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The Credit Crisis and the Role of the Federal Reserve :: November 14, 2008 :: Federal Reserve Bank of Cleveland home | news & media | careers | site map FEDERAL RESERVE BANK o f CLEVELAND A bout U Tours For the Public News & Media Com munit y D e velopm ent S tream ing Media Forefront M agazine Speakers Bureau I Our IRegion I Research I Ban kin g I Learning Center Savings Bonds Home > For th e Public > News and Media > Speeches > 2 0 08 > The C redit Crisis and th e Role of th e Federal... SH RRE ^ f ... The Credit Crisis and the Role of the Federal Reserve Additional Information Sandra Pianalto Introduction T h e la s t tim e I sp o k e a t th is fo ru m w a s b a c k in th e sp rin g o f 2 0 0 4 , ju s t a b o u t a y e a r a f t e r I w a s n a m e d p r e s id e n t a n d CEO o f th e F e d e ra l R e se rv e B ank o f C le v e la n d . A t t h a t tim e , I s h a re d so m e o f m y v iew s on th e s t a t e o f th e re g io n a l e c o n o m y d u rin g a p e rio d o f r e la tiv e p ro s p e rity a t th e n a tio n a l le v e l. S in ce th e n , w e h a v e s e e n d r a m a tic ch a n g e s in o u r c r e d it m a rk e ts t h a t h av e a f f e c te d n o t ju s t o u r re g io n a l a n d n a tio n a l e c o n o m y , b u t e c o n o m ie s ac ro ss th e w o rld . In d e e d , th e s e a r e h isto ric a n d u n p r e c e d e n te d tim e s. President and CEO, Federal Reserve Bank o f Cleveland The City Club of Cleveland C lev e lan d , Ohio November 14, 2008 T h e F e d e ra l R e serv e h as c e r ta in ly b e e n g e ttin g its s h a re o f p ress c o v e ra g e . W e h a v e also s e e n n u m e ro u s s to rie s a b o u t “ W all S t r e e t ” v e rsu s “M ain S t r e e t ,” as if th e r e w e r e a g ia n t w a ll d ividing th e tw o . In r e a lity , th e tw o w o rk to g e th e r — th e s e a r e th e n u ts an d b o lts of fin a n c e an d c o m m e rc e t h a t to u c h o u r e v e ry d a y lives. In my re m a rk s to d a y , I w ill ta lk a b o u t W all S tr e e t a n d M ain S tr e e t. I w ill d e s c rib e th e tu rm o il in fin a n c ia l m a rk e ts , as w e ll as th e F e d e ra l R e se rv e ’s a c tio n s to a d d re s s th e s itu a tio n . I w ill m a k e so m e c o m m e n ts a b o u t th e ec o n o m y . And th e n I w ill a d d re s s th e q u e s tio n I g e t a sk e d m o st o fte n : “ W hen w ill fin a n c ia l m a rk e ts re tu r n to n o rm al? Of c o u rs e , th e v iew s I e x p re ss to d a y a r e m y ow n a n d do n o t n e c e s sa rily r e f le c t th e v iew s o f my c o lle a g u e s in th e F e d e ra l R eserv e S y stem . History L et m e beg in by w alk in g you th ro u g h a b it o f h isto ry b e h in d W all S tr e e t an d Main S tr e e t. I w o u ld like to ta k e you all th e w a y b a c k to th e e a rly y e a rs o f th e tw e n tie th c e n tu r y , b e fo re th e F e d e ra l R eserv e c a m e in to e x i s te n c e 1. T h e s to ry s ta r t s in 1 9 0 6 - a tim e w h e n th e U.S. e c o n o m y h a d b e e n ex p a n d in g fo r m o st o f th e p rev io u s 5 0 y e a rs . B ut t h a t boom e n d e d fo llow ing th e m assiv e e a r th q u a k e in San F ra n cisc o , a n d o v e r th e c o u rs e o f th e f ir s t q u a r te r o f 1 9 0 7 , th e Dow Jo n e s In d u stria l A verage fe ll n e a rly 2 5 p e r c e n t. In O c to b e r o f 1 9 0 7 , th e tu rm o il g rew . A n u m b e r o f le a d in g tr u s t co m p a n ie s h a d s u p p o r te d an a t t e m p t by s p e c u la to r s to m a n ip u la te th e sto c k p ric e o f a c o p p e r m ining c o m p a n y . D ep o sito rs b e g a n to s u s p e c t t h a t so m e tr u s t c o m p a n ie s w e r e in so lv e n t, an d th e y f e a re d t h a t th e ir savings w e r e a t risk. O n ce th e tr u s t c o m p a n ie s lo st th e p u b lic ’s c o n fid e n c e , d e p o s ito rs d e m a n d e d to w ith d ra w th e ir fu n d s im m e d ia te ly b e f o r e th e y lo st e v e ry th in g . http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2008/Pianalto_20081114.cfm[4/29/2014 2:02:08 PM] The Credit Crisis and the Role of the Federal Reserve :: November 14, 2008 :: Federal Reserve Bank of Cleveland P an ic quick ly b ro k e o u t. A b ro k e ra g e firm d e c la re d b a n k ru p tc y , a n d a n u m b e r o f e s ta b lis h e d banks w e r e in tu rm o il. [S ound f a m ilia r?] But 1 0 0 y e a rs ag o , th e r e w as no o ffic ia l m e c h a n ism to a b s o rb th e shocks to th e s y s te m —th e r e w as no F e d e ra l R eserv e. Riding to th e re s c u e w a s s o m e o n e w ho is s till le g e n d a ry in fin a n c ia l circles: J .P . M organ. He fu n c tio n e d as a d e f a c to c e n tr a l b a n k e r fo r th e U.S. e c o n o m y - an d h e p la y e d a v ita l ro le in e n d in g th e p an ic. W ith N ew York C ity te e te r i n g on th e v e rg e o f b a n k ru p tc y , a n d th e o rig in a l tr u s t c o m p a n ie s fa c in g a run on th e ir d e p o s its , h e b ro u g h t to g e th e r th e p re s id e n ts o f d o z e n s o f t r u s t c o m p a n ie s a t his h o m e lib ra ry . He to ld th e m to c o b b le to g e th e r a loan to ta lin g $ 2 5 m illion, o r e ls e , a n d I q u o te , “ th e w alls o f th e ir ow n e d ific e s m ig h t c o m e c ru m b lin g a b o u t th e ir e a r s . ” He le f t th e m to w o rk o u t th e d e ta ils , an d lo c k ed th e d o o r fro m th e o u ts id e , so th e y c o u ld n ’t le a v e u n til th e y h ad an a g r e e m e n t. His ta c tic s w o rk e d . T h e fin a n c ie rs p u t a s id e w h a t th e y p e rc e iv e d as th e ir in d iv id u al in te r e s ts a n d jo in e d to g e th e r to s u p p o rt th e e n tir e fin a n c ia l sy ste m . T hus b eg a n th e re s to r a tio n o f c o n fid e n c e , an d m a rk e t re c o v e ry . B ut th e e p is o d e h ig h lig h te d o u r n a tio n ’s d e p e n d e n c e on th e w illin g n ess o f p riv a te in te r e s ts to s a fe g u a rd o u r fin a n c ia l m a rk e ts . And m an y v ie w e d th is s t a t e o f a ffa irs as p lacin g Main S tr e e t a t th e m e rc y o f W all S tre e t. O ur n a tio n w a s re a d y to c r e a t e a n e w in s titu tio n to u n d e rp in its fin a n c ia l in f ra s tr u c tu re , an d P re s id e n t W oodrow W ilson sig n e d in to law th e F e d e ra l R e serv e A ct in D e c e m b e r 1 9 1 3 . Background on the Federal Reserve T h e p ro file o f th e U.S. e c o n o m y h as c h a n g e d d r a m a tic a lly sin c e 1 9 1 3 , an d so has A m e ric a ’s fin a n c ia l s e c to r . T h e F e d e ra l R e serv e has e v o lv e d as w e ll o v e r th e p a s t 9 5 y e a rs , a lth o u g h o n e key f e a tu r e of th e o rig in a l le g isla tio n has sto o d th e t e s t o f tim e: a d e c e n tra liz e d s tr u c tu r e a im e d a t e n s u rin g t h a t th e F e d e ra l R e serv e is a c c o u n ta b le to th e w h o le c o u n try , an d n o t ju s t th e fin a n c ia l c e n te rs . T h a t is w h y th e r e is a B oard o f G o v ern