He turned on the Fed’s printing presses

TO BE NOTED: From New York:

"Thank Bernanke

More than Obama, more than Geithner, more than anyone, it is the once-maligned Federal Reserve chairman who has saved us from the second Great Depression.

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• By James J. Cramer
• Published Jun 5, 2009

Illustration by André Carrilho

I’ll just come right out and say it: Ben Bernanke will go down as the greatest Federal Reserve chairman in history. The soft-spoken academic who has toiled in the shadows of his legendarily self-promoting predecessor, Alan Greenspan, will be known as the man who averted the Great Depression Two, a sequel that could have eliminated the United States as a world financial superpower and reduced us to this century’s Britain. Make no mistake about the parentage of this success story. President Obama pushed through a stimulus plan that will ultimately help the economy later this year, and Treasury Secretary Tim Geithner chose to adopt Bernanke’s strategy of allowing banks to raise money themselves rather than bowing to calls from politicians and pundits to have taxpayers bail them out even more than they already had. But it was the 55-year-old former Princeton professor who spent his teaching career studying how the Great Depression could have been prevented who deserves the bulk of the credit.

I wasn’t always a fan. For a year after he took the helm from Greenspan in 2006 until the middle of 2008, as it became increasingly clear that the housing market’s crash and the subprime fiasco were getting out of hand, Bernanke simply toed the official line of George W. Bush: The fundamentals are sound. He was slow to cut interest rates, his primary tool to stave off recession, and he handled the Fed as if it were a Princeton debating society, polling the members endlessly and deferring to the inflation hawks. His unwillingness to challenge those who were calling for rate increases to fight inflation in what remains the closest we’ve come to a deflationary spiral since the mid-fifties froze the Fed at a time when the worst of the crisis could have been avoided. Bernanke can’t be absolved for his lack of decisive action in that moment. He assured people in the spring of 2008 that there was no financial chaos worth worrying about. He looked at an economic canvas that resembled a kindergartner’s finger painting and saw a Van Gogh. (At least that was a more accurate critique than that of then–Treasury Secretary Hank Paulson, who thought we were looking at the Mona Lisa.)

But the downfall of Lehman Brothers, a collapse Bernanke and then–New York Fed chief Tim Geithner acceded to when Paulson decided that someone had to pay for the moral hazard, changed everything. Suddenly, as credit froze and production and stocks plummeted as fast as they had between 1929 and 1932, Bernanke broke ranks with the complacency crowd and the inflationistas and relied on the lessons he’d learned back at Princeton to quickly take interest rates to an unheard-of zero percent. He turned on the Fed’s printing presses, forcing dollars into the banking system, and began to buy $500 billion in mortgage bonds to force rates down to stop runaway foreclosures and keep people in their homes. That was the most aggressive policy change in the Fed’s history, something that amounted to nothing short of an economic putsch that bridged the interregnum between presidents and continues to this day.

And we needed it. Just at the time Bernanke seized financial power, the new president took aim at Wall Street, somehow separating it from Main Street, as if the “people” didn’t own stocks and only the rich were being hurt by the massive declines in the stock and bond markets. His famous comment about banks and bankers—“There will be time for them to make profits, and there will be time for them to get bonuses. Now is not that time”—uttered offhandedly soon after his inauguration, caused a stock-market sell-off of what had seemed to be unimaginable proportions even in the horrific bear market that began in 2007. Suddenly, at the point when capitalism was teetering, perhaps far worse than we realize today, the president and his Treasury secretary seemed to be on the verge of nationalizing the banking system to teach those malefactors of wealth a lesson about what life is like outside New York City. The president seemed to be oblivious to the fact that the public was “all in”—that any amount of tax relief would never make up for the tens of thousands of dollars being lost in 401(k)s and 529s and IRAs, in part because of the president’s desire to overtax and demonize Wall Street. By early March, it seemed that if you didn’t work for a federal, state, or local union, or the UAW, Obama branded you a public enemy and would soon force you to wear a dollar sign on your coat when you went outside.

That’s when Bernanke decided to take matters into his own hands in a way that lifetime followers of the famously secretive Fed still can’t believe. He went on 60 Minutes. We may not have known it at the time (unless you’re a financial type, his appearance wasn’t exactly riveting), but when we look back at the beginning of the new bull market of 2009, the one that has taken prices up 30 percent from their bottom, we will discover that Monday morning, March 16, the day after Bernanke sat down and talked to us straight about the jam we were in, was a seminal day.

First, he admitted that we verged on a second Great Depression. I think he knew that we were actually in one, a garden-variety version, but we won’t know that until his memoirs are published. But, he told Scott Pelley, he had a plan and it would work and the nation’s economy would be stabilized by year’s end. It was his clear, simple, no-gobbledygook sentences, spoken calmly and confidently at the camera, that saved the day. Such plainspokenness shocked those of us used to the deliberately opaque statements of Greenspan, a smart tactic for the former chief because it made his tenure so inscrutable, a horrid tactic for the country because Greenspan could and did get away with anything, including helping to create the housing and stock-market bubbles.

Bernanke then proceeded to eviscerate the laissez-faire economics of the previous administration and its endless faith in the markets that produced the fiasco that was Lehman Brothers. At the same time, he made it clear to Obama that the new president was using the wrong road map when castigating Wall Street, because Wall Street leads directly to Main Street. For emphasis, he made it personal: “I came from Main Street. That’s my background. I’ve never been on Wall Street, and I care about Wall Street for one reason and one reason only—because what happens on Wall Street matters to Main Street,” something he said he knew because his father couldn’t get credit for his small business in Dillon, South Carolina, without the help of the big bankers whom Obama was castigating.

In the interview, he gave a stern warning to the hedge-fund managers and other investors who were driving down financial stocks, and everything else along with them, telling Americans that our large national banks, including Citigroup, Wells Fargo, and Bank of America, all of which seemed to be slated for nationalization, “are not going to fail.” He said he was working on a stress test that would make it clear to the public that it would be safe to invest in banks again, and that we’d see the results soon enough.

Finally, he gave us hope. He said he saw “green shoots” of recovery, a phrase that has taken hold in the mainstream and created a sense of optimism about the economy’s emerging from dormancy.

The performance, and Bernanke’s impressive follow-through, marked a turning point. Banks have easily been able to raise the $74 billion that Bernanke and Treasury Secretary Geithner required them to raise in the now incredibly successful stress-test exercise. Mortgage rates have come down dramatically, helping vanquish the housing gluts in Florida, Arizona, and California. In California, which accounts for a huge portion of the housing calamity, we’ve seen two straight months of housing-price appreciation and dramatic increases in turnover, as foreclosed homes get sold by the hundreds of thousands and banks’ balance sheets improve dramatically. Bernanke’s seemingly Panglossian attempt to call a bottom in the U.S. economy by the end of the year is now held to be pretty conventional wisdom, the real explanation why the stock market’s been red-hot.

The moment of crisis has passed, the parallels to the Great Depression are gone, all because Bernanke learned the lessons of history and refused to let it repeat itself. Bernanke once seemed Lilliputian compared to Greenspan. Now their statures have been reversed."

If Americans were convinced of the Fed’s commitment, they’d buy and borrow more now, he says.

TO BE NOTED: From Bloomberg:

"U.S. Needs More Inflation to Speed Recovery, Say Mankiw, Rogoff

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By Rich Miller

May 19 (Bloomberg) -- What the U.S. economy may need is a dose of good old-fashioned inflation.

So say economists including Gregory Mankiw, former White House adviser, and Kenneth Rogoff, who was chief economist at the International Monetary Fund. They argue that a looser rein on inflation would make it easier for debt-strapped consumers and governments to meet their obligations. It might also help the economy by encouraging Americans to spend now rather than later when prices go up.

“I’m advocating 6 percent inflation for at least a couple of years,” says Rogoff, 56, who’s now a professor at Harvard University. “It would ameliorate the debt bomb and help us work through the deleveraging process.”

Such a strategy would be risky. An outlook for higher prices could spook foreign investors and send the dollar careening lower. The challenge would be to prevent inflation from returning to the above-10-percent levels that prevailed in the 1970s and took almost a decade and a recession to cure.

“Anybody who has been a central banker wouldn’t want to see inflation expectations become unhinged,” says Marvin Goodfriend, a former official at the Federal Reserve Bank of Richmond. “The Fed would have to create a recession to get its credibility back,” adds Goodfriend, now a professor at Carnegie Mellon University’s Tepper School of Business in Pittsburgh.

Preventing Deflation

For the moment, the Fed’s focus is on preventing deflation -- a potentially debilitating drop in prices and wages that makes debts harder to repay and encourages the postponement of purchases. The Labor Department reported May 15 that consumer prices were unchanged in April from the previous month and were down 0.7 percent from a year earlier.

