In FED We Trust (21 page)

Long before then, though, the term’s rising acceptance had given Mishkin a platform for arguing that the usual, gradual, one-step-at-a-time monetary policy was precisely the wrong approach to use in a situation like the Great Panic. The Fed, he argued, needed to be “preemptive” to disrupt the adverse feedback loop that would otherwise engage. With hindsight, his was the right diagnosis.

While Mishkin was laying the foundation for the Fed to do more, he was careful to hedge his public predictions about precisely what the Fed would actually do. Fellow Fed governor Randy Kroszner was less careful. In a speech in New York on November 17, he took the usually safe course of reciting the Fed’s last public statement, but he couldn’t resist a little update: “I would add that the limited data and information received since the October FOMC meeting have not changed my thinking in this regard.” Unfortunately for him, it soon became clear that Bernanke and Kohn had changed
their
thinking
in this regard. Less than two weeks later, Kohn and then Bernanke sent unmistakable flares: the worsening markets were casting a shadow over the benign economic forecast on which the Fed had been relying. More rate cuts were likely.

Bernanke realized that his quest to be the un-Greenspan was having unintended consequences: the people who mattered in the markets had grown accustomed to Greenspan’s peculiar prose and counted on him to point them in the direction he was headed. Bernanke was more candid, confessing uncertainty and almost thinking aloud at times. That is, when he could be heard above the divergent perspectives offered by other Fed officials.

“The public should understand that the FOMC members’ … views are likely to be especially diverse when, as in the current situation, circumstances are changing quickly and are subject to many different analyses,” Kohn said plaintively, in the Fed’s defense. Still, there was a reason why the Fed had a chairman, and Bernanke had to begin talking like one. He resolved to give more regular — and authoritative — updates on their outlook for the economy.

It worked. Bernanke’s speeches in 2007 and 2008 had five times the market-moving impact of the next most influential speaker — and number two was Don Kohn, the chairman’s public reinforcer. In contrast, in 2006, Bernanke’s impact was only double that of the next most influential speaker — and number two was attention-grabbing dissenter Bill Poole from St. Louis.

Mishkin, meanwhile, was putting on his own version of a full-court press. He knew that his advocacy of aggressive rate cuts alarmed hawkish bank presidents like Hoenig, but he had allies heading into the December FOMC meeting: Geithner was nearly always more worried than anyone else about the credit crunch. San Francisco’s Yellen and Boston’s Rosengren were also both inclined to cut rates another half-percentage point. The federal funds futures market was betting on a half-point cut as well. Most regional Fed bank presidents, though, used their discount-rate requests as a signal that they were leaning toward a
one-quarter point cut. A couple of the hawks — Richard Fisher in Dallas and Tom Hoenig in Kansas City — didn’t want any rate cut at all.

Several Fed officials believed the economy would recover gradually and be back to normal by late 2008 as weakness in the housing sector abated and financial conditions improved. Their faith in the tendencies of market capitalist economies to right themselves hadn’t yet been shaken. “Underpinning this story is the view that our modern market economy has a keen ability to self-correct as opportunistic capital moves into depressed markets. Markets correct. And market solutions are preferable,” Lockhart said in a speech that could have been delivered by one of several others. “This transition already is happening in the market for subprime mortgages. In this story, financial markets may endure some more weeks or months of volatility, but I believe they will find a restructured state of ‘normality,’” Lockhart said, putting a slightly optimistic sheen on the Fed’s thinking at the time.

While some presidents used speeches to be provocative and get attention, Lockhart tried to avoid making waves. “When I’m out there speaking,” Lockhart confided, “I always run my remarks through a filter of, gee, is this going to contribute to something we don’t want to have happen. I want to be frank and candid. I don’t want to be a Pollyanna. But I don’t want to be a Jeremiah unnecessarily.”

Mishkin, though, wasn’t as sanguine as Lockhart and the tike-minded. Drawing from his work on past financial crises, he argued — as he put it later — that “monetary policy that is appropriate during an episode of financial market disruption is likely to be quite different than in times of normal market functioning.” At a time of a significant disruption of financial markets, the Fed needed to display “less inertia than would otherwise be typical.”

Unhappy that the FOMC was heading to a one-quarter point rate cut, Mishkin arranged to have lunch with Bernanke on Monday, December 10, the day before the meeting. The Fed would be making a huge mistake if it didn’t try to get ahead of the Great Panic and cut rates by a half-percentage point, he told his friend. He felt so strongly that he was contemplating casting a dissenting vote. Bernanke talked him out of it: a dissent from a Washington governor intellectually and personally close to Bernanke would be seen
by outsiders as a sign that Bernanke was losing control of the committee. Mishkin reluctantly voted with the majority.

Bernanke, in fact, had sympathy with those who wanted the more aggressive rate cut, but he didn’t think he could sway the FOMC — and didn’t force the issue, to his later regret. It was another lesson in the limits of prizing consensus in the committee. “Democracy is a good thing, but in times of ‘war’ quicker and more decisive decision making is needed,” Ethan Harris, then a Lehman Brothers economist, wrote in an account of Bernanke’s first year.

The Boston Fed president, Eric Rosengren, in his fifth month as a Fed president, did dissent and argued for a bigger rate cut. Although not nearly as quotable and thus not as prominent as some other presidents, Rosengren emerged as a thoughtful, low-profile Bernanke ally during the Great Panic. He and the Richmond Fed’s Jeff Lacker had gone to the same New Jersey high school, although they didn’t know each other then, and were graduate students in economics at the same time at the University of Wisconsin. Rosengren began his Fed career in the Boston Fed’s research department, focusing for a time on the credit crunch and banking woes of New England in the 1990s as well as Japan’s banking crisis. In 2000, he moved into the nitty-gritty of bank supervision and regulation, an unusual move for a Ph.D. economist but one that gave him highly relevant expertise during the Great Panic and a clear view that some fellow bank presidents lacked. Where others saw signs of hope, Rosengren saw “a deteriorating housing sector, slowing consumer and business spending, high energy prices, and ill-functioning financial markets.”