o rs in W ash in g to n as w e ll as 12 F e d e ra l R eserv e banks, w h ich a r e fo c u se d on e n s u rin g t h a t th e e c o n o m ic n e e d s a n d in te r e s ts o f e v e ry reg io n - in c lu d in g th is o n e a r e w e ll r e p r e s e n te d in th e p o lic y -m ak in g p ro c e ss. F ig u rativ ely s p e a k in g , I am y o u r s e a t a t th e ta b le . T h e e x is te n c e o f R eserv e Banks, b ra n c h o ffic e s, an d th e ir d ire c to rs g u a r a n te e s a tru ly n a tio n w id e Main S tr e e t p e r s p e c tiv e t h a t in flu e n c e s th e fo rm u la tio n o f F e d e ra l R eserv e policy. For c lo se to a c e n tu r y , t h a t s tr u c tu r e h as p ro v id e d a fra m e w o rk fo r th e F e d e ra l R eserv e to p u rsu e its m a n d a te o f k e e p in g p rice s s ta b le an d m ax im izing e c o n o m ic g ro w th . T he F e d e ra l R eserv e h as f a c e d its s h a re o f c h a lle n g e s sin c e its fo u n d in g , b u t w e a r e in th e m id st o f o n e o f o u r b ig g e st c h a lle n g e s e v e r . T o d a y ’s fin a n c ia l s itu a tio n is h isto ric , an d m an y o f o u r a c tio n s a r e w ith o u t p r e c e d e n t. Explaining the Turmoil As w e all know , g lo b a l fin a n c ia l m a rk e ts h a v e b e e n s u b je c te d to e x tr e m e s tre s s fo r a little m o re th a n a y e a r now 2 . W e a r e s e e in g th is s tre s s in th e e q u ity m a rk e ts , w h e r e th e Dow Jo n e s In d u stria l A v erag e has h ad d r a m a tic d aily sw ings. W e a r e also s e e in g c r e d it m a rk e ts s e iz e up. S om e b o rro w e rs sim p ly c a n n o t g e t loan s. So how did th is all h a p p e n ? It is c e r ta in ly a c o m p le x sto ry , an d w e d o n ’t h a v e e n o u g h tim e to d a y to e x p lo re e v e ry c h a p te r . B ut I w ill c o m m e n t on th r e e in p a r tic u la r. F irst, th e e n tir e hou sin g in d u stry b o o m e d as a r e s u lt o f la x u n d e rw ritin g s ta n d a r d s , so a rin g housing http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2008/Pianalto_20081114.cfm[4/29/2014 2:02:08 PM] The Credit Crisis and the Role of the Federal Reserve :: November 14, 2008 :: Federal Reserve Bank of Cleveland p ric e s, a n d an e n d le s s su p p ly o f in v e sto rs looking fo r a t tr a c t iv e re tu r n s . W hen rising d e lin q u e n c y r a te s m a d e it c le a r t h a t h u n d re d s of b illions o f d o lla rs o f m o rtg a g e lo a n s w e r e b a s e d on d u b io u s a s su m p tio n s , le n d e rs s h u t o ff th e su p p ly o f n e w m o n ey , p e o p le tr ie d to se ll o ff th e q u e s tio n a b le in v e s tm e n ts t h a t th e y w e r e h o ld in g , an d ho u sing p ric e s p lu n g e d . S eco n d , te c h n o lo g y an d fin a n c ia l e n g in e e rin g h ad re v o lu tio n iz e d th e m a rk e tp la c e . Loans t h a t w e r e o n c e h e ld on th e books o f w ellc a p ita liz e d b an k s w e r e now p o o le d to g e th e r , an d p o rtio n s o f th e pools w e r e so ld o ff to in v e sto rs as in d iv id u al s e c u r itie s . In c a se s w h e r e c r e d it q u a lity w a s low , th e s p o n so r o f th e s e c u r itie s co u ld a c h ie v e a high ra tin g fo r th e m fro m a ra tin g a g e n c y by p u rc h a sin g a c r e d it g u a r a n te e . W hen housing p ric e s fe ll, th e v a lu e s o f th e s e c o m p le x s e c u r itie s fe ll as w e ll, in so m e c a s e s q u ite s te e p ly . In h in d sig h t, e v e ry o n e re lie d to o