Text: Ben Bernanke's Speech

The Federal Reserve’s Response
Fortunately, after a number of years of strong earnings, most financial institutions entered the current episode in good financial condition. Thus, notwithstanding the effects of multi-billion dollar write-downs on the earnings and share prices of some large institutions, the banking system remains sound. Nevertheless, the market strains have been serious, and they continue to pose risks to the broader economy. The Federal Reserve accordingly has taken a number of steps to help markets return to more orderly functioning and to foster its macroeconomic objectives of maximum sustainable employment and price stability.

Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy.

To help address the significant strains in short-term money markets, the Federal Reserve has taken a range of steps. Notably, on August 17, the Federal Reserve Board cut the discount rate--the rate at which it lends directly to banks--by 50 basis points, or 1/2 percentage point, and it has since maintained the spread between the federal funds rate and the discount rate at 50 basis points, rather than the customary 100 basis points.2 The Fed also adjusted its usual practices to facilitate the provision of discount window financing for as long as thirty days, renewable at the request of the borrower. Loans through the discount window differ from conventional open market operations in that the loans can be made directly to individual banks. In contrast, open market operations are arranged with a limited set of dealers of government securities. In addition, whereas open market operations involve lending against government and agency securities, loans through the discount window can be made against a much wider range of collateral.

The changes to the discount window were designed to assure banks of the availability of a backstop source of liquidity. Although banks borrowed only moderate amounts at the discount window, they substantially increased the amount of collateral they placed with Reserve Banks. This and other factors suggest that these changes to the discount window facility, together with the statements and actions of the FOMC, had some positive influence on market conditions.

However, as a tool for easing the strains in money markets, the discount window has two drawbacks. First, banks may be reluctant to use the window, fearing that markets will draw adverse inferences about their financial condition and access to private sources of funding--the so-called stigma problem. Second, to maintain the federal funds rate near its target, the Federal Reserve System’s open market desk must take into account the fact that loans through the discount window add reserves to the banking system and thus, all else equal, could tend to push the federal funds rate below the target set by the FOMC. The open market desk can offset this effect by draining reserves from the system. But the amounts that banks choose to borrow at the discount window can be difficult to predict, complicating the management of the federal funds rate, especially when borrowings are large.

To address the limitations of the discount window, the Federal Reserve recently introduced a term auction facility, or TAF, through which prespecified amounts of discount window credit can be auctioned to eligible borrowers. As I will discuss in greater detail in a moment, our intention in developing the TAF was to provide a tool that could more effectively address the problems currently affecting the interbank lending market without complicating the administration of reserves and the federal funds rate. In December, the Fed successfully auctioned $40 billion through this facility and, as part of a coordinated operation, the European Central Bank and the Swiss National Bank lent an additional $24 billion. These two central banks obtained the dollars from the Federal Reserve through currency swaps (essentially, two-way lines of credit in which each central bank agrees to lend the other up to a fixed amount in its own currency). As part of the same coordinated action, the central banks of the United Kingdom and Canada conducted similar operations in their own currencies. On January 4, the Federal Reserve announced that we will auction an additional $60 billion in twenty-eight-day credit through the TAF, to be spread across two auctions that will be held later this month. With these actions and the passage of the year end, term premiums in the interbank market and some other measures of strains in funding markets have eased significantly, though they remain well above levels prevailing before August last year.

Based on our initial experience, it appears that the TAF may have overcome the two drawbacks of the discount window, in that there appears to have been little if any stigma associated with participation in the auction, and--because the Fed was able to set the amounts to be auctioned in advance--the open market desk faced minimal uncertainty about the effects of the operation on bank reserves. The TAF may thus become a useful permanent addition to the Fed’s toolbox.3 TAF auctions will continue as long as necessary to address elevated pressures in short-term funding markets, and we will continue to work closely and cooperatively with other central banks to address market strains that could hamper the achievement of our broader economic objectives.

Although the TAF and other liquidity-related actions appear to have had some positive effects, such measures alone cannot fully address fundamental concerns about credit quality and valuation, nor do these actions relax the balance sheet constraints on financial institutions. Hence, they cannot eliminate the financial restraints affecting the broader economy. Monetary policy (that is, the management of the short-term interest rate) is the Fed’s best tool for pursuing our macroeconomic objectives, namely to promote maximum sustainable employment and price stability.

Although economic growth slowed in the fourth quarter of last year from the third quarter’s rapid clip, it seems nonetheless, as best we can tell, to have continued at a moderate pace. Recently, however, incoming information has suggested that the baseline outlook for real activity in 2008 has worsened and the downside risks to growth have become more pronounced. Notably, the demand for housing seems to have weakened further, in part reflecting the ongoing problems in mortgage markets. In addition, a number of factors, including higher oil prices, lower equity prices, and softening home values, seem likely to weigh on consumer spending as we move into 2008.

Financial conditions continue to pose a downside risk to the outlook for growth. Market participants still express considerable uncertainty about the appropriate valuation of complex financial assets and about the extent of additional losses that may be disclosed in the future. On the whole, despite improvements in some areas, the financial situation remains fragile, and many funding markets remain impaired. Adverse economic or financial news has the potential to increase financial strains and to lead to further constraints on the supply of credit to households and businesses. I expect that financial-market participants--and, of course, the Committee--will be paying particular attention to developments in the housing market, in part because of the potential for spillovers from housing to other sectors of the economy.

A second consequential risk to the growth outlook concerns the performance of the labor market. Last week’s report on labor-market conditions in December was disappointing, as it showed an increase of 0.3 percentage point in the unemployment rate and a decline in private payroll employment. Heretofore, the labor market has been a source of stability in the macroeconomic situation, with relatively steady gains in wage and salary income providing households the wherewithal to support moderate growth in real consumption spending. It would be a mistake to read too much into any one report. However, should the labor market deteriorate, the risks to consumer spending would rise.

Even as the outlook for real activity has weakened, there have been some important developments on the inflation front. Most notably, the same increase in oil prices that may be a negative influence on growth is also lifting overall consumer prices and probably putting some upward pressure on core inflation measures as well. Last year, food prices also increased exceptionally rapidly by recent standards, further boosting overall consumer price inflation. Thus far, inflation expectations appear to have remained reasonably well anchored, and pressures on resource utilization have diminished a bit. However, any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring the inflation situation, particularly as regards inflation expectations.

Monetary policy has responded proactively to evolving conditions. As you know, the Committee cut its target for the federal funds rate by 50 basis points at its September meeting and by 25 basis points each at the October and December meetings. In total, therefore, we have brought the funds rate down by a percentage point from its level just before financial strains emerged. The Federal Reserve took these actions to help offset the restraint imposed by the tightening of credit conditions and the weakening of the housing market. However, in light of recent changes in the outlook for and the risks to growth, additional policy easing may well be necessary. The Committee will, of course, be carefully evaluating incoming information bearing on the economic outlook. Based on that evaluation, and consistent with our dual mandate, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.

Financial and economic conditions can change quickly. Consequently, the Committee must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability.