A recent article by Justin Lahart in the Wall Street Journal raises the possibility that the Fed will run out of tools for combating the unfolding financial crisis, and incipient recession.
A lot of this is reminiscent of the discussion back in 2003 – and that discussion was of course reminiscent of the discussion of the tools that were available to the BOJ, but generally left unused. With the funds rate then down at 1%, and people were paying a lot of attention to “unconventional” monetary policy. Bernanke, then a member of the Board of Governors, even at one point suggested targeting or somehow influencing long-term bond yields. Two possibilities were being kicked around: (1) large-scale purchases of long-dated securities with no set targets, and (2) explicit targets for long-term term interest rates, like those in place before the Accord. Purchases of private-sector obligations were also being discussed, but there was some concern that this would overstep the Fed’s legal bounds. (A 2004 Fed working paper by Small and Clouse thoroughly reviews these constraints.) Nothing was ever done along these lines, but drawing on a highly influential paper by Woodford and Eggertsson, the FOMC eventually inserted the famous “considerable period of time” clause into its statement. It would be interesting to know whether any of these options are being dusted off.
There are some obvious similarities between now and 2001-03: (1) the weak real economy, and (2) the collapse of asset prices (stocks then, housing now).
But there are a couple of important differences too: (1) inflation pressure and the spike in commodity prices, and (2) the fragility of the financial system. In 2003, we were able to reassure ourselves that we were not “turning Japanese” because at least the financial system (banks in particular) seemed to be in good shape. Today, banks generally seem to be OK, at least for now – it’s everything else that seems to be coming apart. These are greatly complicating the Fed’s job: If it were just a soft economy and falling inflation, the Fed’s task wouldn’t be easy, but at least it would be relatively straightforward.
Thursday, March 27, 2008
Monday, March 17, 2008
Bailout or fire sale?
It can't be both!
The Fed is sure to take some heat over Friday's decision to extend an emergency loan to Bear Stearns (via JP Morgan), and last night's decision to open the discount window to primary dealers. Terms like "bailout" will inevitably be used to describe what the Fed is doing.
But in defense of the Fed, there are good reasons to think that the Fed acted appropriately in its capacity as lender of last resort. In that role, the Fed's job is to lend funds to solvent institutions, which, for whatever reasons, are experiencing a liquidity crisis -- i.e., a "run". And that's probably a reasonable description of the situation Bear Stearns found itself in on Friday. Why? How do we know Bear wasn't also insolvent? For the simple reason that somebody, namely JP Morgan, was willing to buy it. And, the fact that the $2/share price was viewed as a "fire sale" price suggests that the company was worth substantially more -- maybe not the $50-plus per share price of last Thursday, but something well above zero. Had Bear actually been insolvent, there would have been no buyer at any price.
And what about opening up the discount window to primary dealers? Yes, that sets a very interesting precedent, but it was probably a good idea. After all, "surprise" loans to financial institutions experiencing a liquidity squeeze do absolutely no good: it's the commitment of the central bank to step in and lend during a run that will avert the run. The loan to Bear Stearns obviously suggested an implicit commitment; the Fed has now simply made that explicit. If the policy succeeds, other dealers will never need to avail themselves of the facility.
For commercial banks, the price paid for access to the discount window has been regulatory oversight, the idea being that if the institution is regulated, the Fed will be in a good position to gauge its solvency. The open question now is whether, in opening the discount window for other institutions, the Fed will expect those institutions to a comparable degree of scrutiny. In light of recent events, that might not be such a bad idea...
The Fed is sure to take some heat over Friday's decision to extend an emergency loan to Bear Stearns (via JP Morgan), and last night's decision to open the discount window to primary dealers. Terms like "bailout" will inevitably be used to describe what the Fed is doing.
But in defense of the Fed, there are good reasons to think that the Fed acted appropriately in its capacity as lender of last resort. In that role, the Fed's job is to lend funds to solvent institutions, which, for whatever reasons, are experiencing a liquidity crisis -- i.e., a "run". And that's probably a reasonable description of the situation Bear Stearns found itself in on Friday. Why? How do we know Bear wasn't also insolvent? For the simple reason that somebody, namely JP Morgan, was willing to buy it. And, the fact that the $2/share price was viewed as a "fire sale" price suggests that the company was worth substantially more -- maybe not the $50-plus per share price of last Thursday, but something well above zero. Had Bear actually been insolvent, there would have been no buyer at any price.
And what about opening up the discount window to primary dealers? Yes, that sets a very interesting precedent, but it was probably a good idea. After all, "surprise" loans to financial institutions experiencing a liquidity squeeze do absolutely no good: it's the commitment of the central bank to step in and lend during a run that will avert the run. The loan to Bear Stearns obviously suggested an implicit commitment; the Fed has now simply made that explicit. If the policy succeeds, other dealers will never need to avail themselves of the facility.
For commercial banks, the price paid for access to the discount window has been regulatory oversight, the idea being that if the institution is regulated, the Fed will be in a good position to gauge its solvency. The open question now is whether, in opening the discount window for other institutions, the Fed will expect those institutions to a comparable degree of scrutiny. In light of recent events, that might not be such a bad idea...
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