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approach zero, my work on inflation targeting and the need for policy transparency appeared even more relevant. In March 2003 I began a series of speeches on the topic.

Although inflation targeting was controversial within the FOMC, I wasn’t worried about ruffling feathers by speaking about it outside the walls of the Fed. Board members and Reserve Bank presidents regularly give speeches on topics ranging from monetary policy to banking regulation. Speech texts are sometimes circulated in advance for comment or as a courtesy, but they do not have to be cleared by the chairman or anyone else. Except in rare circumstances, there is no coordination of topic or message. Speakers are expected to make clear that they are expressing their own views and not those of the Committee as a whole. FOMC participants also observe a “blackout period,” just before and just after scheduled FOMC meetings, in which they refrain from discussing current monetary policy and the economic outlook. The practice helps keep markets calmer around meetings.

I began my March 2003 speech by observing that, despite a global trend toward inflation targeting that included advanced economies, emerging markets, and even economies transitioning from communism, few in the United States understood or appreciated its benefits. “Discussions of inflation targeting in the American media remind me of the way some Americans deal with the metric system—they don’t really know what it is, but they think of it as foreign, impenetrable, and slightly subversive,” I said.

One reason for skepticism was that inflation targeting seemed to neglect half of the Fed’s dual mandate (maximum employment) in favor of the other half (price stability). Despite its name, however, inflation targeting was not only about inflation control. Inflation targets generally need be met only over periods of several years, leaving plenty of scope for monetary policy to react to an increase in unemployment. This version of inflation targeting—what economists and central bankers call “flexible inflation targeting”—couples longer-term inflation discipline with shorter-term flexibility to counter economic weakness. Virtually all central banks that target inflation are “flexible” inflation targeters.

Indeed, it seemed to me that an inflation target, if accepted as credible by markets and the public, would give the Fed more rather than less room to respond to an economic slowdown. If the markets and the public are confident that the Fed will act as needed to meet its inflation target over time—or, as economists put it, if the public’s expectations of inflation are “well anchored” at the target—then the demands of wage- and price-setters will tend to be moderate. Moderate wage and price demands would in turn allow the Fed to fight rising unemployment aggressively with less concern that inflation might get out of control.

In the context of 2003, the communications benefits of inflation targeting seemed particularly salient. Facing the possibility of deflation, we needed to stimulate economic demand and nudge inflation a bit higher. But, with the federal funds rate approaching zero, we had little scope left to ease policy in the conventional way, by reducing the federal funds rate further. In any case, the funds rate, by itself, is relatively unimportant. The interest rates that really matter for the economy, such as mortgage rates or corporate bond rates, are much longer-term. These longer-term rates are not under the Fed’s direct

control. Instead, they are set by participants in financial markets.

With little room to cut the funds rate further, how could we put downward pressure on longer-term rates? One way was to convince market participants that we intended to keep the short-term rate that we controlled low for a relatively long time. In setting longer-term rates, market participants take into account their expectations for the evolution of short-term rates. So, if short-term rates were expected to be lower for longer, longer-term rates would tend to be low as well. Suppose, I argued, that the Fed had a numerical inflation target, and that actual inflation was projected to remain well below target. In that situation, investors would infer that we needed to keep short-term rates low for quite a while. As a result, longer-term rates would be lower than would otherwise be the case, stimulating demand and pushing inflation up toward our target.

Without inflation targeting or a coherent communications framework, the Fed had what I called a Marcel Marceau communications strategy. The idea was watch what I do, not what I say. That might have been adequate in normal times. Markets can infer how the Fed is likely to behave based on how it has behaved in the past. However, in 2002 and 2003, with interest rates and inflation quite low, markets didn’t have enough examples of Fed behavior in similar circumstances. Inflation targeting, I argued, could help fill the information vacuum.

The inflation-targeting dispute at the Fed had been going on for a while. Greenspan had staged a debate on the topic at the January 1995 FOMC meeting to sound out the Committee’s position before testifying at congressional hearings. During my time as a rank-and-file Board member, however, Greenspan remained firmly opposed. He also appeared concerned about achieving consensus among the seven Board members and twelve Reserve Bank presidents on what inflation target to set and how to characterize our plans for achieving the target. Finally, as a veteran of political battles, he hinted at his reluctance to change the framework for monetary policy without congressional authorization. Thus, although as a group we endlessly discussed the increasingly evident need for more effective communication, and sometimes mentioned inflation targets, we knew it wasn’t going to happen unless Greenspan changed his views.

