In FED We Trust (38 page)

Perhaps fortuitously, one antagonist was missing: Tim Geithner, who had become a target for the dissenting bank presidents. The Four Musketeers now numbered three. Geithner had been plucked from the New York Fed job (2008 salary: $411,200) to be Obama’s Treasury secretary (salary: $191,300).
In a face-to-face meeting with Obama in Chicago, Geithner won over the president-elect in characteristic Geithner fashion: he gave the president-elect a list of reasons why he should
not
be chosen. Among them was the obvious fact that he was inextricably intertwined with the politically unpopular Paulson-Bernanke approach to banks and hardly represented the change Obama had promised.

Geithner recommended Larry Summers for the job. Obama instead installed Summers in the White House as chief economic policy coordinator and nominated Geithner to succeed Paulson at Treasury. After a contentious public dissection of his failure to pay all the taxes he owed while working at the IMF, Geithner was confirmed by the Senate, 60-34. Bernanke, for his part, was pleased by Obama’s choice: he trusted Geithner and knew they could work well together. He also welcomed the prospect of an administration prepared to be more aggressive and to spend more money to fight the Great Panic. Fiscal policy — spending taxpayer money — was increasingly important because the Fed was entering territory that it had only ruminated about in the Greenspan era: zero interest rate policy, or ZIRP in Fedspeak.

Bernanke knew that Geithner’s absence alone wouldn’t ensure peace among the various FOMC factions. For weeks, he had been laboring to make the twelve regional Fed presidents feel more involved in decision making. One-at-a-time phone calls from Bernanke and Kohn clearly couldn’t keep up with the pace of developments, so Bernanke had begun convening biweekly videoconference staff “briefings” for the entire FOMC. Because no decisions were made, the meetings weren’t announced and no minutes or transcripts were kept.

In another gesture toward the presidents, Bernanke convened the December meeting on Monday afternoon, a day earlier than planned, to allow for extra questioning and argument. The Fed staff distributed in advance twenty-one separate memos on topics, from the side effects of cutting Fed rates to zero to alternative ways the Fed could sustain the economy once rates were at zero. Bernanke moved the usual Monday-morning staff briefing for Fed governors to Monday afternoon so the presidents could participate. He circulated questions that he wanted the presidents to address in Monday afternoon’s discussion. It was the academic’s approach to monetary policy: a seminar first, then a decision on what to do.

Sentiment among Fed officials to cut rates was strong. Although markets were betting the Fed would cut the key rate by one-half percentage point to 0.5 percent, six of the twelve Fed regional banks used their discount-rate petitions to signal support for dropping the Fed’s key rate target by a larger than anticipated three-quarters of a percentage point to just 0.25 percent — even hard-liner Jeff Lacker’s Richmond Fed joined the parade. Three other banks indicated they favored lowering rates to one-half percentage point. And even the three regional Feds that didn’t want any rate cut — St. Louis, Kansas City, and Dallas — weren’t optimistic about the economy; they just “preferred for now” to use ways other than interest-rate cuts “to stimulate the economy,” according to a Fed summary of their views.

The huge sums the Fed already had pumped into the economy had diluted the importance of the FOMC’s target for the federal funds rate. In ordinary times, the trading desk at the New York Fed could keep the rate close to the committee’s goal. By buying Treasury securities, the New York Fed put money into the market and pushed the rate down; by selling securities and draining money, it pushed the rate up. Early in the Great Panic, when the Fed lent banks money through the traditional discount window or the new Term Auction Facility, it had drained an equivalent amount elsewhere. But these were not ordinary times. Since September, the Fed had been lending so much in so many different ways — through its alphabet soup of initiatives — that it couldn’t drain enough money elsewhere to offset the added credit. Ultimately the Fed stopped trying, leaving banks and traders to push the
actual
market federal funds rate toward zero, well below the Fed’s stated target.

