bernanke lecture two 20120322

7/31/2019 Bernanke Lecture Two 20120322

1/41

TH E FEDERAL RESERVE

AND THE FINANCIAL CRISIS


2/41

Lecture 2:

The Federal Reserveaft er W orld W ar II

1. Early Challenges

2. The Great M oderat ion3. Or igins of t he Recent Cr isis


3/41

W hat Is t he M ission of

a Central Bank? M a cro e c o n o m i c st a b i l i t y

- All cent ral banks use m on etary po licy t o st rive forlow and st able inf lat ion; m ost a so use m onet arypolicy to t r y to prom ote stab le grow th in out putand em ploym ent .

Financ ia l st ab i l it y- Cent ral banks t ry to ensure t hat th e nation's

f inancial system fu nct io ns properly; im port ant ly,t hey t ry to prevent or m it igate f inancia panicsorcrises.


4/41

Fed-Treasury Accord of 1951

Dur ing W or ld W ar II and sub sequen t ly , t he Fed

was pressed by the Treasury to keep longer- termin te rest rates low to a llow t he governm ent deb t

accru ed dur ing t he w ar t o be f inanced m ore

cheaply.

Keep ing in terest r ates low even as t he econo m ywas growing s t rong ly r isked economic

overhea t ing and in f la t ion .


5/41

In 1951, t he Treasury agreed t o end th e

arrangem ent and let t he Fed set in t erest ra tesindepen den t ly as needed to ach ieve econo m ic

stabi l i ty .

Th e Fed has rem ained indep end ent since 1951,

cond uc t ing m one t ary po l icy to fost e r econo m icst ab i li t y w i th ou t respon d ing t o sho r t - te rm

pol i t ical pressures.


6/41

The Fed in the 1950s and Early 1960s

Chai rman, 1951-1970

[ q u o t e ] " I n f l a t i o n is a t hief in

th e night and if w edon't act prom ptly anddecisively w e w ill

always be behind."[end o f quote . ]

Be tw e en W o r ld W ar II an d t h erecent f inancial cr is is,

macroeconomic s tab i l i t y was

the p redominan t conce rn o f

centra l banks. Dur ing m ost o f t he 1950s and

early 1960s, the Federal

Reserve fo l low ed a " lean

against th e w ind " m one t arypo l icy t ha t sou ght t o keep

bo th in f l at i on and econo m ic

growth reasonab ly s tab le .


7/41

The Great Inflat ion : M onetary Policy

from t he M id-1960s t o 1979 St a r t i ng in t he m id -

1960s , moneta ry

pol icy was too easy.

Th is st ance led t o a

surge in in f la t ion and

in f la t ion expecta t ions .

In f lat ion peaked atabou t 13 percen t .

I n f l a t i o n

[For the accessible version of this figure, please see the accompanying HTML.]


8/41

The Great Inflat ion :W hy W as M onetary Policy Too Easy?

M o n e ta r y p o l icy m ak ers w e re t o o o p t im i st i cab o u t h o w " h o t " t h e e co n o m y co u ld r un w i t h o u t

genera t ing in f la t ion pr essur es.

W hen in f l at i on began t o r ise , m one t a rypo l icymakers responded too s lowly .


9/41

Exacerb ating fact or s included- o i l and fo od p r ice sho cks

- f iscal po l icies (such as sp en d in g fo r t h e

V ie tn am W ar ) t ha t st re tched econo m ic

capaci ty

- N ixon 's w age-pr ice con t ro ls t ha t a r t i f icial ly

he ld dow n in f lat i on fo r a t im e


10/41

Central Banking in an Evolving Economy

[ imageo f ]Ar thur Burns

Cha i rman, 1970-1978

w or ld the oppor tun i t iesfor making mistakes arelegion."[end of quot e].

These exper iences i llust ratehow cent ral banks have t ost ru ggle w it h an evolvingeconomy and imperfect

knowledge.


11/41

The Volcker Disinflation

[ imageo f ]Paul Volcker

Cha i rman, 1979-1987

[ q u o t e ] " T o b r e a k t h e [ i n f l a t i o n ]

c y c l e , . . . w e m u s t h a v e

c r e d i b l e a n d d i s c i p l i n e d

m o n e t a r y p o l i c y . " [ e n d o fq u o t e ] .

To sub du e dou b le -d igi tin f la t ion , Cha i rm an Vo lcker

anno un ced , in Oct ob er 1979 ,

a d ram at ic b reak in t he w ay

tha t mone ta ry po l i cy wou ldopera te .

In pract ice , t he new

approach to moneta ry po l i cy

involved h igh in terest ra tes

(t i gh t m oney ) to slow t he

economy and f igh t in f la t ion .


12/41

Inflat ion in t he 1980s

In t he years af t e r t he

new d isc ip l ined

monetary po l icy began,

in f la t ion fe l l m arked ly. W h e n C h a i r m a n

Volcker lef t h is post in

1987, the in f la t ion ra te

w as a roun d 3 t o 4

percen t .

