Kamp's Comments - The Fed Takes Even Bolder Moves to Revive Financial Markets and the Economy

by Leo Kamp, Managing Director and Chief Investment Economist, TIAA-CREF

May 19, 2008
Since last summer, the Federal Reserve Board (the Fed) has focused on mitigating the impact of a distressed housing and residential mortgage industry on the broader economy and financial markets. Last August, the Fed, in conjunction with other central banks around the world, started to inject massive amounts of liquidity into the global financial markets, in an effort to lessen the liquidity freeze that had gripped global financial markets in the aftermath of the subprime mortgage market meltdown. These efforts were followed shortly by an interest rate cutting campaign by the Fed beginning about mid-September 2007. Seeing the economy and financial markets continuing to falter, the Fed cut interest rates aggressively throughout the remainder of 2007 and into early 2008. As a result, by the end of April of this year, the Fed funds target rate stood at just 2 percent, a full 325 basis points (3¼ percentage points) below the 5.25 percent that prevailed early last September before the aggressive rate cutting campaign began.

Additionally, throughout that period, the Fed and some other central banks continued to pump liquidity into the global financial system in a variety of ways, in some cases using quite novel means, despite the fact that inflation remained higher than desired.

So how did the economy and financial markets react to these aggressive efforts? Unfortunately, the answer has been not very well, for most of the period. Financial markets have remained quite turbulent and weak, and the U.S. economy has progressively slowed to a crawl and recently has likely fallen into recession. For instance, payroll employment declined during each of the first months of this year, after growing at a reasonable but not buoyant pace throughout the latter half of 2007. Not surprisingly, consumption (representing 70 percent of gross domestic product) and consumer confidence also became extremely weak on the heels of these declining payroll numbers. And, all this malaise occurred at the start of a politically sensitive U.S. presidential election year, putting pressure on the Congress and the Bush Administration to make things better (witness the quick passage of a fiscal stimulus package recently).

As a result of this ongoing distress, it became painfully obvious to the Fed recently that even bolder measures might be necessary to get the financial markets and the economy back to some semblance of health. Obviously, the sharp interest rate cuts and the large liquidity injections of the past several months had not been sufficient or focused enough to avoid continued financial market turmoil or to keep the economy out of recession. Indeed, much of the tepid response from the markets and the economy was not particularly surprising. Economic history indicates that it takes time (sometimes considerable time) for the economy, profits and financial markets to pick up following easing moves by the Fed, even when such moves are aggressive. While aggressive easing increases the probability of a faster pickup, there are no guarantees, since the response time has been quite variable in the past.

Moreover, the Fed was worried about the financial market stresses mounting and spreading to more asset classes and financial institutions. The financial system is much more complicated than it was before deregulation and the huge increases in derivative activities. Largely as a result of deregulation (including the 1999 elimination of the Glass-Steagall Act’s prohibition of securities underwriting by banks), financial institutions engage in a much broader range of activities that cut across financial asset categories and global boundaries. In addition, derivatives activity has soared, resulting in an immense intertwining of financial institutions and activities globally. The net result of these greater interdependencies is that financial distress in one area of the global financial system could spread rapidly to other sectors and institutions across the globe. In short, the structure of the current global financial system makes the contagion of financial distress to other parts of the system potentially more rapid and more intense. Furthermore, financial regulatory regimes globally have not kept up with the rapid changes in the system and are generally ill-equipped to deal with current financial crises, which can now potentially infect much of the global system.

Knowing this, the Fed has taken bold, innovative measures to contain a situation that had the potential to infect vast swathes of the global financial system. Bear Stearns, a well-established Wall Street brokerage firm, faced a severe liquidity crisis recently and was on the brink of defaulting on its financial commitments. Such a default had the potential to precipitate a massive global financial crisis, especially given the firm’s huge derivatives exposure ($13 trillion in notional value). To prevent this from happening, the Fed orchestrated innovative financial aid to Bear Stearns and helped to arrange their takeover by JP Morgan. Furthermore, the Fed created a facility that allowed non-bankers (including investment bankers) to borrow from the Fed using a wide range of collateral. In sum, the Fed took bold innovative moves to head off a potential global financial crisis of significant magnitude. But, even with these innovative moves, the jury is still out as to whether they are sufficient to revive the economy and financial markets. Only time will tell.

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