“We are currently being very aggressive because we are trying to avoid” deflation, Fed Chairman Ben S. Bernanke told an Atlanta Fed conference on May 11.

The central bank has cut short-term interest rates effectively to zero and engaged in what Bernanke calls “credit easing” to spur lending to consumers, small businesses and homebuyers.

Bernanke, 55, said the risk of deflation was receding and that the Fed was ready to reverse course when needed to maintain stable prices and prevent an outbreak of undesired inflation. The Fed has implicitly defined price stability as annual inflation of 1.5 percent to 2 percent, as measured by a price index based on personal consumption expenditures.

Lifting Prices, Wages

Even after all the Fed has done to stimulate the economy, some economists argue that it needs to do more and deliberately aim for much faster inflation that would also lift wages.

With unemployment at a 25-year high of 8.9 percent, workers are being squeezed. Wages and salaries rose 0.3 percent in the first quarter, the least on record, according to the Labor Department, as companies including Memphis, Tennessee-based based package-delivery company FedEx Corp. and newspaper publisher Gannett Co. of McLean, Virginia slashed pay.

Given the Fed’s inability to cut rates further, Mankiw says the central bank should pledge to produce “significant” inflation. That would put the real, inflation-adjusted interest rate -- the cost of borrowing minus the rate of inflation -- deep into negative territory, even though the nominal rate would still be zero.

If Americans were convinced of the Fed’s commitment, they’d buy and borrow more now, he says.

Mankiw, currently a Harvard professor, declines to put a number on what inflation rate the Fed should shoot for, saying that the central bank has computer models that would be useful for determining that.

Gold Standard

In advocating that the Fed commit itself to generating some inflation, Mankiw, 51, likens such a step to the U.S. decision to abandon the gold standard in 1933, which freed policy makers to fight the Depression.

Faster inflation might be preferable to increased unemployment, or to further budget stimulus packages that push up the national debt, says Mankiw, who was chairman of the Council of Economic Advisors under President George W. Bush.

The White House has forecast that the budget deficit will hit $1.84 trillion this fiscal year, or 12.9 percent of gross domestic product. Rogoff doubts that politicians will be willing to reduce that shortfall by raising taxes as much as needed. Instead, he sees them pressing the Fed to accept faster inflation as a way of easing the burden of reducing the deficit.

Easier Debt Repayment

Inflationary increases in wages -- and the higher income taxes they generate -- would make it easier to pay off debt at all levels.

“There’s trillions of dollars of debt, in mortgage debt, consumer debt, government debt,” says Rogoff, who was chief economist at the Washington-based IMF from 2001 to 2003. “It’s a question of how do you achieve the deleveraging. Do you go through a long period of slow growth, high savings and many legal problems or do you accept higher inflation?”

Laurence Ball, a professor at Johns Hopkins University in Baltimore, says it’s risky to try to engineer a temporary surge in inflation because it might spark a spiral of rising prices.

Even so, he sees good reasons for the Fed to lift its implicit, medium-term inflation target to 3 percent to 4 percent from 1.5 percent to 2 percent now.

To battle recession, the Fed had to cut interest rates to 1 percent in 2003 and zero in the current period. That implies its inflation target has been too low because it’s left the Fed running up against the zero bound on nominal interest rates.

Inflation Advantage

“The basic advantage of pushing inflation a little higher is that it would make it less likely that we run into the problem of the interest rate hitting zero and the Fed not being able to stimulate the economy if necessary,” Ball says.

John Makin, a principal at hedge fund Caxton Associates in New York, wants the Fed to go further and target the level of prices instead of simply a rate of inflation. Such a policy would mean that if inflation fell short of 2 percent over a period of time, the Fed would have to push inflation above that rate subsequently to make up for the shortfall and keep prices rising on the desired trajectory.

While that might sound radical, it’s the same sort of policy that Bernanke advocated Japan follow in 2003 to fight deflation. In a speech in Tokyo that year, then-Fed Governor Bernanke called on the Bank of Japan to adopt “a publicly announced, gradually rising price-level target.”

‘Bad for Creditors’

Some investors are already worried that Bernanke will go too far. “We’re on the path of longer-term, higher inflation,” says Axel Merk, president of Merk Investments LLC in Palo Alto, California. “It’s good for debtors but it’s bad for creditors. It’s dangerous and irresponsible.”

Billionaire investor Warren Buffett, chairman of Berkshire Hathaway Inc. in Omaha, Nebraska, suggested that faster inflation was all but inevitable.

“A country that continuously expands its debt as a percentage of GDP and raises much of the money abroad to finance that, it’s going to inflate its way out of the burden of that debt,” he told the CNBC financial news television channel on May 4, adding, “That becomes a tax on everybody that has fixed- dollar investments.”

To contact the reporter on this story: Rich Miller in Washington rmiller28@bloomberg.net"

sheer hypocrisy of many Congressional Republicans who, having never uttered a peep about the huge deficits under George W. Bush

TO BE NOTED: From the NY TIMES:

"It’s No Time to Stop This Train

By ALAN S. BLINDER

CONTRARY to what you may have heard from some doomsayers, 2009 is not 1930 redux. What we must guard against, instead, is 2010 or 2011 becoming another 1936.

Realistically, there is little danger that the economy is heading toward a repeat performance of the Great Depression — when real gross domestic product in the United States declined 27 percent and unemployment soared to 25 percent. What we have is bad enough: our worst recession since the 1930s. But unless our leaders behave unbelievably foolishly, we will not repeat the tragic slide into the abyss of 1930 to 1933 — for two main reasons.

First, our economy has many built-in safeguards that did not exist back then — like unemployment insurance, Social Security and federal deposit insurance, to name just three. These programs serve as safety nets that cushion the fall. And while they are certainly not strong enough to prevent recessions, they should be enough to prevent another depression.

The more important reason is that Barack Obama, Timothy F. Geithner and Ben S. Bernanke are not Herbert Hoover, Andrew Mellon and Eugene Meyer. (Who’s that? Mr. Meyer was the Federal Reserve chairman from September 1930 to May 1933.) In stark contrast to the laissez-faire crowd that ruled the roost in 1930 and 1931, our current economic leaders are not waiting for the sagging economy to right itself. Rather, they have taken numerous extraordinary steps already — and stand ready to do more if necessary.

That’s the good news. But even if another depression is next to impossible, there is still the danger that next year, or the year after, might turn into 1936. Let me explain.

From its bottom in 1933 to 1936, the G.D.P. climbed spectacularly (albeit from a very low base), averaging gains of almost 11 percent a year. But then, both the Fed and the administration of Franklin D. Roosevelt reversed course.

In the summer of 1936, the Fed looked at the large volume of excess reserves piled up in the banking system, concluded that this mountain of liquidity could be fodder for future inflation, and began to withdraw it. This tightening of monetary policy continued into 1937, in a weak economy that was ill-prepared for it.

About the same time, President Roosevelt looked at what seemed to be enormous federal budget deficits, concluded that it was time to put the nation’s fiscal house in order and started raising taxes and reducing spending. This tightening of fiscal policy transformed the federal budget from a deficit of 3.8 percent of G.D.P. in 1936 to a surplus of 0.2 percent of G.D.P. in 1937 — a swing of four percentage points in a single year. (Today, a swing that large would be almost $600 billion.)

Thus, both monetary and fiscal policies did an abrupt about-face in 1936 and 1937, and the consequences were as predictable as they were tragic. The United States economy, which had been rapidly climbing out of the cellar from 1933 to 1936, was kicked rudely down the stairs again, and America experienced the so-called recession within the depression. Real G.D.P. contracted 3.4 percent from 1937 to 1938; the total G.D.P. decline during the recession, which lasted from mid-1937 to mid-1938, was even larger.

The moral of the story should be clear: Prematurely changing fiscal and monetary policies — from stepping hard on the accelerator to slamming on the brake — can be hazardous to the economy’s health.

Wow, we’ve learned a lot since the ’30s, right? Well, maybe not. For the echoes of 1936 are being heard right now, even before the current recession hits bottom.

If you’ve been paying attention, you know that a number of critics of the Fed are sounding alarms over the huge stockpile of excess reserves it has created — more than $775 billion at last count. What these critics are fretting about now is exactly what goaded the Fed into action in 1936: that the vast pool of loose money will ultimately be inflationary. The clear inference is that some of it should be withdrawn before it’s too late.

On the fiscal side, many of President Obama’s critics are complaining vociferously about the huge federal budget deficits. Try to ignore, if you can, the sheer hypocrisy of many Congressional Republicans who, having never uttered a peep about the huge deficits under George W. Bush, are suddenly models of budget probity. But whatever the motives, the worries of today’s deficit hawks sound eerily reminiscent of Roosevelt in 1936 and 1937.