AS THE WAR in Iraq proceeded, uncertainties ebbed somewhat and we got a clearer look at the state of the economy. Leading into the May 2003 meeting, we didn’t like what we saw. Payrolls continued to decline after the big drop in February, bringing the cumulative three-month loss through April to 525,000 jobs.

Moreover, inflation continued to edge lower. Without a well-established communications framework, we struggled to convey our commitment to keep monetary policy easy until inflation increased and job growth resumed.

The FOMC’s communications had indeed followed a long and tortuous journey. Until 1994, the Committee had made no postmeeting statement, not even when the decision was to change the federal funds rate. Instead, market participants had to guess at the FOMC’s decision by watching developments in

short-term money markets. Starting in February 1994, Greenspan issued a postmeeting “chairman’s statement,” usually drafted with the help of Don Kohn. However, Committee members soon recognized the effect that the statement could have on markets, and, over time, they became increasingly involved in its drafting. The statement also grew longer as the Committee tried to communicate its leanings without necessarily committing to a specific action.

The statement we issued after our May 2003 meeting included a key new sentence, one that reflected the Committee’s growing concerns about deflation. We said that “the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup of inflation from its already low level.” The statement, though convoluted, focused attention on too-low inflation and, most importantly, conveyed that substantially lower inflation would be “unwelcome”—in stark contrast to the past forty years, when declining inflation was invariably viewed as good. Effectively, the Committee was saying that we had an inflation target—but without giving a number—and that we were concerned that inflation would fall below it.

The markets got the message. Expecting easier monetary policy, or at least a continuation of the current level of ease, traders bid down longer-term interest rates, adding more stimulus to the economy. The yield on ten-year Treasury securities, at 3.92 percent on the day before the meeting, fell as low as 3.13 percent by mid-June. Thirty-year fixed rate mortgages fell from 5.7 percent to 5.2 percent. Notably, we had attained this result through words only. At our June meeting, we followed up by cutting the federal funds rate, from 1-1/4 percent to 1 percent—the lowest level since the Fed had begun using the rate as a policy instrument in the 1960s.

Around this time, I used my speeches, including one in May in Japan, the poster child for deflation, to raise awareness that inflation could be too low as well as too high. In July, at the University of California, San Diego, I said the Fed must take even a small risk of deflation seriously and make clear that it was prepared to prevent it. Explaining our policy intentions was key. “The success of monetary policy depends more on how well the central bank communicates its plans and objectives than on any other single factor,” I said. Of course, I saw the adoption of a numerical inflation target as the cleanest way to make our policy intentions clear.

The FOMC wasn’t ready to take that step, but we spent many hours debating how to communicate our policy plans. In the statement after our August meeting, we offered guidance, albeit vague, on our own expectations for monetary policy. We said we expected we would maintain low interest rates for “a considerable period.” The goal of that phrase was to keep longer-term interest rates low by influencing market expectations for short-term rates.

As the FOMC was pushing for a stronger recovery, we got some help from fiscal policy. In May 2003, the Bush administration won new tax cuts from Congress, on top of tax cuts approved in 2001. The bill put cash into people’s pockets by cutting taxes on wages and on personal interest and dividends. To the extent they spent their tax cuts, demand for goods and services would increase, thus encouraging more

production and hiring.

IN NOVEMBER, TIM GEITHNER replaced Bill McDonough as president of the New York Fed. The New York Fed president, as the vice chairman of the FOMC, has an important voice in monetary policy and— because many of the nation’s largest banks are headquartered in New York—in banking supervision as well. I would ultimately become a big fan of Tim’s, but when I first met him I was underwhelmed. Tim is slight, soft-spoken, and looked if anything younger than his forty-two years. He had neither professional credentials in economics nor experience as a bank supervisor. What he had was unqualified support from heavy hitters including former Treasury secretaries Larry Summers and Bob Rubin, as well as the chairman of the New York Fed’s board—Pete Peterson, a former commerce secretary under Richard Nixon and the cofounder of the Blackstone private equity firm. I was skeptical about giving someone such an important job based on recommendations rather than on qualifications and a record of sustained accomplishment.

It turned out, however, to have been the right appointment. Tim did not have a doctorate but he had the equivalent of a PhD in financial crisis management. After working at Henry Kissinger’s global consulting firm, he had joined the staff of the Treasury Department in 1988. He rose quickly, impressing Rubin and Summers with his intelligence and savvy and playing an important role in the Treasury’s efforts to put out financial fires around the world, most notably the Asian financial crisis in 1997.

By the December 2003 meeting, Geithner’s first, the economy looked stronger. Impressively, a preliminary estimate put economic growth in the third quarter at more than an 8 percent annual rate. FOMC participants during the go-round were upbeat. Several noted that the “considerable period” language appeared to be helping to keep longer-term interest rates down. “It’s very evident that our effort to communicate that message has succeeded,” Greenspan said. Despite the improved outlook, inflation remained too low for us to feel confident that deflation risks had been eliminated; and unemployment was still at 6 percent. The FOMC kept the funds rate at 1 percent and continued to project that policy accommodation would be maintained for a considerable period.

MY APPOINTMENT TO the Board in August 2002 had been to serve what was left of Mike Kelley’s term, which would expire on January 31, 2004. White House officials had made no firm commitment but said I would receive strong consideration if I wanted a new term. It seemed too soon to return to Princeton, and so, during the summer of 2003, I asked to be reappointed. I soon received word that the reappointment had been approved. Princeton extended my two-year leave to three years but made clear it would not grant further extensions.

Attendance was sparse at my confirmation hearing before the Senate Banking Committee, on October 14, 2003, even though I appeared with Roger Ferguson, who was being nominated for another four-year term as Board vice chairman. As he usually did, Senator Jim Bunning of Kentucky, a Baseball Hall of

Fame pitcher, criticized the Fed. He would continue to throw high and inside at me and other Fed officials for his remaining years in Congress. Bunning asked for assurances that Ferguson and I would not “rubber-stamp” Greenspan’s decisions. I replied that I had been generally comfortable with the direction of policy, but noted that I had staked out independent positions on issues like inflation targeting. The nominations moved to the full Senate and Roger and I were reconfirmed without fanfare.

BY THE TIME of the first FOMC meeting of 2004, in late January, the economic outlook had brightened further still. The economy had grown at better than a 6 percent annual rate in the second half of 2003, and unemployment, at 5.7 percent in December, seemed to be on a mild downtrend. On the other hand, job growth remained flat and inflation was still very low. Ned Gramlich, who had dissented in favor of easier monetary policy in September 2002, proved to be a bellwether by swinging to the hawkish camp that worried about keeping interest rates too low for too long. He said a pattern of vigorous growth was spreading throughout the economy and it was time to start gradually reducing monetary stimulus. Greenspan too was optimistic that, even with less support from monetary policy, the economy could continue to improve.

Managing our communications had been critical in the easing process, and it would be equally important for a successful tightening of policy. As a first step in reducing stimulus, we dropped the assertion in our postmeeting statement that we would maintain low rates for a considerable period and said, instead, that we thought we could “be patient in removing” easy policy. Markets apparently missed the hint that we were moving, albeit slowly, toward tightening policy. Both short- and long-term interest rates changed little.

The economy continued to improve through 2004. Meanwhile, we continued to fiddle with the statement language. At the May meeting, we dropped “be patient” and said we thought easy policy could “be removed at a pace that is likely to be measured.” We were signaling now not only the timing of the next rate increase (soon) but also the pace of subsequent increases (slow). In June, we abandoned our reliance on language alone and agreed, without dissent, to raise the target for the federal funds rate from 1 percent to 1-1/4 percent. It was the first increase since May 2000, before the recession had begun. Continued strength in job creation and receding deflation risk justified the action. Initial rate increases by the Fed can sometimes jar financial markets, but in this case market participants anticipated the move. They were seeing the same improvements in the economy that we observed and, with help from our statements, were guessing correctly how monetary policy would respond.

“The economy has come a long way in the past year, and . . . we should pause to take some satisfaction in the Federal Reserve’s contribution to the turnaround,” I said at the June meeting. “Our policy actions, reinforced by innovations in our communication strategy, helped provide crucial support to the economy during a dangerous period.”

After sputtering for a year and a half, the recovery over the second half of 2003 and through 2004

went from jobless to job-creating. At the same time, inflation went from worryingly low levels to something closer to 2 percent—high enough to provide a buffer against deflation but not so high as to interfere with the healthy functioning of the economy. If we hadn’t supported the economy by lowering interest rates and through our communication, the recovery would have been more halting, unemployment would have been higher for longer, and deflation risks would have been much higher.*

True to our word, the FOMC would increase rates at a “measured pace” over the next two years. By Greenspan’s last FOMC meeting in January 2006, the Fed had raised the federal funds rate to 4-1/2 percent. Nevertheless, the economy continued to create jobs with modest inflation. The unemployment rate in Greenspan’s last month in office was 4.7 percent, and inflation was trending just under 2 percent.