h ea v ily on m o d e ls t h a t w e r e b a se d on h isto ric a l a s su m p tio n s. C o m p lic atin g m a tte r s f u r th e r , loans b a c k e d by d if f e r e n t kinds o f in c o m e s tr e a m s , su ch as s tu d e n t lo an s, c r e d it c a rd lo a n s, a n d a u to m o b ile lo a n s, w e r e also p o o le d to g e th e r an d s e c u r itiz e d . W hen th e housing b u s t s e t in, in v e sto rs lo st c o n fid e n c e in all kinds o f fin a n c ia l a s s e ts an d h e a d e d fo r th e e x its. F inally, m an y le n d e rs w e r e highly le v e ra g e d , m e a n in g t h a t th e y w e re fin a n c in g th e ir a c tiv ity w ith v e ry little o f th e ir ow n c a p ita l a t risk. In ste a d , th e y w e r e rely in g on b o rro w e d m on ey . N ot su rp risin g ly , th e c r e d ito r s w ho w e r e a t risk w a n te d th e ir m o n e y b ac k , an d to pay th e m th e le n d e rs h a d to se ll th e ir a s s e ts a t d is tre s s e d p ric e s, m e a n in g t h a t th e y h ad to ta k e la rg e lo sses. W ith little c a p ita l to p r o te c t th e m a g a in s t th e s e lo sses, p e o p le b e g a n to q u e s tio n th e so lv e n cy o f n e a rly all firm s in v o lv ed in th e s e m a rk e ts . A r e c e n t a r tic le in T h e W all S tr e e t Jo u rn a l n ic ely illu s tr a te d h o w th is f e a r m a n ife s ts its e lf. H e re ’s w h a t th e a u th o r w ro te: Imagine th a t you a re playing poker with 10 people and th at you learn th a t a m inority of them is broke and would no t pay you if they lose. You don't know, however, who the ones are who won’t pay. In this environm ent, the risk o f losing would be too high even if you know th a t m ost o f the players are p erfec tly sound financially and would pay up if they lose. In this environm ent, any rational card p layer would stop making b ets until the true solvency position of each player is revealed and the bankrupt ones are expelled from the game. Having insolvent players sittin g a t the table spoils the gam e3. L ikew ise, in to d a y ’s g lo b a l fin a n c ia l sy ste m , th e c o m m e rc ia l b anks, in v e s tm e n t b an k s, s e c u r itie s d e a le rs , c r e d it ra tin g a g e n c ie s , in s u ra n c e c o m p a n ie s, a n d m u tu a l fu n d s all d e a l c lo se ly w ith o n e a n o th e r . So it isn ’t su rp risin g t h a t th e t h r e a t t h a t an y o n e o f th e m m ig h t b e in so lv e n t je o p a r d iz e s c o n fid e n c e in th e e n t ir e sy ste m . R e m e m b e r t h a t th e fo u n d a tio n o f e v e ry fin a n c ia l sy ste m is c o n fid e n c e . In o r d e r fo r m o n e y to c ir c u la te th ro u g h an ec o n o m y , in th e fo rm o f c r e d it, t h e r e m u st b e c o n fid e n c e t h a t fu n d s t h a t a r e lo a n e d w ill b e p aid b ac k . S im ilarly, th e r e m u st b e c o n fid e n c e th a t th e in f ra s tr u c tu re su p p o rtin g th e fin a n c ia l sy ste m w ill s u p p o r t th e sy ste m in tim e s o f tu rm o il. R em ove th is c o n fid e n c e a n d y o u ’re le ft w ith fin a n c ia l m a rk e ts in a s t a t e o f p ara ly sis. Responding to the Recent Volatility J u s t as J .P . M organ to o k bo ld a c tio n in 1 9 0 7 to h e lp r e s to r e fin a n c ia l s ta b ility a n d c o n fid e n c e , so has th e F e d e ra l R eserv e a c e n tu r y la te r . O ver th e p a s t y e a r , th e F e d e ra l R eserv e h as b e e n p lay in g a p iv o ta l ro le in h e lp in g to r e s to r e s ta b ility to th e fin a n c ia