Since the key short-term interest rate appeared headed to zero anyhow, Fed officials reasoned, why not let it get there quickly? So the FOMC agreed to cut the target for the federal funds rate to a range of between zero and 0.25 percentage point — effectively to zero, a milestone in monetary policy.
Whatever it takes
.

Once the federal funds rate was at zero, then what? The Fed’s models of the economy suggested that, with unemployment rising and inflation quiescent, the federal funds rate should be three or four percentage points
below
the inflation rate. However, with an underlying inflation rate of roughly 2 percent, it was impossible for the Fed to get its interest rate low enough — even zero was too high. The Fed was forced to confront one of the few immutable facts of monetary policy: a central bank cannot easily cut the sticker price for money below 0 percent, a circumstance the Bank of Japan had confronted in the 1990s. Though the Fed had contemplated this possibility during the U.S. deflation scare of the early 2000s, it was now a living reality. Before the Fed shot the last bullet in its interest-rate gun, it needed to figure out what it could do next — and how to explain this new approach.

The intellectual foundations of the discussion were already laid. Bernanke and the Fed staff had been contemplating ZIRP for years. Brian Madigan, the top Fed monetary staffer, had written about monetary policy in a world of zero interest rates as early as 1994. An influential 1999 research paper by two respected Fed economists, David Reifschneider and John C. Williams, had offered an aggressive prescription for this circumstance: cut the federal funds rate early and sharply to give the economy an early push to compensate for times when the rate will be higher than warranted (because it cannot fall below zero). In his 2002 speech “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” Bernanke himself had previewed many of the options that were now on the table in 2008. “A central bank whose accustomed policy rate has been forced down to zero has most definitely
not
run out of ammunition,” he said then. He believed it still.

But all this theoretical talk of zero interest rates was akin to physicists plotting the course of an as-yet-unbuilt rocket on a computer screen. “Such episodes are fairly rare,” Reifschneider and Williams had observed accurately — “about once every 100 years.” When they briefed the FOMC in person in January 2002 — while the federal funds rate was at 1.75 percent and
falling — Reifschneider had confessed that much was still unknown: “We did the best we could, though we’re extremely uncertain about what would actually take place. The only real guide is to look back at either the Great Depression of the United States or at the more recent experience of Japan.”

In a transcript of the same meeting, Greenspan described the discussion as “a rather interesting conversation, and I trust an academic one.” No longer: the Fed was like a team of rocket scientists poised to push the launch button, uncertain whether the weather, sunspots, or some undiagnosed mechanical malfunction might divert the rocket from its computer-plotted course.

Developing monetary policy for a weakened economy while the federal funds rate hovered in ZIRP territory raised two distinct sets of issues. One knot of questions clustered at the intersection of ideology, economic theory, and practicality: How best to use the Fed’s ability to print unlimited amounts of money to compensate for the private players’ unwillingness or inability to provide credit? How best to calibrate what the Fed was doing?

The second issue was turf, which, in Fed deliberations, went by the more dignified term “governance.” Would big decisions be made by the Fed governors in Washington or by the entire committee, which included the regional bank presidents? Given the peculiarities of the Federal Reserve Act, the answer depended crucially on how the Fed described what it was doing.

The menu of monetary policy options was laid out, as always, in the Blue Book prepared before every FOMC meeting by Brian Madigan. The custom had been to offer three alternative interest-rate options to the FOMC on late Thursday before the meeting. At times of economic weakness, for instance, the choices usually were (a) cut interest rates a lot, (b) cut them a little, or (c) don’t cut them at all. Insiders joked that the
right
answer, the one the chairman favored, was usually (b), the middle answer and the middle ground. The Blue Book also offered alternative wording for the Fed’s end-of-meeting statement, a couple of paragraphs that were scrutinized by traders, economists, Fed watchers, and the financial press with the devotion of Talmudic scholars.

