Monetary Policy and the Financial Crisis of 2007-2008
Stephen G. Cecchetti*
Revised 3 April 2008
*This essay was written while the author was the Barbara and Richard M. Rosenberg Professor of Global Finance, Brandeis International Business School; and a Research Associate, National Bureau of Economic Research. Note that as this draft was written, events were continuing to unfold. Hopefully, what I have written in February and March 2008 remains accurate. Among the vast number of people I spoke with in preparing this essay, I would especially like to thank Peter Fisher, Jens Hilscher, Spence Hilton, Anil Kashyap, Kim Schoenholtz, Jeremy Stein and Paul Tucker for their insights and comments. All errors are my own. All links in this document worked on 3 April 2008. Cecchetti Monetary Policy and the Financial Crisis of 2007-2008 March 2008 1
Central bankers are conservative people. They take great care in implementing policy; they speak precisely; they explain changes completely; and they study the environment trying to pinpoint where the next disaster looms. Good monetary policy is marked by its predictability. But when the world changes around them, policymakers change with it. If a crisis hits and the tools at hand are not up to the job, then central bank officials can and will improvise. In August 2007, the world changed and the traditional instruments of monetary policy were not up to the task.
For some time now, there has been a consensus among monetary economists on the fundamentals of policy design. These agreed upon principles of best practice extend from central bank design to operational policy. They include the belief that central banks should be independent, but have clearly defined policy objectives for which they are held accountable; policymakers’ operational instrument should be an interest rate; and officials need to be transparent and clear in communicating what they are doing and why they are doing it. Furthermore, there is agreement that the central bank is the right institution to monitor and protect the stability of the financial system as a whole.1
An important part of the consensus has been that central banks should provide short-term liquidity to solvent financial institutions that are in need. But, as events in 2007 and 2008 show, not all liquidity is created equal. And critically, the consensus model used by monetary economists to understand central bank policy offers no immediate way to organize thinking about this sort of problem.2
This paper provides an account of the financial crisis that began on 9 August 2007 and continued into 2008. It is the story of how the crisis came about and how the Federal Reserve worked to contain the damage. To understand what has happened, I will start with financial developments that led up to the crisis. Section II describes some of the most relevant recent innovations in the financial system and their impact on residential mortgage lending, the focus of the early stages of the crisis. A full appreciation of the Fed’s response requires an understanding of how the traditional tools of monetary policy work. This is the task of section III. Section IV describes the nature of the crisis, describing the symptoms and speculating about the causes.
Finally in Section V we get to the monetary policy responses. Because of the specific nature of the financial distress, it became clear during the fall of 2007 that the traditional central bank tools were of limited use. While officials were able to inject liquidity into the financial system, they had no way to insure that the funds got to the institutions that needed it most. Realizing the failings of their traditional tools, Fed officials innovated creating a new lending procedures in the form of the Term Auction Facility and the Primary Dealer Credit Facility, as well as changed their securities lending program creating the Term Securities Lending Facility. I describe how these new systems work and...
References: Bagehot, Walter. 1873. Lombard Street: A Description of the Money Market. London: Henry S. Kin & Co.
Cecchetti, Stephen G. Money, Banking, and Financial Markets, 2nd edition. New York, N.Y.: McGraw Hill
– Irwin, 2008.
Princeton University Press, 2003.
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