Earlier this week Jim Hamilton had an informative post -- for my students, consider this a recommendation -- on financial crises and the role of the Fed:
There are two factors that could make some institutions a poor credit risk in such circumstances. The first is solvency problems-- if the value of gross assets of a bank is less than its liabilities, there is no way for creditors to get all their money back. In this case, the sooner you get your deposits out of the bank, the better off you will be. The second issue is liquidity problems-- the bank may have assets in excess of its liabilities, but trying to convert these assets into immediate cash could be very costly...
With the establishment of the Federal Reserve in 1913, the United States obtained an institution with the power to create as much liquidity as might be needed to completely eliminate the second and most damaging element of historical financial panics.
At Economic Dreams - Economic Nightmares, Dave Iverson picks up on Professor Hamilton's closing thoughts:
... the Fed's capacity to move aggressively [in providing liquidity] is potentially limited by the need to avoid a precipitous collapse in the value of the dollar. Whether the outcome would look more like the U.S. in 2001 or Korea in 1997 remains to be seen.
The reference to the U.S. in 2001 refers to this...
Along with the loss of life and property when the World Trade Center towers collapsed on September 11, many of the financial institutions that played a key role in trades of government securities and interbank loans were wiped out or incapacitated, posing potentially huge liquidity problems. The Fed reacted with an extremely aggressive temporary creation of reserves, which prevented those liquidity disruptions from having major consequences.
... and the reference to Korea 1997 refers to this:
... other countries continue to experience a closely related phenomenon, exemplified by the currency and financial crises of 1997. If you're a smaller country like Korea for which a lot of the short-term debt is denominated in dollars, your central bank does not have the power to create extra dollars if everybody suddenly demands their payment and refuses to extend credit. Trying to flood the market with more of your own currency is just going to make the outflow of capital more severe.
It might be worth noting that, in the aftermath of 9-11, the immediate actions of the Federal Reserve were concentrated in the area of discount window lending, or direct loans to financial institutions. This response was not so much about "flooding the market" with currency -- initially, the federal funds market was inoperative -- but about temporarily replacing funds that were in effect "locked up" because they could not be transferred from the affected financial institutions in New York City. (To provide some perspective on the magnitude of this operation, on a typical day discount window lending by the System might be on the order of $200-500 million. On September 12 the value was in the neighborhood of $45 billion. The total for the week was about $90 billion.)
As things progressed over the week of 9/11 and into the week after, standard open market operations once again took center stage, and "flooding the market" with liquidity is an apt description as the sharp decline in the effective federal funds rate indicates that more reserves were being supplied than demanded at the pre-9/11 price:
The key word in Jim Hamilton's description of this event -- evident in the picture -- is "temporary": Once markets stabilized, policy returned more or less to normal (or at least as normal as it could be under the circumstances).
With that in mind, I'll suggest that U.S. monetary policy in the fall of 1998 might provide a better contrast than Korea 1997. You'll recall that the Asian currency crisis of summer 1997 was followed by the devaluation of the Russian ruble and the subsequent fall of Long-Term Capital Management in August 1998. Those events were followed by this in September...
The Federal Open Market Committee decided today to ease the stance of monetary policy slightly, expecting the federal funds rate to decline 1/4 percentage point to around 5-1/4 percent.
The action was taken to cushion the effects on prospective economic growth in the United States of increasing weakness in foreign economies and of less accommodative financial conditions domestically. The recent changes in the global economy and adjustments in U.S. financial markets mean that a slightly lower federal funds rate should now be consistent with keeping inflation low and sustaining economic growth going forward.
... and yet another rate cut following a special unscheduled conference call in October:
The Federal Reserve today announced the following set of policy actions:
- The Board of Governors approved a reduction in the discount rate by 25 basis points from 5 percent to 4-3/4 percent.
- The federal funds rate is expected to fall 25 basis points from around 5-1/4 percent to around 5 percent.
Growing caution by lenders and unsettled conditions in financial markets more generally are likely to be restraining aggregate demand in the future. Against this backdrop, further easing of the stance of monetary policy was judged to be warranted to sustain economic growth in the context of contained inflation.
The Federal Open Market Committee would choose to move one more time, at their next meeting in November:
The Federal Reserve today announced the following set of policy actions:
- The Board of Governors approved a reduction in the discount rate by 25 basis points from 4-3/4 percent to 4-1/2 percent.
- The federal funds rate is expected to fall 25 basis points from around 5 percent to around 4-3/4 percent.
Although conditions in financial markets have settled down materially since mid-October, unusual strains remain. With the 75 basis point decline in the federal funds rate since September, financial conditions can reasonably be expected to be consistent with fostering sustained economic expansion while keeping inflationary pressures subdued.
This series of rate cuts would not be so temporary. The federal funds rate target remained at 4-3/4 percent until June 1999, a fact that did not please everyone. From the minutes of the November meeting:
[Cleveland Fed President Jerry] Jordan dissented because he believed that the two recent reductions in the Federal funds rate were sufficient responses to the stresses in financial markets that had emerged suddenly in late August. An additional rate reduction risked fueling an unsustainably strong growth rate of domestic demand. He expressed concern that the excessively rapid rates of growth of the monetary and credit aggregates were inconsistent with continued low inflation. Moreover, any further monetary expansion in response to economic weakness abroad could ultimately have a disrupting influence on domestic prosperity if policy were forced to reverse course at a later date to defend the purchasing power of the dollar.
In fact, the rate of inflation accelerated through 1999 and into 2000, prompting a cumulative increase in the federal funds rate target of 175 basis points between June 1999 and May 2000. In retrospect, it is clear that the economy began to weaken in earnest soon after. One would, I think, be forgiven for entertaining the thought that the FOMC may have gone too far, and hung on too long, in its response to the very real liquidity strains in Autumn 1998. Consequently, some people might be tempted to rephrase the Hamilton question just slightly: In the event that "the Fed can and will prevent [potential liquidity strains] from cascading into broader liquidity problems," will the outcome be more like the U.S. in 2001 or the U.S. in 1998?