l sy ste m w h ile w e http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2008/Pianalto_20081114.cfm[4/29/2014 2:02:08 PM] The Credit Crisis and the Role of the Federal Reserve :: November 14, 2008 :: Federal Reserve Bank of Cleveland n a v ig a te th ro u g h th e m an y e c o n o m ic c ro s s -c u rre n ts . In d e e d , o u r ro le as p ro v id e r o f liq u id ity a n d le n d e r o f la s t r e s o r t has n e v e r b e e n m o re im p o r ta n t. W e h av e ta k e n a c tio n s on a n u m b e r o f d if f e r e n t fro n ts . I’ll m e n tio n a few . F irst, in re s p o n s e to th e e a rly tu r b u le n c e in th e su m m e r o f 2 0 0 7 , w e b eg a n re d u c in g o u r f e d e r a l fu n d s r a te ta r g e t. O ur e f f o rts h av e b e e n a g g re ssiv e —w e h a v e lo w e re d t h a t r a te by 4 2 5 b asis p o in ts as th e e c o n o m ic o u tlo o k h as p ro g re ssiv e ly w e a k e n e d . B ut w e h a v e d o n e m o re th a n c u t in te r e s t r a te s . To a d d re s s liq u id ity issu es in th e c o m m e rc ia l b an k in g s e c to r , th e F e d e ra l R e serv e has u se d its tr a d itio n a l le n d in g a u th o rity in c r e a tiv e w ay s. W e h av e e x te n d e d c r e d it to b an k s in s ig n ific a n t a m o u n ts an d fo r lo n g e r p e rio d s th a n is ty p ic a l. C u rre n tly w e h a v e roug h ly $ 5 0 0 billion o u ts ta n d in g in th e s e lo a n s, v e rsu s a b o u t $ 3 0 0 m illion a y e a r ago. N orm ally, w e le n d on ly to c o m m e rc ia l b an k s. As th e fin a n c ia l tu rm o il s p r e a d , it b e c a m e c le a r t h a t w e w o u ld h av e to b ro a d e n o u r s c o p e . In th e sp rin g o f th is y e a r , w e b e g a n to u se o u r e m e rg e n c y p o w ers to d e a l w ith p ro b le m s a t sy ste m ic a lly im p o r ta n t n o n -b a n k s su ch as B ear S te a rn s a n d AIG. In a d d itio n , th e F e d e ra l R e serv e has b e e n le n d in g to a g ro u p o f p rim a ry s e c u r itie s d e a le rs w h o a r e c ritic a lly im p o r ta n t to th e fu n c tio n in g o f c r e d it m a rk e ts . U n fo rtu n a te ly , th e fin a n c ia l tu rm o il has n o t b e e n lim ite d to th e U n ited S ta te s . It h as b e c o m e a g lo b a l p ro b le m , a n d th e d e m a n d fo r d o lla r liq u id ity e x te n d s w e ll b ey o n d o u r b o rd e rs . C o n se q u e n tly , th e F e d e ra l R eserv e h as b e e n p roviding s u b s ta n tia l a m o u n ts o f d o lla r liq u id ity to o th e r c e n tr a l banks. W e a r e also p aying c lo s e a t te n t io n to th e p e rfo rm a n c e o f so m e p a r tic u la r fin a n c ia l in s tru m e n ts , su ch as c o m m e rc ia l p a p e r , w h ich a re c ritic a l to fin a n c in g d aily b u sin e ss fu n c tio n s su ch as m e e tin g p ay ro ll. W e h av e ta k e n a n u m b e r o f a c tio n s to s u p p o r t tra d in g in th e s e in s tru m e n ts . T h e se v ario u s a c tiv itie s illu s tr a te how fo rc e fu lly w e a r e using o u r a u th o rity to h e lp fin a n c ia l m a rk e ts reg a in th e ir h e a lth . In to ta l, o u r v ario u s le n d in g f a c ilitie s h a v e p ro v id e d m o re th a n a trillio n d o lla rs of a d d e d liq u id ity to th e fin a n c ia l sy ste m . W hile th e F e d e ra l R e serv e has u n d e r ta k e n h isto ric an d u n p r e c e d e n te d a c tio n s , th e s e v e rity o f th e s itu a tio n h as re q u ire d th e e x e c u tiv e a n d le g isla tiv e b ra n c h e s o f g o v e rn m e n t to also s te p in. As you a r e a w a re , th e T re a s u ry h as a llo c a te d $ 7 0 0 billion to its T ro u b le d A sset R elief P ro g ram , also know n as TARP. W hile th e r e h av e b e e n w e ll-p u b lic iz e d c h a n g e s to th e d ire c tio n o f th is p ro g ram in ju s t th e p a s t f e w day s, th e m ission o f th e TARP re m a in s c le a r —to g e t p riv a te c r e d it flo w in g a g a in . I c a n u n d e rs ta n d w hy so m e p e o p le fin d it d iffic u lt to k e e p tr a c k of th e m an y in itia tiv e s I h av e b e e n d e s c rib in g , an d e v e n w h y so m e c ritic s d e s c rib e th e m as a “ b a ilo u t” o f W all S tr e e t firm s. In m y v iew , th e c ritic s a r e m issing th e p o in t. W ith o u t th e n o rm a l fu n c tio n in g o f c r e d it m a rk e ts , Main S tr e e t c a n n o t fu n c tio n e ith e r . T h e b r o a d e r p o in t, a b o u t th e ra n g e o f a c tio n s ta k e n by f e d e ra l a u th o ritie s , is t h a t a c tio n s to o k p la c e o nly w h e n i t b e c a m e c le a r th e r e w e r e g ra v e th r e a ts to th e o v e ra ll s ta b ility o f th e fin a n c ia l sy ste m a n d to th e o u tlo o k fo r e c o n o m ic g ro w th . T h e a c tio n s o f th e F e d e ra l R eserv e , th e U.S. T re a s u ry , in te r n a tio n a l c e n tr a l b an k s, an d o th e r g o v e rn m e n t e n titie s h av e to g e th e r h e lp e d http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2008/Pianalto_20081114.cfm[4/29/2014 2:02:08 PM] The Credit Crisis and the Role of the Federal Reserve :: November 14, 2008 :: Federal Reserve Bank of Cleveland to m itig a te m uch o f th e p o te n tia l d a m a g e to th e g lo b a l ec o n o m y . Still, th e tu rm o il has ta k e n its to ll, a n d to d a y th e e c o n o m ic o u tlo o k is d e c id e d ly n e g a tiv e . A t th e F e d e ra l R e serv e Bank o f C le v e la n d , w e look a t a lo t of e c o n o m ic d a t a a n d a t th e re s u lts o f c o m p le x fo re c a s tin g m o d e ls. We also ta lk w ith a lo t o f p e o p le . In r e c e n t w e e k s w e h av e s te p p e d up o u r c o n ta c ts w ith b u sin e ss, b an k in g , a n d civ ic le a d e rs . W e a r e h e a rin g t h a t th e c r e d it c ru n c h is a f f e c tin g m an y s e c to r s o f th e re g io n a l a n d n a tio n a l e c o n o m y . W e a r e also se e in g a rip p le e f f e c t p lay o u t a c ro ss th e r e a l ec o n o m y . Recession and Recovery C o llec tiv e ly , th e in fo rm a tio n I h av e b e e n looking a t te lls m e t h a t th e e c o n o m y is now in a re c e ssio n , a lth o u g h th e N a tio n a l B ureau o f E co nom ic R e se a rc h , th e r e f e r e e in su ch m a tte r s , has y e t to c a ll o n e . N atio n ally , e m p lo y m e n t has b e e n d e c lin in g all y e a r , an d in la s t w e e k ’s e m p lo y m e n t r e p o r t w e sa w th e c h a r a c te r is tic m o n th ly e m p lo y m e n t losses t h a t a r e a s s o c ia te d w ith a re c e ssio n . M a n u fa c tu rin g o u tp u t h as b e e n fo llo w in g a sim ila r c o u rs e . And you w o n ’t b e s u rp rise d to le a rn t h a t r e ta ile r s a r e p o stin g d ism al sa le s fig u re s --s o m e o f th e lo w e s t s e e n in d e c a d e s . In f a c t, j u s t th is m o rning, th e C o m m e rc e D e p a rtm e n t r e p o r te d th e w o rs t r e ta il sa les fig u re s in 4 0 y e a rs . I h ad b e e n e x p e c tin g th e p a c e o f e c o n o m ic a c tiv ity to slo w d ow n fo r m o re th