FORTUNATELY, Mr. Bernanke is a keen student of the Great Depression who will not allow the Fed to repeat the errors of 1936-37. But his critics, both inside and outside the Fed, are already branding his policies as dangerously inflationary, and no Fed chairman wants to be called an inflationist.

Similarly, I hope and believe that President Obama will not transform himself from the spendthrift Roosevelt of 1933 to the deficit-hawk Roosevelt of 1936 — at least not until the economy is back on solid ground. That said, a growing flock of budget hawks are already showing their talons. They will have their day — but please, not yet.

To avoid a replay of the policy disasters of 1936-37, both the Fed and our elected officials must stay the course. Mark Twain once explained that, while history does not repeat itself, it often rhymes. We don’t want any rhymes just now.

Alan S. Blinder is a professor of economics and public affairs at Princeton and former vice chairman of the Federal Reserve. He has advised many Democratic politicians."

liquidity driven story, not a fundamentals-based, or market price of risk/systematic risk-based story

TO BE NOTED: From the Streetwise Professor:

"So Speaketh Chairman Bernanke–to SWP

Filed under: Economics, Financial crisis, Politics — The Professor @ 10:10 pm

I am participating in the Atlanta Fed’s conference on Financial Crises and Innovation in Jekyll Island, GA. The keynote speaker tonite (the first evening of the conference) was Ben Bernanke, Chairman of the Fed.

Bernanke’s speech was about the stress tests. I thought he did a good job in explaining and defending the tests. He clarified a few things in my mind. Which is not to say he persuaded me that all is well. In other words, I’m not ready to help revive Tinker Bell just yet.

Three things he said about the stress tests gave me some disquiet.

First. He emphasized that they were a “confidence building exercise.” That seems like assuming the conclusion. I would like a fact finding exercise, with a clear statement of the findings, good or bad. Stating that the objective is to build confidence suggests a pre-ordained result–Kabuki Theater. It’s like saying that something is needed to build “self-esteem.” Success builds self-esteem, not the other way around. Similarly, success builds confidence; confidence building does not ensure success.

Second, he argued that the stress tests were based on models calibrated to extensive historical experience. Well, we are in uncharted territory here, which raises doubts about the probative value of historical experience. I can think of some ways to massage historical data that could be useful. But one of the problems I see is that the characteristics–the quality–of loans issued in the 2005-2007 period differed substantially from the quality of loans issued in prior years even holding measurable characteristics constant. What’s more, the unemployment and growth scenarios used in the stress tests differ substantially from anything in the historical data likely to have been employed. Thus, there are at least two reasons to believe that historical experience may be misleading.

Third, Bernanke stated something that I had conjectured in my previous post Tinkerbell Goes to Wall Street. Namely, that the stress tests are not intended to estimate the market value of bank assets under alternative scenarios, and are not intended to be solvency tests. Instead, they are based on a view that market prices are deeply discounted from fundamental values due to liquidity effects, and that as long term investors funded by deposits, banks can hold assets to maturity. As a result, when evaluating the capital banks need, expected losses (in the “physical measure” if you will) are the relevant measure, not mark-to-market losses.

This last is a view that Bernanke has maintained since early in the crisis; he testified to this effect in the days immediately following Lehman. Maybe. But this is essentially speculation. Indeed, although Bernanke cited one of the papers presented earlier in the day to support his view, the other paper (by Michael Brennan) supports a contrary view. Specifically, that by focusing on expected losses alone one ignores the states of the world in which the losses occur, and the systematic risk of those losses. Losses that occur in very bad economic times are discounted more heavily. The disparity between valuations based purely on expected losses and market prices may be due to liquidity effects, but it may be due to fundamental risk pricing issues–the shift from the physical to the pricing measure. By ignoring this possibility, the stress tests could seriously underestimate the amount of capital banks really need.

In sum, Bernanke took a particular view on why many asset prices are so heavily discounted. It is a liquidity driven story, not a fundamentals-based, or market price of risk/systematic risk-based story. If he is right, there is some justification for the stress test estimates of capital needs and the capital position of banks. If he is wrong . . .

Bernanke took questions afterwards. In response to his statement that the Fed was committed to price stability, I asked: “How does the Fed make its commitment to price stability credible in light of the extraordinary measures it has taken in the past year?”

Bernanke gave a very long answer–I’d guess it took 3-4 minutes. He looked me in the eye the entire time. His answer was, it seemed to me, well practiced. But it was not entirely reassuring. He said (and I paraphrase, obviously): we’re doing two things. First of all, all of the members of the Board of Governors and the Fed Open Market Committee are making public our views on what the “right” amount of inflation is–about 2 percent. Second, we are making clear that we have the tools–charging interest on reserves, reverse repos–to withdraw liquidity from the system without selling assets. That’s fine, to a point. I have no doubt he knows that inflation is costly and has the tools to fight it; the question, though, is whether he can credibly commit to use these tools.

He went on to say that he understands clearly the nature of the problem, and is getting heat from both sides–those that fear inflation if he doesn’t respond to a rebounding economy by withdrawing liquidity, and those who fear a prolonged recession/deflation if he withdraws liquidity too quickly. He suggested that this is nothing new–he said a couple of times that this is the kind of problem central bankers always face when an economy is at a turning point.

Fair enough. But as with my reservations about the use of historical data in the stress test, here I believe that we are in uncharted waters, and that although this problem may be of a kind that central bankers are quite familiar with, it is of a scale that none (at least none living) have had to navigate. The amount of liquidity overhang is so large; the severity of the recession is so much greater than any of recent memory, and as a result the political reaction to a “double dip” recession would be commensurately greater; the banking system is so much more fragile than during previous downturns; and the independence of the Fed has been called into question as a result of its extraordinary actions more than ever before. All of these factors make the Fed’s job of steering between the Scylla of deflation and the Charybdis of inflation very daunting indeed. And although Bernanke certainly was personally impressive and appealing, I still believe that there is a very serious inflationary risk going forward.

And for the record. I’m damn glad I don’t have his job."

its failure could have triggered a 1930s-style global financial and economic meltdown, with catastrophic implications for production, incomes,and jobs

TO BE NOTED: From the Fed:

Chairman Ben S. Bernanke
At the Morehouse College, Atlanta, Georgia
April 14, 2009

Four Questions about the Financial Crisis

I am pleased to have the privilege of speaking today to the students and faculty of Morehouse College, the only all-male historically black institution of higher learning in the United States. It is sufficient to note that Martin Luther King, Jr., was a graduate of Morehouse. Yet a roster of distinguished alumni that also includes former Atlanta Mayor Maynard Jackson, former U.S. Surgeon General David Satcher, and filmmaker Spike Lee testifies to the success of your stated mission of "producing academically superior, morally conscious leaders for the conditions and issues of today."

My remarks today will focus on the ongoing turmoil in financial markets and its consequence, the global economic recession. The financial crisis, the worst since the Great Depression, has severely affected the cost and availability of credit to both households and businesses. Credit is the lifeblood of market economies, and the damage to our economy resulting from the constraints on the flow of credit has already been extensive. With recent job losses exceeding half a million per month, this year's college graduates are facing the toughest labor market in 25 years. In the communities in which you and I grew up, many families are trying to cope with lost employment and depleted savings or are facing foreclosure on their homes. Firms have shut factories and cancelled construction projects. States and municipalities are scrambling to find the funding to provide critical services. And although we naturally tend to be most aware of conditions in the United States, we should not overlook the impact that the crisis is having virtually everywhere in the world, particularly on many citizens of countries that struggle economically even when the global economy is doing well.

In the midst of all of these concerns, many Americans have recently celebrated Easter or Passover. As you may know, a highlight of the traditional Passover meal occurs when the youngest child asks four questions, the answers to which tell the history of the Jews when they were slaves in Egypt and during their exodus to the Promised Land. In the spirit of the holiday, today I will pose and answer four important questions about the financial crisis. Of course, my answers will have to be brief, but we will have more time for additional questions at the conclusion of my prepared remarks.

How Did We Get Here?
The first question I would like to address is: How did we get here? What caused our financial and economic system to break down to the extent it has? Not surprisingly, the answer to this question is complex, and experts disagree on how much weight to give various explanations. In my view, however, to tell the story fully--and, in particular, to understand its international scope--we need to consider how global patterns of saving and investment have evolved over the past decade or more, and how those changes affected credit markets in the United States and some other countries.

