The Fed's Liquidity Measures

May 2008

Moderator: Welcome to the Federal Reserve Bank of Atlanta's Financial Update Focus podcast. We're speaking today with Dave Altig, senior vice president and director of research for the Atlanta Fed. Dave will talk about the Fed's liquidity measures in light of the current financial stress. Thanks for joining us, Dave.

Dave Altig: Thank you.

Moderator: Dave, the Federal Reserve has taken a number of actions over the past eight months to address issues in credit markets and the broader economy. Can you explain what prompted the Fed to take these actions?

Altig: I think it's useful to start with thinking about what credit markets really do, which is channel funds from lenders to borrowers. Now, usually in this exchange, lenders want some sort of collateral or asset that guarantees repayment in case something goes wrong with the borrower: if the borrower becomes insolvent or for some reason is unable to pay. Now, it's been the case that a lot of collateral that got traded in these credit markets was related to mortgaged-backed assets. Around about August, we found ourselves in a situation where the value of assets that were backed by mortgages became somewhat suspect. And in fact in many cases—those related to the subprime market, for instance—the values began to fall fairly precipitously. That yielded a situation in which lenders were much less likely to be willing to accept mortgage-backed assets in exchange for providing these funds to borrowers. As a consequence, the functioning of credit markets really became quite compromised.

Moderator: Can you briefly describe what those actions were?

Altig: It's really a sequence of actions that the Federal Reserve has engaged in since August. The very first actions were actually fairly standard and not at all unusual. In August, we cut the interest rate that we charged banks on direct loans, called the primary credit rate, sometimes called the discount rate. In September we cut the federal funds rate. And these really are measures designed to provide markets the sort of liquidity—banks in particular—the sort of liquidity necessary to function in a more or less usual way. Now, we became a little bit more innovative as time went on. The first thing we did was really engage in a combination of activities that effectively extended the maturity of loans that we made to various players in the financial markets. Again, we're talking about mainly banks. So, these things went by names like the Term Auction Facility, repurchase agreements. But, really, what they amounted to was—rather than engaging in providing funds on an overnight basis to various players in the market—we provided funds on a slightly longer-term basis, 28 days. The idea being here is that many of these liquidity pressures that were bubbling up really were about funding over an extended period of time, and by stepping in and providing a source of those sorts of loans, the intent was to sort of break up the logjam in that part of the market. We got more innovative yet as time went on and broadened ourselves the sorts of collateral that we would take in exchange for the operations that we did with banks, in terms of both loans and in terms of open market operations. So the name for that sort of innovation was the Term Security Lending Facility. And of course, finally, we eventually extended the types of institutions that we would make loans to, moving beyond our traditional market of banks and then going into extending loans to broker-dealers. So, really, first what we did was, we took our standard tools and extended them a little bit by lengthening the maturity of loans we made to banks and the maturity of the dealings we did with our federal open market operations. From there we went to broadening the class of assets that we accepted in our policy operations and then finally extending our standard lending tools, really, to a broader set of institutions in the credit markets.

Moderator: To some people recent Fed actions appear to be a significant departure from past practices, and somewhat ad hoc. How would you characterize the Fed's actions to date?

Altig: Well, as I indicated just a minute ago, really, when all these actions are put together, there's a logic to them that looks a little clearer than it might when you look at each one of them in isolation. And in the big picture, although many of these things are quite unusual for the Federal Reserve, they're not unusual in the bigger community of central banking. For instance, broader classes of collateral acceptance—the dealing with beyond commercial banking—is more or less standard for the European central bank. So it's not like these ideas were all just sort of floated down out of the blue. They are part of the tool kit of central banking, even if not the ones that we've typically used in the past.

Moderator: Can you also provide your perspective on why the Federal Reserve stepped in to help facilitate the deal for JPMorgan Chase to purchase Bear Stearns?

Altig: The issue with Bear Stearns was that it was a particular example of a financial institution that was in the middle of a lot of transactions with many, many different players in the financial market on a very short-term basis. And the concern, of course, was that the failure of a central party in this market would really significantly spill over into other aspects of the market and create quite a lot of damage not just to players in financial markets but to the economy more generally, potentially. There's a tendency, I think, for people to call this a "bailout" of Bear Stearns. I think the shareholders of Bear Stearns might disagree with that. But I will say that it is true that, of course, there are probably some parties that found themselves in more desirable circumstances than they would have had Bear Stearns outright failed. That, of course, is part of the point because we want markets to continue to function as normally as they possibly could. There's always a risk of unintended consequences in these sorts of things, and I can assure you they're thought out very completely when actions of this sort are taken, but the judgment was made that the potential problems associated with an outright breakdown of this market far outweighed whatever risk might exist on the side of moral hazard problems and the sorts of things like that.

Moderator: What effect do you think the Fed's actions to date have had on credit markets and the broader economy?

Altig: Many of these actions were taken around the time of evidence of fairly extreme stress in financial markets. For instance, one of the series that we look at pretty continuously is the spread between interest rates that people have to pay on, say, 30-day loans, and those they have to pay on overnight loans. And those are often very close together. Since August they've been quite far apart in a historical context. And at times they've spiked up quite dramatically. And in fact many of our actions were taken around exactly those times, and the markets—although not returning to something that looks like the pre-August 2007 norm—they did settle down quite substantially. It's important I think to emphasize that there really is nobody in policy making circles that believes that all the innovations done by the Fed—the federal funds rate cuts or any other actions the central bank might take—solve every problem that exists out there in the economy at the moment. There are very, very substantial issues with, for example, real estate markets that we all know about and that we have no pretensions that we're going to fix. Really, the best context in which to think about Federal Reserve actions, or maybe all policy actions, is a way to provide a stable enough environment so that markets can work out the problems that markets have to work out. The issue is really avoiding a crisis scenario, where markets cease to function, and move back into the more normal context of people in markets realizing losses, thinking about the next investment opportunities going forward, and getting on with the business of consuming and investing and all that sort of stuff. And though that may take time, it may not be seamless, it may go slow, it will surely happen. And as long as we have a stable enough environment for that to happen, that's really the most we can expect to accomplish.

Moderator: Does the addition of all this liquidity to address credit market issues increase bank reserves in a way that could increase inflationary pressures?

Altig: The best answer to that is, it need not. Some of the actions, the Term Purchase Agreements, for example, really don't have any consequence on bank reserves, and Federal Reserve monetary policy at all. Others potentially could, but of course generally the approach would be to offset that with other sorts of actions that are quite standard open market operations so that monetary policy can be conducted independently of immediate needs when liquidity crises present themselves. So I think it's fair to say and worthy of emphasis that all of these actions are always taken with our eye on the ball of the other objectives, and first and foremost among those, of course, is to maintain a low and stable inflationary environment.

Moderator: Thank you for joining us today, Dave.

Altig: It was my pleasure, and I hope we are able to talk in calmer circumstances in the future.

Moderator: We've just spoken with Dave Altig, senior vice president and director of research at the Atlanta Fed. This concludes our Financial Update Focus podcast on the Fed's new liquidity measures. For more information, please see Financial Update Focus on the Atlanta Fed Web site, Thanks for listening, and please return for more podcasts. If you have a question, mail it to