The Maestro looked to have done it again. At the Kansas City Fed’s annual Jackson Hole symposium in August 2005, his last as chairman, he was hailed as the greatest central banker in history.

* Data revisions suggest the deflation risk may have been slightly less than we thought at the time, although inflation was certainly very subdued. Policymakers must of course make their decisions based on the data available at the time. Moreover, given the economy’s weakness, inflation was at risk of dropping meaningfully further.

CHAPTER 5

The Subprime Spark

Even as the United States enjoyed what appeared to be a Goldilocks economy (not too hot, not too cold) and Alan Greenspan was receiving accolades for a successful eighteen-year run, dangerous risks were building. These risks are clear now in hindsight but were less so at the time.

Toward the end of my tenure as chairman, I was asked what had surprised me the most about the financial crisis. “The crisis,” I said. I did not mean we missed entirely what was going on. We saw, albeit often imperfectly, most of the pieces of the puzzle. But we failed to understand—“failed to imagine” might be a better phrase—how those pieces would fit together to produce a financial crisis that compared to, and arguably surpassed, the financial crisis that ushered in the Great Depression.

A few people had warned about various risks but few, if any, economists—or, for that matter, policymakers or financial executives—had assembled all the pieces into a coherent whole. Future Nobelist Robert Shiller of Yale warned of a possible bubble in house prices in his 2005 book Irrational Exuberance. Even earlier, in 2003, at the annual Federal Reserve Bank of Kansas City conference inJackson Hole, Wyoming, Claudio Borio and William White of the Bank for International Settlements (BIS) wrote that long periods of financial calm could lead investors and financial institutions to become complacent and take excessive risks. Their arguments echoed ideas published decades earlier by the economist Hyman Minsky, who believed that, absent a crisis, risks in the financial system tend to build up. In 2005, also at Jackson Hole, University of Chicago economist (and later governor of India’s central bank) Raghuram Rajan spoke about poorly designed compensation arrangements that might lead asset managers to take excessive risks. Of course, as always seems to be the case, many commentators also warned about imminent crises that did not occur, such as the return of high inflation or a collapse of the

dollar in the face of the nation’s large trade deficit.

If a hurricane knocks down a house, you can blame it on the strength of the hurricane or on structural deficiencies in the house. Ultimately, both factors matter. A destructive financial crisis is analogous. There are the immediate causal factors, or triggers—the hurricane. But the triggers cannot cause extensive damage without structural weaknesses, the vulnerabilities of the system itself—a house with a weak foundation.

The financial crisis of 2007–2009 had several triggers. The most important and best known is the rapid run-up and subsequent collapse in housing prices and construction. As is also widely appreciated, the housing boom and bust was in turn fueled by a widespread breakdown in discipline in mortgage lending, particularly in subprime lending (lending to borrowers with weak credit records).* Other, less-emphasized, triggers included excessively risky lending to commercial real estate developers and a huge global demand for financial assets perceived to be safe—a demand that incentivized Wall Street to construct and sell complicated new financial instruments that would ultimately blow up.

Many accounts of the financial crisis focus almost entirely on the triggers, particularly the housing bust and irresponsible subprime lending. These triggers, like a powerful hurricane, would have had destructive effects in any scenario. But in the absence of key structural vulnerabilities in the financial system itself, the hurricane would not have come nearly so close to bringing down our entire economy. The American financial system had become increasingly complex and opaque, the financial regulatory system had become obsolete and dangerously fragmented, and an excessive reliance on debt—particularly short-term debt—had rendered the system unstable under pressure. The extraordinary complexity of the interaction of triggers and structural vulnerabilities helps explain why so few people anticipated the full nature and extent of the crisis.

But even if housing and subprime lending were only part of the story, they nevertheless were critical elements. It’s accordingly important to understand how the Fed saw the developments in those areas before the crisis and why we and other regulators were not more effective in defusing the growing risks.

THE EVOLUTION OF housing finance offers as good an illustration as any of the sea changes in the financial system from the mid-twentieth century to the early twenty-first century. Decades ago, it was common for bankers to take deposits from people they nodded hello to at the grocery store and to make mortgage loans to people in neighborhoods within a thirty-minute drive of the bank. Community bankers, or the local representatives of larger banks, often knew personally the people to whom they were lending and had good information as well about the collateral (the home) that backed the loan. They usually kept those loans on their own books, giving them every incentive to try to make sound lending decisions.