At the most basic level, the role of banks and other financial institutions is to take the savings generated by households and businesses and put them to use by making loans and investments. For example, financial institutions use the funds they receive from savers to provide loans that help families buy homes or allow businesses to finance inventories and payrolls. Financial markets, such as the stock and bond markets, perform a similar function, as when a firm raises funds for a new factory by selling a bond directly to investors. When the financial system is working as it should, it allocates funds both prudently (that is, with proper attention to risk) and efficiently (to the most productive uses).

Importantly, in our global financial system, saving need not be generated in the country in which it is put to work but can come from foreign as well as domestic sources. In the past 10 to 15 years, the United States and some other industrial countries have been the recipients of a great deal of foreign saving. Much of this foreign saving came from fast-growing emerging market countries in Asia and other places where consumption has lagged behind rising incomes, as well as from oil-exporting nations that could not profitably invest all their revenue at home and thus looked abroad for investment opportunities. Indeed, the net inflow of foreign saving to the United States, which was about 1-1/2 percent of our national output in 1995, reached about 6 percent of national output in 2006, an amount equal to about $825 billion in today's dollars.

Saving inflows from abroad can be beneficial if the country that receives those inflows invests them well( NB DON ). Unfortunately, that was not always the case in the United States and some other countries. Financial institutions reacted to the surplus of available funds by competing aggressively for borrowers, and, in the years leading up to the crisis, credit to both households and businesses became relatively cheap and easy to obtain. One important consequence was a housing boom in the United States, a boom that was fueled in large part by a rapid expansion of mortgage lending. Unfortunately, much of this lending was poorly done( NB DON ), involving, for example, little or no down payment by the borrower or insufficient consideration by the lender of the borrower's ability to make the monthly payments. Lenders may have become careless because they, like many people at the time, expected that house prices would continue to rise--thereby allowing borrowers to build up equity in their homes--and that credit would remain easily available, so that borrowers would be able to refinance if necessary. Regulators did not do enough to prevent poor lending, in part because many of the worst loans were made by firms subject to little or no federal regulation.

Mortgage markets were not the only ones caught up in the credit boom. The large flows of global saving into the United States drove down the returns available on many traditional long-term investments, such as Treasury bonds, leading investors to search for alternatives. To satisfy the enormous demand for investments both perceived as safe and promising higher returns, the financial industry designed securities that combined many individual loans in complex, hard-to-understand ways. These new securities later proved to involve substantial risks--risks that neither the investors nor the firms that designed the securities adequately understood at the outset.

The credit boom began to unravel in early 2007 when problems surfaced with subprime mortgages( NB DON )--mortgages offered to less-creditworthy borrowers--and house prices in parts of the country began to fall. Mortgage delinquencies and defaults rose, and the downturn in house prices intensified, trends that continue today. Investors, stunned by losses on assets they had believed to be safe, began to pull back from a wide range of credit markets, and financial institutions--reeling from severe losses on mortgages and other loans--cut back their lending. The crisis deepened last September, when the failure or near-failure of several major financial firms caused many financial and credit markets to freeze up. Stock prices fell sharply as investors lost confidence in the financial sector and became gloomy about economic prospects. Declining stock values, a teetering financial system, and difficulties in obtaining credit triggered a remarkably rapid and deep contraction in global economic activity and employment, a contraction that has persisted through the first months of 2009. Both the ongoing financial crisis and economic contraction have posed major challenges to economic policymakers.

What Is the Fed Doing to Address the Situation?
Those challenges bring me to my second question: What has the Federal Reserve been doing to address the economic and financial crisis?

The Fed's mandate from the Congress is to promote maximum sustainable employment and stable prices. In addition, the Fed is expected to contribute to financial stability by acting to contain financial disruptions and prevent their spread outside of the financial sector. Thus, we have been serving as a first responder to the crisis.

The Fed's basic policy tool for influencing economic activity and inflation is its ability to control very short-term interest rates--specifically, the federal funds rate, which is the rate that banks pay each other for overnight loans. Lower interest rates can be used to stimulate private-sector borrowing and spending at times like the present when the economy is suffering from a lack of demand. In September 2007, shortly after the turbulence in financial markets began and signs of economic weakness started to appear, the Federal Open Market Committee (FOMC), the body that determines the Federal Reserve's monetary policy, began to aggressively reduce the federal funds rate. By the spring of 2008, we had cut that interest rate from 5-1/4 percent to 2 percent, a highly proactive policy that helped to cushion the economy from some of the effects of the financial turmoil. But, as I mentioned a moment ago, the intensification of the financial crisis in the fall of 2008 led to a further significant deterioration in the economic outlook. The FOMC responded with additional interest rate cuts, and since December, our policy interest rate has been essentially zero. In addition, the FOMC has made clear that it expects economic conditions to warrant holding the federal funds rate low for an extended period.

However, given the ongoing problems in credit markets, conventional monetary policy alone is not adequate to provide all the support that the economy needs. The Fed has therefore taken a number of steps to help the economy by unclogging the flow of credit to households and businesses. In doing so, we have demonstrated that the Fed's toolkit remains potent, even though the federal funds rate is close to zero and thus cannot be reduced further.

We have taken a wide range of actions to help restore the flow of credit, of which I will only mention a few of the most important. One set of actions involves making short-term loans to banks and other financial institutions. Banks and other financial intermediaries normally make longer-term commitments--such as residential mortgages and business loans--yet rely on funding that may be relatively short-term, such as customer deposits that can be withdrawn at any time. To have the confidence to commit to longer-term loans and investments, banks must be sure that they will have ample access to funding when necessary. To give this assurance to banks, the Federal Reserve has made clear that it will provide short-term credit to sound financial institutions as needed. Indeed, serving as a lender of last resort to financial institutions is a method that central banks have used for centuries to try to calm financial crises.( NB DON )

To underscore our commitment to providing short-term funding to banks when they need it, we have lowered the interest rate we charge for short-term loans and extended the term of the loans to up to three months. We have also begun to auction funds to financial institutions, thereby allowing the interest rate paid to depend on the level of demand. Importantly, this lending is extremely safe from the point of view of both the Fed and the taxpayer. Not only is our lending short-term and restricted to healthy institutions, but we require that the borrowers pledge, as security, collateral whose value exceeds the amount we are lending. The Fed's lending to financial institutions has helped to ease conditions in a number of key financial markets, reduced important benchmark interest rates (such as the London interbank offered rate, or Libor, to which payments on some mortgages and other types of loans are tied), and increased the willingness of banks to make credit available.

A second strategy the Fed has employed is to use targeted lending to help free up critical credit markets outside of the banking system. A good example of targeted lending is our efforts in the commercial paper market. Commercial paper is a form of short-term debt issued by a variety of businesses to finance their operations; paychecks and payments to suppliers can depend on it. Among the largest investors in commercial paper are money market mutual funds. At the peak of the crisis last fall, many people who had invested in money market mutual funds lost confidence in those funds and withdrew their money( NB DON ); this loss of funding forced money market mutual funds to reduce their own investments, which in turn caused serious problems in the commercial paper market. Through a series of lending programs, and in coordination with steps taken by the Treasury, the Federal Reserve helped restore confidence in both money market mutual funds and the commercial paper market. Over time, withdrawals from money market mutual funds have been replaced by modest net inflows, and borrowers in the commercial paper market have seen significant improvements in the cost and availability of funding.

More recently, the Federal Reserve has also initiated a lending program, with the cooperation of the Treasury, designed to free up the flow of credit to households and small businesses. Among the forms of credit on which the program is currently focused are auto loans, credit card loans, student loans, and loans guaranteed by the Small Business Administration. We are currently reviewing other types of credit for possible inclusion in this program. In all cases, we will be taking the appropriate measures to minimize the risk of loss to the Federal Reserve.

Restoring stability to the market for housing and home mortgages has been a particular area of concern. To address this problem, the Fed has employed a third type of policy tool--namely, buying securities in the open market. The FOMC has approved purchases of well over $1 trillion this year of mortgage-related securities guaranteed by the government-sponsored mortgage companies, Fannie Mae and Freddie Mac. Buying mortgage-related securities helps to drive down the interest rates that consumers pay on mortgages, and, indeed, the rate on a traditional 30-year fixed-rate mortgage has recently fallen to less than 5 percent, the lowest level since the 1940s. Certainly, the housing market remains depressed, but lower interest rates and house prices are making houses more affordable. For example, two years ago, when mortgage rates were higher than 6percent, payments on a mortgage covering 80 percent of the cost of a $215,000 home would have been more than $1,000 per month; today, the price of that same house may have fallen to $170,000, and, at today's mortgage interest rates, the monthly payment would be about $700. Lower mortgage rates are also helping some homeowners refinance their mortgages to reduce their monthly payments.

