Should Bernanke and the Fed Have Moved Sooner?

The posting for February 4 ended with a concern shared by many, that Bernanke and the Fed did not act in 2007 soon enough or with enough force to advert a major economic or financial dislocation. This week we take a closer look at the accusation. First, let me say that it is important to know how people and agencies have responded in the past so that we can have some view as to how they will act in the future. Learning about how the Federal Reserve acted in 2007, might help us to anticipate what could happen in 2008 or beyond. We still have to be cautious, however, because making monetary policy is an art and not a science and no two market situations are ever exactly alike.

Furthermore, we must continually realize that there is only so much a central bank can do. It needs, in a sense, to ‘keep its powder dry’ so that it can act when it is really needed. If it is always chasing the latest statistic or piece of market psychology then it will not be as effective when its actions are really needed. So, in setting the stage for a review of some of the events that took place in 2007 we must remember that through most of the year the economy seemed to be growing at a relatively decent pace and the rate of inflation experienced tended to be slightly higher than the Federal Reserve had stated was desirable. The value of the United States dollar continued to decline and there was concern that it would decline further in 2007 and 2008. In summary, it seemed as if there was less risk of economic growth declining, especially in the first three quarters of the year, than there was of the possibility of inflation remaining too high and the dollar declining further. Federal Reserve policy statements reflected these factors.

In terms of financial markets, the first real information that became public about the problems in the housing market and in subprime lending came about in February, 2007. I remember the first time information on this really caught my attention. It was early in February when I picked up a small article buried in the third section, the Money & Investing section, of the Wall Street Journal. I began to pay attention to similar articles and I tracked the news as it moved from deep in the third section of the paper to nearer the first page of the third section to the first section, second page and so on. Knowledge of the problems in these areas was limited, little alarm was raised, and that alarm was often dismissed.

As new information on the situation continued to surface, the Federal Reserve had to incorporate this new information into its analysis of the performance of financial markets and the real economy. But, concerns over these two areas were only a small part of the total picture the Fed had to keep track of.

The liquidity of the financial markets is really the first thing that the Fed pays attention to. Why? The Fed is a participant in the money markets because it has to operate in these markets on a daily basis. Thus, the traders on the Open Market Desk in New York have the first knowledge of whether or not the money markets are experiencing a change in liquidity. This is where the story usually begins.

To examine the year 2007, let’s start out with what occurred in the banking system. Here one finds some counter-intuitive results: Total Bank Reserves and Nonborrowed Reserves declined throughout the year on a year-over-year basis. The initial interpretation of these data is that the Federal Reserve was tightening up on bank reserve positions. Digging deeper we see that Required Reserves in the banking system declined as well. The year-over-year rate of decline of Required Reserves was around 4.0% in the first half of the year and around a 2.0% rate of decline in the second half. This seems to re-enforce the interpretation that the Fed was tightening throughout the year. Furthermore, we see that the narrow measure of the money stock, M1, also declined throughout the year. The year-over-year rate of change of this measure was negative throughout the year except for the months of September and October when the rates of growth were modestly positive.

The picture begins to clear up when we examine the year-over-year rate of growth of the broader measure of the money stock, M2, which was positive throughout the year, growing at a rate between 5.3% and 6.4%. The conclusion one draws from this is that people were moving funds from transactions deposits at banks that required bank reserves to time and savings deposits that required few or no bank reserves. That is, bank reserves were being released throughout the year as a result of people moving their financial resources around within the banking system.

The Federal Reserve responded to this release of reserves by reducing the amount of reserves in the banking system. Operationally, the Federal Reserve does not like ‘sloppy’ money markets because it cannot tell where the market is if it is not ‘taunt.’ Therefore, it removed these excess reserves as they were released. This seemingly caused no harm to the money markets. The escape valve for the banking system experiencing undue pressure is the Federal Reserve’s Discount Window. Primary borrowings at the Discount Window remained very low during this time with not much variation up until August. The only conclusion I can draw from this is that through July 2007, the Federal Reserve perceived no extraordinary liquidity pressures in the money markets. Hence, no overt action was needed.

What happened in August and September? The Federal Reserve sensed some pressure in the money markets and wanted to maintain the “orderly functioning” of these financial markets. On August 17 there was a reduction in the Fed’s discount rate to avoid “deterioration of financial markets.’ Looking at the data from the Federal Reserve statistical release H.4.1, Factors Affecting Reserve Balances, we see a jump in Loans to Depository Institutions of about $1.2 billion for the week ended August 22 and these loans stayed near the same level until they jumped another $1.6 billion in the banking week ended September 12 indicating some pressure was being felt within the markets. But, two other things were also happening. First, there was the usual seasonal increase in currency outstanding for the Labor Day weekend which the Fed generally supports with repurchase agreements (Repos). Repos are used because this movement reverses itself once the weekend is over. Second, there was a reduction in Treasury securities held outright of about $10.0 billion through the end of August into early September. The conclusion one can draw is that any pressures that were experienced at this time were relieved.

The target Federal Funds rate was lowered on September 18, to “avoid disruptions to the financial markets” and the discount rate was also dropped at the same time. Loans to Depository Institutions dropped back to a relatively insignificant amount while the Fed conducted repurchase agreements to smooth financial market adjustments during the week ending September 26. Whatever market pressure existed during late August through early September were satisfactorily relieved, for there appear to have been no further operational changes at the Fed through the month of October.

The Federal Funds target was dropped again on October 31 (along with another cut in the discount rate) but nothing out of the ordinary can be seen in the November data only the usual seasonal rise in currency in circulation related to the Thanksgiving/Christmas holiday season. This increase was underwritten, as usual, by a rise in repurchase agreements. So we come to December but this month, along with early 2008, needs its own post. This is because of all the “new” things that occurred, especially the introduction of the Term Auction Credit facility that was begun in that month.

The basic conclusion I draw from reviewing the data from 2007 and the actions taken by Bernanke and the Federal Reserve is that financial markets were reasonably benign. Concern arose about possible ‘disorderly markets’ in late August and early September, but this period passed without any major disruption taking place. The Fed seemingly performed well. Should the Fed have been more concerned about a looming crisis? To me, it is hard to develop an argument for a more active central bank during 2007. Apparently, Bernanke and the Fed did not make any major mistakes during the year. There was no indication at any time that a major liquidity problem was brewing…this was to come in early 2008.