By the time I arrived at the Fed in 2002, the traditional model of mortgage lending had been largely replaced by a sleeker, shinier version. In theory, the changes to the traditional model were improvements, designed to address weaknesses of the older system. New technologies, like computerized credit records

and standardized credit scores, made mortgage lending more efficient and more competitive, reducing costs and expanding the range of borrowers that lenders could serve. Moreover, firms that made mortgage loans were no longer mostly limited to lending funds raised by deposits, as had once been the case. Instead, they could sell their mortgages to third parties, who packaged them together and sold the newly created securities to investors—a process called securitization. Securitization allowed mortgage lenders access to an enormous pool of global savings to fund new loans. The suppliers of funds also saw benefits. The new mortgage-backed securities (MBS) could be structured in ways that increased diversification— by combining mortgages from different regions of the country, for example—and could be sliced into segments, or tranches, to accommodate the risk preferences of investors.

The advantages of the new model (sometimes called the originate-to-distribute model) were real. But by the early 2000s, the system was also facilitating, or even encouraging, risky and irresponsible behavior. Because mortgage originators no longer expected to retain the loans they made for very long, they cared less about the quality of those loans. Often, they delegated the responsibility of arranging loans to brokers with no more skin in the game than a month-to-month lease on an office in a strip mall. Brokers, often paid by commission, raced to connect as many borrowers as possible with mortgage originators. As in the traditional model, sometimes the originator was a commercial bank or savings and loan. But often, the originator of the loan was a nonbank company financed by Wall Street through various forms of short-term lending—a source of funding that could disappear literally overnight.

As the chain from borrower to broker to originator to securitizer to investor grew longer, accountability for the quality of the underlying mortgages became more and more diffused. Ultimately the complex securities, blessed by supposedly independent rating agencies (private firms paid by the issuers of securities to grade those very securities), were purchased by investors ranging from U.S. pension funds to German banks to sovereign wealth funds owned by Asian or Middle Eastern governments. Most investors did not independently analyze the securities they bought and had limited understanding of the risks involved. In some cases, unethical investment firms intentionally palmed off bad mortgage securities on investors. But many securitizers did not themselves appreciate the risks of the products they were selling. One study found that many Wall Street managers engaged in securitized finance had aggressively increased their personal investments in housing from 2004 through 2006, on the expectation that house prices would continue to rise.

For a time, these arrangements seemed to work well for both borrowers and investors. Investors liked that they could purchase highly rated assets with higher yields than government debt. Mortgage borrowers benefited from lower origination costs and increased credit availability. Indeed, thanks to the easy availability of subprime mortgages with low monthly payments, at least initially, many more Americans were participating in what the housing industry and politicians liked to call the American dream of homeownership. What happened if a homeowner couldn’t pay the mortgage when the introductory interest rate reset higher? The assumption was, with house prices moving ever upward, a homeowner could

refinance into a new mortgage or, as a last resort, sell the house and repay the loan. If a homeowner defaulted, investors in mortgage-backed securities would be protected because the house would be worth more than the mortgage. Diversification and the magic of financial engineering spread the risk thin and dispersed it around the world.

What if house prices fell precipitously and a lot of homeowners defaulted? No one really knew—but it seemed very, very unlikely. Until, of course, it happened.

IN THE YEARS FOLLOWING the 2001 recession, my colleagues at the Fed and I were paying close attention to developments in housing and mortgage markets, but we saw pluses as well as minuses. Robust home construction helped bolster otherwise sluggish economic growth, and rising home values supported consumer confidence. Chairman Greenspan often noted that homeowners’ borrowing against the equity in their homes was an important source of consumer spending. We talked more about banks’ profitability and improved capital positions than about their risks from mortgage lending. Indeed, the banking system seemed exceptionally strong. Not a single bank failed in 2005, the first year without a failure since the inception of federal deposit insurance during the Depression. Industry-wide, banks reported high profits and low credit losses.

We were not entirely unaware of or unconcerned about the risks to housing or the financial sector more generally. For example, at several FOMC meetings, Boston Fed president Cathy Minehan said she worried that low interest rates could be inducing investors to “reach for yield,” that is, to make excessively risky investments in the hope of earning higher returns. Atlanta Fed president Jack Guynn regularly reported on overheated housing markets in Florida (part of his district) and fretted that his region’s banks would be hurt by their lending to construction companies. Sue Bies, who became the head of the Board’s bank supervision committee in August 2002, voiced serious concerns about troubled subprime mortgage loans and their potential effects on lenders and borrowers. At several meetings, Board members Ned Gramlich and Roger Ferguson quizzed the staff about the risk of bubbles.

Date: 2016-04-22; view: 732