The Federal Reserve will continue to take the necessary steps to unclog the credit markets and strengthen the economy. We will also continue to work closely with other agencies, such as the Treasury and the Federal Deposit Insurance Corporation (FDIC), each of which has also taken a variety of actions to help stabilize financial markets, as well as with other central banks around the world.

Does the Fed's Aggressive Response Risk Inflation Down the Road?
The multifaceted policy response that I've described has been aggressive. I am confident that such a proactive policy response is well justified by the serious ongoing problems in financial markets and the economy. However, some have raised the third question I will address: Could the Fed's aggressive actions to stabilize the economy today lead to an inflation problem down the road?

I mentioned earlier that the Fed's mandate from the Congress is to foster price stability as well as maximum sustainable employment. The FOMC treats its obligation to ensure price stability extremely seriously. Price stability supports healthy economic growth, for example, by making it easier for households and businesses to plan for the future. In practice, price stability does not require that inflation be literally zero; indeed, although inflation can certainly be too high, it can also be too low. Experience suggests that inflation rates that are close to zero or even negative (corresponding to deflation, or falling prices) can at times be associated with poor economic performance. Cases in point include the United States in the 1930s and the more recent experience of Japan. In their latest quarterly projections of the economy, most members of the FOMC indicated that they would like to see an annual inflation rate of about 2 percent in the longer term. Right now, because of the weakness in economic conditions here and around the world, inflation has been running less than that, and our best forecast is that inflation will remain quite low for some time. Thus, the Fed's proactive policy approach is not at all inconsistent with the goal of price stability in the medium term.

Although inflation seems set to be low for a while, the time will come when the economy has begun to strengthen, financial markets are healing, and the demand for goods and services, which is currently very weak, begins to increase again. At that point, the liquidity that the Fed has put into the system could begin to pose an inflationary threat unless the FOMC acts to remove some of that liquidity and raise the federal funds rate. We have a number of effective tools that will allow us to drain excess liquidity and begin to raise rates at the appropriate time; that said, unwinding or scaling down some of our special lending programs will almost certainly have to be part of our strategy for reducing policy stimulus once the recovery is under way.

We are thinking carefully about these issues; indeed, they have occupied a significant portion of recent FOMC meetings. I can assure you that monetary policy makers are fully committed to acting as needed to withdraw on a timely basis the extraordinary support now being provided to the economy, and we are confident in our ability to do so. To be sure, decisions about when and how quickly to proceed will require a careful balancing of the risk of withdrawing support before the recovery is firmly established versus the risk of allowing inflation to rise above its preferred level in the medium term. However, this delicate balancing of risks is a challenge that central banks face in the early stages of every economic recovery. I believe that we are well equipped to make those judgments appropriately. In addition, when the time comes, our ability to clearly communicate our policy goals and our assessment of the outlook will be crucial to minimizing public uncertainty about our policy decisions.

Why Did the Fed and the Treasury Act to Prevent the Bankruptcy of Some Major Financial Firms?
The final question is as difficult as it is important: Why did the Fed and the Treasury act to prevent the bankruptcy of some major financial firms, such as the investment bank Bear Stearns and the insurance company American International Group, or AIG? We must answer that question not only because the decisions have been controversial, but also because it bears on the steps we need to take as a country if we are to avert a repetition of the crisis.

As a general rule, my strong preference is that any firm that cannot meet its obligations should bear the consequences of the marketplace. But recent circumstances have been truly extraordinary. Consider the situation on September 16 of last year, when the insurance conglomerate AIG faced pressures that threatened to force it imminently into bankruptcy. At that time, the strains in the global financial system were unprecedented and extreme, and the confidence of financial market participants in the system was rapidly eroding. The investment bank Lehman Brothers had filed for bankruptcy the day before, and the mortgage giants Fannie Mae and Freddie Mac, after suffering losses that threatened their solvency, had effectively been taken over by the government just two weeks earlier. As waves of panic and fear washed over the markets, the Fed and the Treasury became very concerned about the stability of a number of other major financial firms.

Large, complex financial institutions tend to be highly interconnected with other firms and markets, and AIG was more interconnected than most. For example, AIG had insured many billions of dollars of loans and securities held by banks around the world, and its failure would have rendered those insurance contracts worthless, imposing large losses on the global banking system. In addition, banks had extended more than $50 billion in credit to the company, much of which would have been lost. Many other serious consequences would have followed from a default by AIG: Insurance policyholders would have faced considerable uncertainty about the status of their policies; state and local governments, which had lent more than $10 billion to AIG, would have suffered losses; workers whose 401(k) plans had purchased $40 billion of insurance from AIG against the risk of loss would have seen that insurance disappear; and holders of AIG's substantial quantities of commercial paper would have also borne serious losses.

But much more important, the disorderly failure of AIG would have put at risk not only the company's own customers and creditors but the entire global financial system. Historical experience shows that, once begun, a financial panic can spread rapidly and unpredictably( NB DON ); indeed, the failure of Lehman Brothers a day earlier, which the Fed and the Treasury unsuccessfully tried to prevent, resulted in the freezing up of a wide range of credit markets, with extremely serious consequences for the world economy. The financial and economic risks posed by a collapse of AIG would have been at least as great as those created by the demise of Lehman. In the case of AIG, financial market participants were keenly aware that many major financial institutions around the world were insured by or had lent funds to the company. The company's failure would thus likely have led to a further sharp decline in confidence in the global banking system and possibly to the collapse of other major financial institutions. At best, the consequences of AIG's failure would have been a significant intensification of an already severe financial crisis and a further worsening of economic conditions. Conceivably, its failure could have triggered a 1930s-style global financial and economic meltdown, with catastrophic implications for production, incomes, and jobs. ( NB DON )

The Federal Reserve and the Treasury agreed that in the environment then prevailing, AIG's failure would have posed unacceptable risks for the global financial system and for our economy. Accordingly, the Federal Reserve, with the full support of the Treasury, made a loan to AIG to prevent its failure. The loan imposed tough terms; in addition, senior management was replaced, and shareholders lost almost all of their investments. However, because the firm avoided a declaration of bankruptcy, creditors of AIG were protected.

In my view, preventing the failure of AIG was the best of the very bad options available, but it nevertheless involved major costs, including financial risks to the taxpayer. The American people also quite correctly see as unfair that AIG was saved from bankruptcy because of the dangers to the system that its failure would have posed, even as many other companies, including nonfinancial and smaller financial firms, have not received the same treatment. Allowing AIG to at least partly avoid the discipline of the marketplace also sets a bad precedent.

For these reasons, it is essential that we make changes to the financial rules of the game to prevent a similar episode from occurring in the future. First, we must ensure that all types of financial institutions, especially large and interconnected ones like AIG, receive strong and effective government oversight. AIG's regulatory oversight was limited, which allowed it to take dangerous risks largely out of sight of federal regulators.

Second, the AIG experience demonstrates that federal regulators urgently need a new set of procedures for dealing with a complex, systemically important financial institution on the brink of failure. Such rules already exists for banks: If a bank approaches insolvency, the FDIC is empowered to intervene as needed to protect depositors, sell the bank's assets, and take any necessary steps to prevent broader consequences to the financial system. However, for an insurance conglomerate like AIG, or for a large financial holding company that owns many subsidiary companies, these rules do not apply. Among other things, a good system for resolving nonbank financial institutions would allow federal regulators to unwind a failing company in ways that minimize disruptions in financial markets. An effective regime would also provide the authorities greater latitude to negotiate with creditors and to modify contracts entered into by the company, including contracts that set bonuses and other compensation for management. More generally, we need significant reforms to financial regulation and financial practices that will reduce the risk of future financial crises like the one we are currently experiencing. The Federal Reserve strongly supports such reform efforts.

Conclusion
The current crisis has been one of the most difficult financial and economic episodes in modern history. Recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, homebuilding, and consumer spending, including sales of new motor vehicles. A leveling out of economic activity is the first step toward recovery. To be sure, we will not have a sustainable recovery without a stabilization of our financial system and credit markets. We are making progress on that front as well, and the Federal Reserve is committed to working to restore financial stability as a necessary step toward full economic recovery.

I am fundamentally optimistic about our economy. Among its many intrinsic strengths are universities and colleges like Morehouse, which help talented students gain not only a command of a body of knowledge but also the capacity to think creatively and independently. Institutions like this one train the professionals, entrepreneurs, and leaders who will shape our economy in the future. Today's economic conditions are difficult, but the foundations of our economy are strong, and we face no problems that cannot be overcome with insight, patience, and persistence. The Federal Reserve will certainly do its part to help restore prosperity and opportunity to our economy."

