Federal reserve and the Financial Crisis summary

federal reserve policies and financial market conditions during the crisis and what did the federal reserve do during the financial crisis of 2008 and 2009
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Published Date:17-07-2017
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THE FEDERAL RESERVE AND THE FINANCIAL CRISIS Lecture 2: The Federal Reserve after World War II 1. Early Challenges 2. The Great Moderation 3. Origins of the Recent Crisis What Is the Mission of a Central Bank? • Macroeconomic stability - All central banks use monetary policy to strive for low and stable inflation; most a so use monetary policy to try to promote stable growth in output and employment. • Financial stability - Central banks try to ensure that the nation's financial system functions properly; importantly, they try to prevent or mitigate financia panics or crises. Fed-Treasury Accord of 1951 • During World War II and subsequently, the Fed was pressed by the Treasury to keep longer-term interest rates low to allow the government debt accrued during the war to be financed more cheaply. • Keeping interest rates low even as the economy was growing strongly risked economic overheating and inflation. • In 1951, the Treasury agreed to end the arrangement and let the Fed set interest rates independently as needed to achieve economic stability. • The Fed has remained independent since 1951, conducting monetary policy to foster economic stability without responding to short-term political pressures. The Fed in the 1950s and Early 1960s • Between World War II and the recent financial crisis, macroeconomic stability was the predominant concern of central banks. image of William McC. Martin • During most of the 1950s and Chairman, 1951-1970 early 1960s, the Federal quote"Inflatio n is a thief in Reserve followed a "lean the night and if we against the wind" monetary don't act promptly and policy that sought to keep decisively we will both inflation and economic always be behind." growth reasonably stable. end of quote. The Great Inflation: Monetary Policy from the Mid-1960s to 1979 Inflation • Starting in the mid- For the accessible version of this figure, please see the accompanying HTML. 1960s, monetary policy was too easy. • This stance led to a surge in inflation and inflation expectations. • Inflation peaked at about 13 percent. The Great Inflation: Why Was Monetary Policy Too Easy? • Monetary policymakers were too optimistic about how "hot" the economy could run without generating inflation pressures. • When inflation began to rise, monetary policymakers responded too slowly. • Exacerbating factors included - oil and food price shocks - fiscal policies (such as spending for the Vietnam War) that stretched economic capacity - Nixon's wage-price controls that artificially held down inflation for a time Central Banking in an Evolving Economy • These experiences illustrate how central banks have to struggle with an evolving economy and imperfect knowledge. image of Arthu r Burns Chairman, 1970-1978 quote "In a rapidly changing world the opportunities for making mistakes are legion."end of quote. The Volcker Disinflation • To subdue double-digit inflation, Chairman Volcker announced, in October 1979, a dramatic break in the way that monetary policy would operate. image of Paul Volcker Chairman, 1979-1987 • In practice, the new approach to monetary policy quote "T o break th e inflation involved high interest rates cycle , ... w e must have (tight money) to slow the credibl e an d disciplined monetar y policy."en d of quote. economy and fight inflation. Inflation in the 1980s Inflation For the accessible version of this figure, please see the accompanying HTML. • In the years after the new disciplined monetary policy began, inflation fell markedly. • When Chairman Volcker left his post in 1987, the inflation rate was around 3 to 4 percent. The 1981-1982 Recession Unemployment Rate For the accessible version of this figure, please see the accompanying HTML. • The high interest rates needed to bring down inflation were costly. • In the sharp recession during 1981 and 1982, unemployment peaked at nearly 11 percent. The Great Moderation • During the Great Inflation of the 1970s, both output and image of Alan Greenspan inflation were highly volatile. Chairman, 1987-2006 • Following the Volcker quote ".. . a n environmen t of disinflation, from the mid- greate r economi c stability 1980s through 2007 ha s bee n ke y to (primarily Chairman impressiv e growt h in th e Greenspan's term), both standard s o f livin g an d economi c welfar e so output and inflation were eviden t in th e United much less volatile. States. " end of quote. • This was the period of "The Great Moderation." The Variability of Real GDP Growth Real GDP Growth For the accessible version of this figure, please see the accompanying HTML. The Variability of Inflation CPI Inflation For the accessible version of this figure, please see the accompanying HTML. Understanding the Great Moderation • Improved monetary policy after 1979 contributed to the Great Moderation. • In particular, low and stable inflation promoted broader economic stability. • Structural change (such as better inventory management) and simple good luck may also have contributed. • Financial stresses occurred (for example, the 1987 stock market crash), but they did not cause major economic damage. - One exception was a boom and bust in the stock prices of "dot-com" companies that touched off a mild recession in 2001. • Because of the relative tranquility during this period, monetary policy generally received greater emphasis than financial stability policies. Prelude to the Financial Crisis: The Housing Bubble Prices of Existing Single-Family Houses • From the late For the accessible version of this figure, please see the accompanying HTML. 1990s until early 2006, house prices soared 130 percent. • Meanwhile, mortgage lending standards deteriorated. Inflationary House Price Psychology • Rising house prices and weakening mortgage standards fed off each other: - Rising house prices created an expectation that housing was a "can't lose" investment. - Lax underwriting and the availability of exotic mortgages drove up demand for housing, raising prices further.

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