“It was a tough decision,” Rosengren said later of his dissent. “You should really feel strongly before you dissent. I hadn’t been on the FOMC for very long. We were moving in the right direction, just not at the same magnitude that I thought was appropriate.” The attention his dissent drew surprised him, he said. “I probably underappreciated that.” For their part, markets were disappointed with the miserly rate cut and the absence of any innovative attacks on the nascent credit crunch. The Dow Jones Industrial Average responded by plunging nearly 300 points. “From talking to clients and traders, there is in their view no question the Fed has fallen way behind the
curve,” David Greenlaw, economist at Morgan Stanley told the
Wall Street Journal
. “There’s a growing sense the Fed doesn’t get it.”

Bernanke might have been wary of overreaching, but he had not been idle. The Friday before Tuesday’s FOMC meeting, he convened a conference call — unannounced at the time — to approve two innovations tailored to the peculiarities of the Great Panic. One was a new way to lend money directly to U.S. banks that were reluctant to come to the Fed’s discount window. The other was a long-discussed deal to help European central banks satisfy their banks’ craving for U.S. dollars. To fight the Great Panic, Bernanke was becoming the Great Experimenter.

BERNANKE’S DASHBOARD
January 22, 2008

The Fed’s Tuesday afternoon statement gave no indication that anything more was coming, though there were a few Fed-supplied hints in the next day’s
Wall Street Journal
and
Financial Times
that something was up. The big announcement came at 9
A.M.
Wednesday, timed so word of international cooperation would come during daylight hours in Europe. That annoyed Fed watchers on Wall Street, who were embarrassed Tuesday when the Fed did less than they had predicted, and it hurt investors who lost money when the
stock market dropped on the small rate cut. Neither was a big deal, but this was another instance where the Bernanke Fed seemed to be stepping on its own story and contributing to the confusion about what it was doing. After the Fed initiatives were announced, the stock market recovered all that it had lost the day before and then some. And in any event, the significance of the moves outlived the kvetching about the timing of the announcement.

The Fed in the fall of 2007 had two basic pipelines to the credit market. One was open market operations. The New York Fed bought and sold government securities through twenty or so big banks and government-securities trading firms, known as primary dealers, to influence the federal funds interest rate — that is, the rate at which banks lent to one another overnight. When the Fed bought securities and put cash into the markets, the fed funds rates went down; when it sold them and sucked cash out, rates went up. The resulting changes in the federal funds interest rate would provoke changes in other interest rates throughout the economy. (By June 2009, the number of primary dealers was down to seventeen because of mergers and bankruptcies.)

The other pipeline was to lend directly to individual banks through the discount window. But banks were reluctant to go to the discount window, for fear that they would be deemed unstable if word leaked out that they had borrowed from the Fed. Indeed, this stigma had become so feared as the economy spiraled downward that for 30 percent of the days since August, banks had been paying more to borrow from one another than they would have had to pay to borrow from the Fed. This was definitely
not
the way things were supposed to work.

As economist Stephen Cecchetti explained it, “Central banks have great tools for getting funds into the banking system, but they have no mechanism for distributing it to the places where it needs to go. The Fed can get liquidity to the primary dealers, but it has no way to ensure that those reserves are then lent out to the banks that need them.”

To unclog the financial circulatory system — and to get the blood flowing to where it was needed — the Fed decided to try a bypass operation that it called the Term Auction Facility, or TAF as it was named by one of its architects, Bill Dudley, who then served as the New York Fed’s markets chief and later succeeded Geithner as its president.

Through TAF, the Fed would begin auctioning off funds to any of the seven thousand or so banks in the country, not just twenty primary dealers. The acceptable collateral would be anything that a bank might have pledged as security for an overnight loan at the discount window, a much broader set of securities than the Fed usually bought and sold in open market operations. For banks, it was a way to get money — initially for twenty-eight days, later extended to eighty-four days — that was hard to secure in ordinary markets without the potential embarrassment of being seen waiting in line at the Fed’s discount window.

For the Fed, TAF was a small but significant step toward selling the sterling U.S. government securities that it owned and using the proceeds to take riskier securities that were out of favor. In peacetime, the Fed occasionally used its Treasury securities to solve a peculiar shortage in the markets. It once had even contemplated seriously buying securities other than Treasury debt in the long-ago days when the U.S. government surplus was so large that speculation focused on whether the supply of Treasury debt might just dry up. But this was the financial equivalent of war. In one market, the Fed was taking riskier-than-Treasury securities onto its balance sheet, and in another, it was offsetting those purchases with sales of U.S. Treasury securities.

The purpose — unlike nearly everything the Fed had done for decades — was not to lower the overall level of interest rates in the economy. That’s what changes in the federal funds rate were supposed to do. The purpose was instead to reduce an important gap once of concern only to bond geeks: the spread between Fed-influenced rates and the rates banks were charging one another for loans, the London Interbank Offered Rate (LIBOR). This spread usually was a few hundredths of a percentage point. By early December, though, it had widened to around a full percentage point — a huge move, though not nearly as wide as it would get later. Basically, the gap revealed that banks were so wary of one another and so worried about their own balance sheets that they were hoarding cash instead of lending it out. And the interest rates their customers paid on many of the loans they had made in the past were tied to the now-rising LIBOR rate.