This so-called lender-of-last-resort activity is particularly useful during a financial crisis

TO BE NOTED: From Bloomberg:

"Bernanke Says Fed Must Retain Flexibility on Credit (Update1)

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By Scott Lanman and David Mildenberg

April 3 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke said the central bank must retain the flexibility to withdraw its record injection of credit into the economy to keep inflation in check when the crisis abates.

The central bank’s emergency “activities must not constrain the exercise of monetary policy as needed to meet our congressional mandate to foster maximum sustainable employment and stable prices,” Bernanke said in the text of a speech in Charlotte, North Carolina.

The U.S. central bank has effectively printed money to buy or lend against a range of assets to alleviate the credit crunch and revive the economy. Bernanke’s speech today detailed steps that the Fed can take to remove that liquidity.

Bernanke also rebuffed criticism from some analysts that the Fed is favoring some credit markets over others in the emergency programs it has set up in the past six months. The Fed chief hailed a decline in home-loan rates in the wake of the central bank’s purchases of mortgage securities, and said the drop may help improve the housing market.

“Relieving disruptions in credit markets and restoring the flow of credit to households and businesses are essential if we are to see, as I expect, the gradual resumption of sustainable economic growth,” the Fed chief said today.

Balance Sheet

The central bank has expanded its balance sheet by $1.2 trillion over the past year, taking on assets including mortgage securities, corporate debt and now long-term Treasuries under the Fed’s latest policy decision last month.

The Fed’s Open Market Committee decided to buy as much as $300 billion of long-term Treasuries after a split between some officials over how best to ease the credit crunch. Richmond Fed President Jeffrey Lacker dissented in a January FOMC vote, favoring purchases of Treasuries rather than the use of credit programs. Philadelphia Fed President Charles Plosser has also expressed concern about affecting particular credit markets.

Bernanke said that the Fed’s lending for purchases of commercial paper and securities backed by consumer and business loans don’t mean it’s engaging in “credit allocation.” He said “our programs have been aimed at improving financial and credit conditions broadly.”

‘Uncomfortable’ Steps

The Fed chairman also hailed last month’s joint statement with the Treasury that spelled out the principles underlying the central bank’s work with the Treasury to revive credit. While the Fed has implemented “unconventional” measures and taken some “extremely uncomfortable” steps, it’s critical that its efforts “do not interfere with the independent conduct of monetary policy,” Bernanke said.

The Fed’s tools for raising short-term interest rates once the crisis wanes include unwinding the emergency-loan programs, conducting reverse repurchase agreements against long-term securities holdings and increasing the rate the Fed pays on bank reserves, Bernanke said. The emergency programs were designed to be “unwound as markets and the economy revive.”

Home-loan rates have declined since the Fed announced the purchases of mortgage debt, and “over time, lower mortgage rates should help to improve conditions in the housing market, whose persistent weakness has had a major impact on economic and financial conditions more broadly,” Bernanke said in remarks prepared for a conference hosted by the Richmond Fed bank.

New Tools

Bernanke reiterated that the Fed and Treasury are seeking unspecified legislation to give the Fed “additional tools for managing bank reserves.” San Francisco Fed President Janet Yellen said last month that the central bank wants authority to issue its own debt.

“The large volume of reserve balances outstanding must be monitored carefully, as -- if not carefully managed -- they could complicate the Fed’s task of raising short-term interest rates when the economy begins to recover or if inflation expectations were to begin to move higher,” Bernanke said.

The Fed normally raises interest rates by selling Treasuries on its balance sheet, draining reserves from the banking system. That task is tougher with the Fed’s commitment last month to buy more than $1 trillion in mortgage-backed securities, which are harder to sell quickly without roiling markets.

Bernanke said the Fed expects to be “fully repaid” on loans made in connection with the bailouts of Bear Stearns Cos. and American International Group Inc. “From a credit perspective, these support facilities carry more risk than traditional central bank liquidity support, but we nevertheless expect to be fully repaid,” Bernanke said.

Share of Assets

Credit extended under those rescues accounts for about 5 percent of the Fed’s balance sheet, he reiterated.

Earlier today, Fed Vice Chairman Donald Kohn said the central bank, Congress and the Obama administration must remain “flexible and open” to additional policies to stimulate growth and cushion the financial system. A report today showed the U.S. unemployment rate jumped in March to the highest level since 1983 as the economy lost 663,000 jobs.

The Fed is also trying to restart the market for securities backed by loans through a program that may rise to $1 trillion. The Term Asset-Backed Securities Loan Facility, or TALF, though, is encountering resistance from investors, undermining Bernanke’s attempt to further drive down borrowing costs.

Deals arranged for the TALF may fail to rise much next week from the $8.3 billion first round in March, said Reed Auerbach, co-chief executive officer of law firm McKee Nelson LLP in New York. Hedge funds and other investors are balking because of visa limits on workers and possible efforts to tax earnings.

Bernanke said today that the TALF is “expected to grow in the months ahead.”

The ballooning Fed balance sheet has also attracted calls from Congress for more transparency in the identity of borrowers. Yesterday, the Senate voted 59-39 for an amendment to a pending budget plan that calls on the Fed to release details on which banks have received last-resort loans, how much they have taken and what they are doing with the money."

From the Fed:

Chairman Ben S. Bernanke
At the Federal Reserve Bank of Richmond 2009 Credit Markets Symposium, Charlotte, North Carolina
April 3, 2009

The Federal Reserve's Balance Sheet

In ordinary financial and economic times, my topic, "The Federal Reserve's Balance Sheet," might not be considered a "grabber." But these are far from ordinary times. To address the current crisis, the Federal Reserve has taken a number of aggressive and creative policy actions, many of which are reflected in the size and composition of the Fed's balance sheet. So, I thought that a brief guided tour of our balance sheet might be an instructive way to discuss the Fed's policy strategy and some related issues. As I will discuss, we no longer live in a world in which central bank policies are confined to adjusting the short-term interest rate. Instead, by using their balance sheets, the Federal Reserve and other central banks are developing new tools to ease financial conditions and support economic growth.

Some Principles for Balance Sheet Policy
Before I get into the details of our balance sheet and how it reflects various Federal Reserve initiatives, I would like to note some general considerations that have been important in shaping our policy approach. As you know, financial markets and institutions both in the United States and globally have been under extraordinary stress for more than a year and a half. Relieving the disruptions in credit markets and restoring the flow of credit to households and businesses are essential if we are to see, as I expect, the gradual resumption of sustainable economic growth. To achieve this critical objective, the Federal Reserve has worked closely and cooperatively with the Treasury and other agencies. Such collaboration is not unusual. We have traditionally worked in close concert with other agencies in fostering stable financial conditions, even as we have maintained independent responsibility for making monetary policy.

Though we have been creative in deploying our balance sheet, using a multiplicity of new programs (and coining a multiplicity of new acronyms, I might add), we have done so prudently. As much as possible, we have sought to avoid both credit risk and credit allocation in our lending and securities purchase programs. As I will discuss further today, the great majority of our lending is extremely well secured. And our programs have been aimed at improving financial and credit conditions broadly, with an eye toward restoring overall economic growth, rather than toward supporting narrowly defined sectors or classes of borrowers.

In pursuing our strategy, which I have called "credit easing," we have also taken care to design our programs so that they can be unwound as markets and the economy revive. In particular, these activities must not constrain the exercise of monetary policy as needed to meet our congressional mandate to foster maximum sustainable employment and stable prices.

We are also committed to working with the Administration and the Congress to develop a new resolution regime that would allow the U.S. government to effectively address, at an early stage, the potential failure of systemically critical nonbank financial institutions. As this audience well knows, the lack of such a regime greatly hampered our flexibility in dealing with the failure or near-failure of such institutions as Bear Stearns, Lehman Brothers, and American International Group (AIG).

The principles I have just noted were recently formalized in a joint Federal Reserve-Treasury statement.¹ Those principles are: (1) that the Fed will cooperate closely with the Treasury and other agencies in addressing the financial crisis; (2) that the Fed in its lending activities should avoid taking credit risk or allocating credit to narrowly defined sectors or classes of borrowers; (3) that the Fed's independent ability to manage monetary policy must not be constrained by its programs to ease credit conditions; and (4) that there is a pressing need for a new resolution regime for nonbanks that, among other things, will better define the Fed's role in preventing the disorderly failure of systemically critical financial institutions. I welcome the clarity that this public statement brings to the principles underlying our policy strategy during this very difficult period.

The Balance Sheet as a Tool of Monetary Policy
The severe disruption of credit markets that began late in the summer of 2007 and the associated tightening in credit conditions and declines in asset prices have weighed heavily on economic activity here and abroad. The Federal Reserve has responded by aggressively easing short-term interest rates, beginning in September 2007. In October 2008, as the financial crisis intensified, the Federal Reserve participated in an unprecedented coordinated rate cut with other major central banks. At its December 2008 meeting, the Federal Open Market Committee (FOMC) reduced its target for the federal funds rate close to its lower bound, setting a target range between 0 and 1/4 percent. And, with inflation expected to remain subdued for some time, the Committee has indicated that short-term interest rates are likely to remain low for an extended period. With conventional monetary policy having reached its limit, any further policy stimulus requires a different set of tools.

The Federal Reserve has been a global leader in developing such tools. In particular, to further improve the functioning of credit markets and provide additional support to the economy, the Fed has established and expanded a number of liquidity programs and recently initiated a large-scale program of asset purchases. These actions have had significant effects on both the size and composition of the Federal Reserve's balance sheet. Notably, the balance sheet has more than doubled, from roughly $870 billion before the crisis to roughly $2 trillion now. In the remainder of my remarks, I will walk you through the major components of the Fed's balance sheet, which is a convenient way to discuss the range of policy tools the Fed is employing and some of the issues we are confronting in our policy decisions.

An excellent source of information on our balance sheet, by the way, is a new section of the Board's website, entitled Credit and Liquidity Programs and the Balance Sheet.² This section brings together much diverse information about the Fed's balance sheet, including some only recently made available, as well as detailed explanations and analyses. Serious Fed watchers should add this link to their online favorites list.

Let me begin with the asset side of our balance sheet. For decades, the Federal Reserve's assets consisted almost exclusively of Treasury securities. Since late 2007, however, our holdings of Treasury securities have declined, while our holdings of other financial assets have expanded dramatically. It is useful to group the Federal Reserve's assets into three broad categories: (1) short-term credit extended to support the liquidity of financial firms such as depository institutions, broker-dealers, and money market mutual funds; (2) assets related to programs focused on broader credit conditions; and (3) holdings of high-quality securities, notably Treasury securities, agency debt, and agency-backed mortgage-backed securities (MBS).³ As I will discuss later, the Federal Reserve also has provided support directly to specific institutions in cases when a disorderly failure would have threatened the financial system.

Liquidity Programs for Financial Firms
The first of these categories of assets--short-term liquidity provided to financial institutions--totals almost $860 billion and today represents nearly 45 percent of the assets on our balance sheet. These loans are made to sound institutions, are fully secured, and are for maturities no greater than 90 days, usually less. Thus, they are very safe. The main components of this category are lending to commercial banks and primary dealers, as well as currency swaps with other central banks to support interconnected global dollar funding markets.⁴

From its beginning, the Federal Reserve, through its discount window, has provided credit to depository institutions to meet unexpected liquidity needs, usually in the form of overnight loans. The provision of short-term liquidity is, of course, a long-standing function of central banks. In August 2007, conditions in short-term bank funding markets deteriorated abruptly, and bank funding needs intensified sharply. In response to these developments, the Federal Reserve reduced the spread of the primary credit rate--the rate at which most institutions borrow at the discount window--relative to the target federal funds rate, and also made it easier for banks to borrow at term. However, as in some past episodes of financial distress, banks were reluctant to rely on discount window credit to address their funding needs. The banks' concern was that their recourse to the discount window, if it became known, might lead market participants to infer weakness--the so-called stigma problem. The perceived stigma of borrowing at the discount window threatened to prevent the Federal Reserve from getting much-needed liquidity into the system.

To address this issue, in late 2007, the Federal Reserve established the Term Auction Facility (TAF), which, as the name implies, provides fixed quantities of term credit to depository institutions through an auction mechanism. The introduction of this facility seems largely to have solved the stigma problem, partly because the sizable number of borrowers provides anonymity, and possibly also because the three-day period between the auction and auction settlement suggests that the facility's users are not relying on it for acute funding needs on a particular day. As of April 1, 2009, we had roughly $525 billion of discount window credit outstanding, of which about $470 billion had been distributed through auctions and the remainder through conventional discount window loans.

Like depository institutions in the United States, foreign banks with large dollar funding positions were also experiencing powerful liquidity pressures. This unmet demand for dollars was spilling over into U.S. markets, including the federal funds market. To address this issue, the Federal Reserve has cooperated with foreign central banks in establishing what are known as reciprocal currency arrangements, or liquidity swap lines. In these arrangements, the Federal Reserve provides dollars to foreign central banks which they, in turn, lend to banks in their jurisdictions. Credit risk is minimal in these arrangements, as the foreign central bank is responsible for repayment, rather than the institutions that ultimately receive the funds; in addition, the Fed receives foreign currency from its central bank partner of equal value to the dollars lent. Liquidity provided through such arrangements peaked ahead of year-end 2008 but has since declined as pressures in short-term funding markets have eased; the outstanding amount currently stands at about $310 billion.

In addition, following the sharp deterioration in market conditions in March 2008, the Federal Reserve used its emergency lending authority to provide primary dealers access to central bank credit. Primary dealers can obtain short-term collateralized loans from the Fed through the Primary Dealer Credit Facility, or PDCF. The PDCF, which is closely analogous to the discount window for commercial banks, currently has about $20 billion in borrowings outstanding. Another program for primary dealers, called the Term Securities Lending Facility, lends Treasury securities to dealers, taking investment-grade securities as collateral. The primary dealers then use the more-liquid Treasury securities to obtain private-sector funding. Extensions of credit under this program, which currently total about $85 billion, do not appear as distinct assets on the Fed's balance sheet, because the Federal Reserve continues to own the Treasury securities that it lends.

As I mentioned, the provision of liquidity on a collateralized basis to sound financial institutions is a traditional central bank function. This so-called lender-of-last-resort activity is particularly useful during a financial crisis, as it reduces the need for fire sales of assets and reassures financial institutions and their counterparties that those institutions will have access to liquidity as needed. To be sure, the provision of liquidity alone cannot address solvency problems or erase the large losses that financial institutions have suffered during this crisis. Yet both our internal analysis and market reports suggest that the Fed's ample supply of liquidity, along with liquidity provided by other major central banks, has significantly reduced funding pressures for financial institutions, helped to reduce rates in bank funding markets, and increased overall financial stability. For example, despite ongoing financial stresses, funding pressures around year-end 2008 and the most recent quarter-end appear to have moderated significantly.

Before leaving this category of assets, I should mention briefly the Fed's actions to ensure liquidity to another category of financial institution, money market mutual funds. In September, a prominent money market mutual fund "broke the buck"--that is, was unable to maintain a net asset value of $1 per share. This event led to a run on the other funds, which saw very sharp withdrawals. These withdrawals in turn threatened the stability of the commercial paper market, which depends heavily on money market mutual funds as investors. Following the long-standing principle that the central bank should lend into a panic, the Federal Reserve established two programs to backstop money market mutual funds and to help those funds avoid fire sales of their assets to meet withdrawals. Together with an insurance program offered by the Treasury, the Fed's programs helped end the run; the sharp withdrawals from the funds have been replaced by moderate inflows. Although credit extended to support money funds was high during the intense phase of the crisis in the fall, borrowings have since declined substantially, to about $6 billion.

Direct Lending to Borrowers and Investors
A second set of programs initiated by the Federal Reserve--including the Commercial Paper Funding Facility (CPFF) and the Term Asset-Backed Securities Loan Facility (TALF)--aims to improve the functioning of key credit markets by lending directly to market participants, including ultimate borrowers and major investors. The lending associated with these facilities is currently about $255 billion, corresponding to roughly one-eighth of the assets on the Fed's balance sheet. The sizes of these programs, notably the TALF, are expected to grow in the months ahead.

The commercial paper market is a key source of the short-term credit that American businesses use to meet payrolls and finance inventories. Following the intensification of the financial crisis in the fall, commercial paper rates spiked, even for the highest-quality firms. Moreover, most firms were unable to borrow for periods longer than a few days, exposing both firms and lenders to significant rollover risk. By serving as a backstop for commercial paper issuers, the CPFF was intended to address rollover risk and to improve the functioning of this market. Under this facility, the Fed stands ready to lend to the highest-rated financial and nonfinancial commercial paper issuers for a term of three months. As additional protection against loss, and to make the facility the last rather than the first resort, the CPFF charges borrowers upfront fees in addition to interest. Borrowing from this facility peaked at about $350 billion and has since declined to about $250 billion as more firms have been able to issue commercial paper to private lenders or have found alternative sources of finance. Conditions in the market have improved markedly since the introduction of this program, with spreads declining sharply and with more funding available at longer maturities. Market participants tell us that the CPFF contributed to these improvements.

