was higher than ever before. The quality of newly originated mortgages was declining substantially. And, most importantly, the securitisation of these mortgages – where they were put into large pools that formed the collateral for what are known as mortgage-backed securities – had spread well beyond the government-sponsored enterprises (Fannie Mae and Freddie Mac) that traditionally engaged in this task.
On 9 August 2007, the crisis hit and central banks swung into action, supplying large quantities of reserves in response to stresses in the interbank lending market. The spread on 3-month versus overnight interbank loans exploded. And, as problems worsened into the winter, the spread between U.S. government agency securities – those issued by Fannie Mae, Freddie Mac and the like – and U.S. Treasury securities of equivalent maturity rose as well. Investors shunned anything but U.S. Treasury securities themselves.
As the crisis deepened, it became painfully clear that traditional central bank tools were of limited use. Reductions in the target federal funds rate, the objective of Federal Reserve policy in normal times, had little impact on interbank lending markets. And while the purchase of securities through open market operations enabled policymakers to inject liquidity into the financial system, they could not insure that it went to the institutions that needed it most.
The policy response
In response to intensifying financial sector problems, Fed officials created new lending procedures in the form of the Term Auction Facility (TAF) and the Primary Dealer Credit Facility (PDCF), and changed their securities lending program creating the Term Securities Lending Facility (TSLF). The TAF offers commercial banks funds through an anonymous auction facility that seeks to eliminate the stigma attached to normal discount borrowing. The PDCF extends lending rights from commercial banks to investment banks (technically to the 19 so-called primary dealers with whom the Fed does its daily open market operations). And the TSLF allows investment banks to borrow Treasury bills, notes and bonds using mortgage-backed securities as collateral. All of these programs offered funding for terms of roughly one month at relatively favourable interest rates.
Beyond creating these new facilities, the Fed made adjustments to existing procedures. First, they extended the term of their normally temporary repurchase agreements to 28 days and accepted mortgage-backed securities rather than the normal Treasury securities. Second, the Fed extended swap lines to the European Central Bank and the Swiss National Bank that allowed them to offer dollars to commercial banks in their currency areas. And third, they provided a loan that allowed the investment bank Bear Stearns to remain in operation and then be taken over by JP Morgan Chase.
These new programs are very different from the ones that had been in place prior to the crisis. To understand the difference, it is important to realise that a central bank’s contact with the financial system is through its balance sheet, and there are two general principles associated with managing these assets and liabilities. First, policymakers control the size of their balance sheet – that is the quantity of what is commonly known as the monetary base. By changing the level of the monetary base (really commercial bank reserve deposits at the central bank) Fed officials keep the market-determined federal funds rate near their target.
Second, the central bank controls the composition of the assets it holds. Given the quantity of assets it owns, the Fed can decide whether it wants to hold Treasury securities, foreign exchange reserves, or a variety of other things. Each of the new programs implemented by the Fed involved changes in the assets the Fed holds. And in nearly every case, officials provided either reserves (cash) or Treasury securities in exchange for low quality collateral. By the end of March 2008, the Fed had committed more than half of their nearly $1 trillion balance sheet to these new programs:
- $100 billion to the Term Auction Facility,
- $100 billion to 28-day repo of mortgage-backed securities,
- $200 billion to the Term Securities Lending Facility,
- $36 billion to foreign exchange swaps,
- $29 billion to a loan to support the sale of Bear Stearns,
- $30 billion so far to the Primary Dealer Credit Facility.
Changes in the composition of central bank assets are intended to influence the relative price a financial assets – that is, interest rate spreads. So, by changing its lending procedures, Fed officials hoped that they would be able to reduce the cost of 3-month interbank loans and the spread between U.S. agency securities and the equivalent maturity Treasury rate. At this writing, these programs have met with only modest success.
Editor’s Note: This column is a brief summary of Policy Insight No. 21.