This Blue Book was different. Working even more closely with Bernanke than usual, Madigan offered
four
options, none of which resembled anything the FOMC had said before. One option dropped even a mention of a federal
funds rate, the Fed’s primary lever for decades and the centerpiece of every communiqué it had been issuing since 1994 — a clear indication of how unusual this moment was.

Breaking with his own tradition of speaking last at FOMC meetings, Bernanke spoke first — for about fifteen minutes, according to participants. He talked about issues of substance and questions of “governance.” Bernanke also talked a lot about harmony, trying to set a tone for what he knew threatened to be a divisive discussion. “We need to collaborate, work together, and do things in good faith,” he said. He was clear that he wanted the Fed to continue aggressive lending targeted at markets that weren’t functioning. But he gave few hints as to what he wanted the Fed to say. He sought consensus and was prepared to rewrite the statement at the meeting if necessary. With these unusual efforts, Bernanke attempted to start — productively — confronting a question simpler to state than answer: What else can the Fed do once it has bottomed out its short-term interest rate?

One device was rhetorical: be explicit about the Fed’s intent to hold short-term interest rates low for a long time in the hope of influencing longer-term rates. The rates on five- and ten-year Treasury securities are, in part, a bet on where the Fed will set short-term rates over that period. So, by promising to keep short-term rates low, the Fed hoped the bond market would pull down longer-term rates, key numbers for the interest rates that companies and home buyers pay.

However, some FOMC members had misgivings about making this promise. The conventional wisdom, both in and out of the Fed, was that Greenspan had held interest rates too low for too long earlier in the decade, a policy embodied in the Fed’s August 2003 promise to keep rates low for a “considerable period.” Several Fed officials wanted to be sure the Fed would raise rates promptly when the day for that came.

A few members of the FOMC argued for eliminating any reference to the federal funds rate. They said this would “focus attention” on the shift
in Fed policy away from targeting interest rates toward directly expanding the amount of credit in the economy. This option had one side effect that appealed to a few of the regional Fed bank presidents: it might help struggling small banks in their districts that tended to link rates they charged on loans to the Fed-set rates. If the Fed didn’t have any explicit target for the federal funds rate, they reasoned, the banks could charge higher rates on loans, fatten their profits, and rebuild their capital cushions. It wasn’t a winning argument. Others countered that the goal was helping the economy, not bank profits. In the end, the FOMC’s statement made what was, for the Fed, a strong promise about the future: “The committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

It was a remarkable example of the Fed using words as a substitute for action. The Fed couldn’t make credit any cheaper to banks than 0 percent, but instead, with a few carefully selected phrases, it was trying to
talk down
interest rates it didn’t directly control.

A second device was to set a public target for the inflation rate and then vow to do whatever it took to achieve it. This wasn’t a new idea, of course. Bernanke had been advocating an inflation target for years. But it took on a different cast at a time when the inflation rate was falling and the conversation crackled with fear about deflation, a widespread decline in prices and wages. At earlier discussions, advocates of an inflation target were the inflation hard-liners, the hawks; their opponents tended to be those who worried more about unemployment. But now, some of the doves found a target appealing: the Fed would be promising to keep inflation from falling too low, even to push up prices if necessary.

There was also talk at the meeting of publicly promising to avoid “an unwelcome decline” in inflation, one of the options in Madigan’s Blue Book. But setting a specific target raised thorny issues, not the least of which was exactly what number to pick as the target. One camp favored a target for the
Fed’s favorite inflation gauge close to 1.5 percent a year; another 2 percent. The committee, unable to find a consensus, punted. The result: the FOMC statement vowed to “preserve price stability,” a phrase meant to convey a determination to avoid too much and too little inflation, and the inflation target discussion was deferred. (In January 2009, the FOMC decided against an explicit target to avoid an unwelcome political debate, but it provided something very close: each member of the committee offered a forecast for inflation five or six years in the future, which was basically his or her inflation target. Most put the inflation goal at between 1.9 percent and 2 percent. A minority wanted it a lower 1.75 percent or even 1.5 percent.)