Most recently, the Federal Reserve launched the TALF, which is aimed at restoring securitization markets, now virtually shut down. The closing of securitization markets, until recently an important source of credit for the economy, has added considerably to the stress in credit markets and financial institutions generally. Under the TALF, eligible investors may borrow to finance their holdings of the AAA-rated tranches of selected asset-backed securities. The program is currently focused on securities backed by newly and recently originated auto loans, credit card loans, student loans, and loans guaranteed by the Small Business Administration. The first TALF subscription attracted about $8 billion in total asset-backed securities deals and used about $4.7 billion in Federal Reserve financing. Over time, the list of securities eligible for the TALF is expected to expand to include additional securities, such as commercial mortgages, as well as securities that are not newly issued.

Relative to the Fed's short-term lending to financial institutions, the CPFF and the TALF are rather unconventional programs for a central bank to undertake. I see them as justified by the extraordinary circumstances in which we find ourselves and by the need for central bank lending practices to reflect the evolution of financial markets; after all, a few decades ago securitization markets barely existed. Notably, other central banks around the world have shown increasing interest in similar programs as they address the credit strains in their own countries. These programs also meet the criteria I stated at the beginning of my remarks regarding credit risk and credit allocation. Credit risk is very low in both programs; in particular, the TALF program requires that loans be overcollateralized and is further protected by capital provided by the Treasury. Both programs are directed at broad markets whose dysfunction impedes the flow of numerous types of credit to ultimate borrowers; consequently, I do not see these programs as engaging in credit allocation--the favoring of a particular sector or a narrow class of borrowers over others.

Purchases of High-Quality Assets
The third major category of assets on the Fed's balance sheet is holdings of high-quality securities, notably Treasury securities, agency debt, and agency-backed MBS. These holdings currently total about $780 billion, or about three-eighths of Federal Reserve assets. Of this $780 billion, holdings of Treasury securities currently make up about $490 billion. Some of these Treasury securities are lent out through the Term Securities Lending Facility that I mentioned earlier. Obviously, these holdings are very safe from a credit perspective. Longer-term securities do pose some interest-rate risk; however, because the Federal Reserve finances its purchases with short-term liabilities, on average and over time, that risk is mitigated by the normal upward slope of the yield curve.

The Fed's holdings of high-quality securities are set to grow considerably as the FOMC, in an attempt to improve conditions in private credit markets, has announced large-scale open-market purchases of these securities. Specifically, the Federal Reserve will purchase cumulative amounts of up to $1.25 trillion of agency MBS and up to $200 billion of agency debt by the end of the year, and up to $300 billion of longer-term Treasury securities over the next six months. The principal goal of these programs is to lower the cost and improve the availability of credit for households and businesses. As best we can tell, so far the programs are having the intended effect. For example, 30-year fixed mortgage rates, which responded very little to our cuts in the target for the federal funds rate, have declined 1 percentage point to 1-1/2 percentage points since our first MBS purchase program was announced in November. Over time, lower mortgage rates should help to improve conditions in the housing market, whose persistent weakness has had a major impact on economic and financial conditions more broadly, and will improve the financial condition of some households by facilitating refinancing. In addition, open-market purchases should benefit credit markets by adding liquidity and balance sheet capacity to the system.

Support for Specific Institutions
In addition to those programs I have just discussed, the Federal Reserve has provided financing directly to specific systemically important institutions. With the full support of the Treasury, we used emergency lending powers to facilitate the acquisition of Bear Stearns by JPMorgan Chase & Co. and also to prevent default by AIG. These extensions of credit are very different than the other liquidity programs discussed previously and were put in place to avoid major disruptions in financial markets. From a credit perspective, these support facilities carry more risk than traditional central bank liquidity support, but we nevertheless expect to be fully repaid. Credit extended under these programs has varied but recently has accounted for only about 5 percent of our balance sheet. That said, these operations have been extremely uncomfortable for the Federal Reserve to undertake and were carried out only because no reasonable alternative was available. As noted in the joint Federal Reserve-Treasury statement I mentioned earlier, we are working with the Administration and the Congress to develop a formal resolution regime for systemically critical nonbank financial institutions, analogous to one already in place for banks. Such a regime should spell out as precisely as possible the role that the Congress expects the Federal Reserve to play in such resolutions.

Liabilities
Having reviewed the Federal Reserve's main asset accounts, let me now touch briefly on the liability side of the balance sheet. Historically, the largest component of the Federal Reserve's liabilities has historically been Federal Reserve notes--that is, U.S. paper currency. Currency has expanded over time in line with nominal spending in the United States and demands for U.S. currency abroad. By some estimates, a bit over one-half of U.S. currency is held outside the country.

Other key liabilities of the Federal Reserve include the deposit accounts of the U.S. government and depository institutions. The U.S. government maintains a "checking account" with the Federal Reserve--the so-called Treasury general account--from which most federal payments are made. More recently, the Treasury has established a special account at the Federal Reserve as part of its Supplementary Financing Program (SFP). Under this program, the Treasury issues special Treasury bills and places the proceeds in the Treasury supplementary financing account at the Federal Reserve. The net effect of these operations is to drain reserve balances from depository institutions.

Depository institutions also maintain accounts at the Federal Reserve, of course, and over recent months, as the size of the Federal Reserve's balance sheet has expanded, the balances held in these accounts have increased substantially. The large volume of reserve balances outstanding must be monitored carefully, as--if not carefully managed--they could complicate the Fed's task of raising short-term interest rates when the economy begins to recover or if inflation expectations were to begin to move higher. We have a number of tools we can use to reduce bank reserves or increase short-term interest rates when that becomes necessary. First, many of our lending programs extend credit primarily on a short-term basis and thus could be wound down relatively quickly. In addition, since the lending rates in these programs are typically set above the rates that prevail in normal market conditions, borrower demand for these facilities should wane as conditions improve. Second, the Federal Reserve can conduct reverse repurchase agreements against its long-term securities holdings to drain bank reserves or, if necessary, it could choose to sell some of its securities. Of course, for any given level of the federal funds rate, an unwinding of lending facilities or a sale of securities would constitute a de facto tightening of policy, and so would have to be carefully considered in that light by the FOMC. Third, some reserves can be soaked up by the Treasury's Supplementary Financing Program. Fourth, in October of last year, the Federal Reserve received long-sought authority to pay interest on the reserve balances of depository institutions. Raising the interest rate paid on reserves will encourage depository institutions to hold reserves with the Fed, rather than lending them into the federal funds market at a rate below the rate paid on reserves.⁵ Thus, the interest rate paid on reserves will tend to set a floor on the federal funds rate.

The FOMC will continue to closely monitor the level and projected expansion of bank reserves to ensure that--as noted in the joint Federal Reserve-Treasury statement--the Fed's efforts to improve the workings of credit markets do not interfere with the independent conduct of monetary policy in the pursuit of its dual mandate of ensuring maximum employment and price stability. As was also noted in the joint statement, to provide additional assurance on this score, the Federal Reserve and the Treasury have agreed to seek legislation to provide additional tools for managing bank reserves.

Conclusion
These are extraordinarily challenging times for our financial system and our economy. I am confident that we can meet these challenges, not least because I have great confidence in the underlying strengths of the American economy. For its part, the Federal Reserve will make responsible use of all its tools to stabilize financial markets and institutions, to promote the extension of credit to creditworthy borrowers, and to help build a foundation for economic recovery. Over the longer term, we also look forward to working with our counterparts at other supervisory and regulatory agencies in the United States and around the world to address the structural issues--some of which have been discussed in this conference--that have led to this crisis so as to minimize the risk of ever facing such a situation again.

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Footnotes

1. Board of Governors of the Federal Reserve System and Department of the Treasury (2009), "The Role of the Federal Reserve in Preserving Financial and Monetary Stability: Joint Statement by the Department of the Treasury and the Federal Reserve," joint press release, March 23. Return to text

2. Credit and Liquidity Programs and the Balance Sheet is available on the Board's website. Return to text

3. Agency debt, in this instance, is debt issued by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Agency MBS are backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Return to text

4. Primary dealers are broker-dealers that trade in U.S. government securities with the Federal Reserve Bank of New York. Return to text

5. The interest rate on reserves did not establish a hard floor on the federal funds rate during the short period between the time that payment of interest on reserves was introduced and the FOMC's decision to bring the federal funds rate target close to zero. Possible reasons were the unfamiliarity of banks with the program, the fact that some institutions are not legally eligible to receive interest on reserve balances and were therefore willing to lend funds in the federal funds market at a rate below the rate paid by the Fed, and the reluctance of banks to use scarce balance sheet space to arbitrage the difference between the federal funds rate and the rate paid on reserves. We expect these problems to be reduced with time. Return to text"