I n f l a t i o n



13/41

The 1981-1982 Recession

The h igh in t erest ra tes

needed t o b r ing dow n

in f la t ion were cost ly .

In t he sharp recessiondur ing 1981 and 1982,

u n e m p lo y m e n t p e a k e d

at n ear ly 11 per cent .

Unemployment Rate



14/41

The Great Moderation

Chai rman, 1987-2006

[quo t e] " . . . a n e n v i r o n m e n t o f

g r e a t e r e c o n o m i c s t a b i l i t y

h a s b e e n k e y t o

i m p r e s s i v e g r o w t h i n t h e

s t a n d a r d s o f l i v i n g a n d

e c o n o m i c w e l f a r e s o

e v i d e n t i n t h e U n i t e d

S t a t e s . " [endo fquote.]

Dur ing t he Great In f lat ion o fthe 1970s , bo th ou tpu t and

in f la t ion were h igh ly vo la t i le .

Fo l low ing t he Vo lcker

d isin f l at i on , f rom t he m id -1980s th rough 2007

(pr imar i ly Cha i rman

Greenspan 's te rm) , bo th

o u t p u t an d i n f lat i o n w e rem uch less vo lat i le .

Th is w as t he per iod o f " The

Great M oderat ion ."


15/41

The Variabilit y of Real GDP Grow t hReal GDP Grow th



16/41

The Variabil ity of InflationCPI Inf lat io n



17/41

Understanding the Great Moderation

Im proved m one t ary po l icy af t e r 1979 con t r ibu t ed

to t h e Gre at M o d e rat i o n . In par t i cu lar , low and st ab le in f lat ion p ro m ot ed

broader economic s tab i l i ty .

St ru ct ur a l change (such as bet t e r invent or y

management) and s imple good luck may a lso

have con t r ibu ted .


18/41

Financial st resses occur red ( for exam ple, t h e

1987 stock market crash) , but they d id not causem ajo r econo m ic dam age .

- One except ion w as a bo om and bust in the stockpr ices of " dot -com " com panies t hat t ouched off a

m ild recession in 2001. Because o f t he re lat i ve t ranqu i li t y du r ing t h is

per iod , monetary po l icy genera l ly rece ived

greater emphasis than f inancia l s tab i l i ty po l ic ies.


19/41

Prelude t o the Financial Cr isis:

The Housing Bubble From t he late

1990s unt i l ear ly

2006, house pr ices

soared 130

percen t .

M e a n w h i l e ,

mor tgage lend ings tandards

de te r io ra ted .

Prices ofExisting Single-Family Houses



20/41

Inflationary House Price Psychology

Rising h ou se pr ices andweaken ing mor tgage s tandards

fed o f f each o t her :

- Rising house pr ices created an

expectat ion t hat hou sing w as a" can't lose" investm ent.

- Lax underw rit ing and t heavailabil ity of exotic m ort gages

drove up dem and for housing,raising pr ices fu rt her.


21/41

Det eriorat ion o f M ort gage Quali t y

Pr io r t o t he ear ly 2000s, ho m ebuyers typ ical ly

m ade a sign i f i can t d ow n p aym ent anddo cum ent ed t he i r f inances in de ta i l.

But as ho use pr ices ro se, m any lenders began

o f fe r ing m or t gages t o less-qua li f ied bor row ers(nonpr ime mor tgages) tha t requ i red l i t t le o r no

d o w n p a ym e n t a n d lit t le o r n o d o cu m e n ta t i o n .


22/41

The Deterioration of Mortgage QualityN o n p r i m e M o r t g a g e Or i g i n a t i o n s

( A s a s h a r e o f t o t a l o r i g i n a t i o n s )


P e r c e n t o f N o n p r i m e Lo a n s w i t h

L o w o r N o D o c u m e n t a t i o n



23/41

The House Price Bubble Bursts

Hou se pr ice increasesmade housing less

a f fo rdab le .

M o r t gage p ay m e n t s

as a shar e of incom e

rose sharply.

Event ual ly, r ising

costs ofh o m e o w n e r s h i p

began t o dam p

hous ing demand.

M o r t g a g e D e b t Se r v i c e R a t i o



24/41

Decl in ing dem and fo rho uses led t o a dro p

in house pr ices

beginning in ear ly

2006 .

Since t hen , hou se

pr ices have fa l len

m o re t h a n 3 0

percen t .

P r i c e s o f Ex i s t i n g Si n g l e - F a m i l y H o u s e s



25/41

The Af t erm ath of t he House Price Bust

As ho use pr ices fe l l ,

bo r rowersespec ia l l y

t h o se w h o h a d m ad e

lit t le o r no do w npaymentincreas ing ly

w e n t " u n d e r w a t e r "

(o w e d m o re on t h e i r

m or t gages t han t he i rhouses w e re w o r t h ) .

M or t gages w i t h Nega t i ve Equ i t y



26/41

M o r tg age d e li n q u e n cies

and f o r eclosures

surged.

M o r t g a g e D e l i n q u e n c i e s



27/41

Banks and o t her ho lders o f m or t gage-re lat ed

securi t ies suffered sizable lossesa key tr igger ofthe crisis.


28/41

How a Housing Bust Became a Financial

Crisis: Triggers versus Vulnerabilities

It is im po r t an t t o d ist ingu ish be t w een t r iggersand vu lnerab i l i t ies :

- The decline in house p rices and t he associatedm or tgage losses w ere key tr iggers of t he crisis.

- The effect s of t ho se t riggers w ere am plif ied byvulnerabil it ies in t he econo m y and f inancialsystem.


29/41

Private-Sector Vulnerabilities

Perhaps lu l led in to com placency du r ing t he Great

M odera t ion , bo r ro w ers and lenders t ook on to omuch debt ( leverage) .

Banks and o t her f in anc ial inst i t u t ions fa i led t oadequa te ly m on i t o r and m anage t he r i sks t hey

w ere t ak ing (fo r exam p le , exposures t o sub pr im e

mor tgages) .


30/41

Fi rm s re l ied excessive ly on sho r t - t e rm fu nd ing,

such as com m erc ia l paper.

The increased use o f exot ic f in anc ia l ins t r um ent s

concent ra ted r isk .


31/41

Gaps in t he regu lat o ry st ruc t u re lef t im po r t an t

f i rms w i thou t s t rong superv is ion ( fo r examp le ,AIG).

Ther e w ere fa ilu res o f regu lat ion and sup erv ision ,

inc lud ing consumer p ro tec t ion .

Insu f f i cien t a t t en t ion w as pa id t o t he st ab il it y o f

t he f inan c ia l syst em as a w ho le .


32/41

The Role of M onetary Policy

Som e have argued t ha t th e Fed 's low in t erest rate

m onet a ry po l icy in t he ear ly 2000s con t r ibu t ed t ot he hou sing bu bb le , w h ich in t u r n w as a t r igger o f

the crisis.


33/41

M ost ev idence suggest s o t he rw ise :

- Int ernat ional com par isons: For exam ple, th eUnited Kingdom had a house pr ice boom dur ingth e 2000s despi te t ight er m onetary pol icy than t heUnited States.

- Size of t hebubble: Changes in mortgage ratesduring th e boom years seem ed far too sm al l toaccount for the magnitude of house priceincreases.


34/41

- Tim ing oft hebubble: House pr ices began to pickup (late 1990s) before monetary policy beganeasing and rose sharp ly after m onetary po licybegan tightening (2004).

Econ om ist s con t inue t o deb a te t h is i ssue .


35/41

References on M onetary Policy Role

Kenneth Kut tner (for th com ing). "Low In terest Rates and Housing Bubbles:

Sti l l No Smoking Gun," in Douglas Evanoff, ed., The Role of Cent ral Banks in

Financial St abil it y: How Ha s it Chang ed? Hackensack, N.J.: World Scienti f ic.

Jane Dokko and ot hers (2011) . "M onet ary Pol icy and t he Housing Bubble,"

EconomicPolicy, vol . 26 (Apr i l ), pp. 2 37 -87 .

Carm en Reinhart and Vincen t Reinhart (2011). " Pr ide Goes befo re a Fall :

Feder al Reserve Policy and Asset M arket s," NBER W or king Paper Serie s 168 15.

Cam br idge, M ass.: Natio nal Bureau of Econom ic Research, February. Ben S. Bernanke (2010). " M on et ary Pol icy and t he Housing Bubble," speech

del ivered at t he Annual M eet ing of t he Am er ican Econom ic Associat ion,

Atlanta, Ga., January 3,

www. federa l reserve .gov /newsevents /speech /bernanke20100103a.h tm.


36/41

Econom ic Consequences of t he Cr isis

Finan cial st re ss

skyrocketed. (Note :

Shaded areas represent

per iod s of recession .)

F i n a n c i a l St r e s s I n d e x



37/41

The st ock m arke t

p lunged .

S A P 5 0 0 C o m p o s i t e I n d e x



38/41

Ho m e co n st r u ct i o n

cont inued i ts sharp

dec l ine .

S i n g l e - F a m i l y H o u s i n g S t a r t s



39/41

T h e u n e m p l o y m e n t r a t e

rose sharply.

U n e m p l o y m e n t R a t e



40/41

The next t w o lect u res exam ine t he un fo ld ing o f

t h e cr isis and t h e recession and descr ib e t h e po l icy

response:- Lecture 3 describes t he fin ancial st ability po licy

respo nses t o t he crisis and recession by t he Fedand others.

- Lecture 4 discusses m onetary po licy respo nses t othe recession, the sluggish recovery, post-crisischanges in financial regulation, and theim plications of t he crisis for cent ral bank pract ice.

t


41/41

TH E FEDERAL RESERVE

AND THE FINANCIAL CRISIS

bernanke lecture two 20120322

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