a n a y e a r now , a lth o u g h I h a d n o t b e e n e x p e c tin g a re c e ssio n . E conom ic fo re c a s tin g is n e v e r an e x a c t s c ie n c e , an d th e s e e x c e p tio n a lly v o la tile c r e d it m a rk e t c o n d itio n s m a k e f o re c a s ts a ll th e m o re u n c e r ta in . T h e w o rs e n in g o f fin a n c ia l m a rk e t c o n d itio n s d u rin g th e y e a r , a n d e s p e c ia lly sin c e S e p te m b e r, h as p ro fo u n d ly a f f e c te d my o u tlo o k fo r th e e c o n o m y . T h e fin a n c ia l s tr e s s is raisin g th e c o s t o f c r e d it, re s tr ic tin g th e a v a ila b ility o f c r e d it, an d in d u cin g c a u tio u s b e h a v io r by b o rro w e rs an d le n d e rs . All o f th is is re d u c in g s p e n d in g by b o th b u sin e sse s an d c o n s u m e rs. S ta te a n d lo c a l g o v e rn m e n t fin a n c e s a r e b ein g a f f e c te d as w ell. A t th e m o m e n t, th e signs p o in t to a re c e ssio n b e y o n d j u s t a “ g a rd e n v a r ie ty ” d o w n tu rn . T h e le n g th an d s e v e rity o f th e re c e ssio n w ill d e p e n d on how quick ly c r e d it m a rk e ts re tu r n to n o rm a l. And th e r e is e v id e n c e in so m e fin a n c ia l m a rk e ts , su ch as in te r - b a n k le n d in g a n d c o m m e rc ia l p a p e r, t h a t p ro g re ss is b ein g m a d e . B ut ho w w ill w e know w h e n th e fin a n c ia l m a rk e ts a r e b a c k on so lid g ro u n d ? H ere a re s o m e signs o f “ n o rm a l” t h a t I am looking for: F irst, b an k s h av e to beg in le n d in g to o n e a n o th e r an d c r e d it m a rk e ts h av e to o p e r a te w ith o u t e x tra o rd in a r y in v o lv e m e n t fro m th e F e d e ra l R eserv e a n d th e T re a s u ry . W hile th e F e d e ra l R e se rv e ’s in v o lv e m e n t has b e e n c o n s is te n t w ith o u r ro le as th e le n d e r o f la s t r e s o r t, th e p riv a te s e c to r ’s a b ility to s ta n d on its ow n tw o f e e t w ill b e p iv o ta l to an e v e n tu a l re c o v e ry o f fin a n c ia l m a rk e ts . S eco n d , h o m e p ric e s m u s t s ta b iliz e . T h e d o w n tu rn in th e housing m a rk e t, o f c o u rs e , w a s th e c a ta ly s t in d riving th e v o la tility in th e b r o a d e r e c o n o m y a n d in fre e z in g up th e c r e d it m a rk e ts . I am looking f o r h o using p ric e s to re a c h a b o tto m , an d I d o n ’t th in k w e a r e q u ite th e r e y e t. T h ird , to d a y ’s e x tre m e ly low tra d in g v o lu m e s in th e p riv a te m a rk e ts f o r m o rtg a g e s, s tu d e n t lo a n s, a n d a u to loans m u st pick u p . I b e lie v e th is p ro c e ss w ill a c c e le r a te as c o n fid e n c e in th e p ricin g o f th e s e a s s e ts is slow ly re s to r e d . F inally, ju s t fro m m y p e rso n a l p e rs p e c tiv e , I’ll c o n s id e r us to b e b ack to n o rm a l w h e n th e F e d e ra l R e serv e re tu r n s to th e b a c k p a g e s o f th e http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2008/Pianalto_20081114.cfm[4/29/2014 2:02:08 PM] The Credit Crisis and the Role of the Federal Reserve :: November 14, 2008 :: Federal Reserve Bank of Cleveland p a p e r ’s b u sin ess s e c tio n . B ut w e a r e n o t t h e r e q u ite y e t. And e v e n w h e n m a rk e ts re tu r n to w h a t is ty p ic a lly th o u g h t o f as “ n o r m a l,” c h a n g e s w ill s till b e n e e d e d fo r th e long te r m . W e n e e d to fo cu s on th e f a c to rs I c ite d as c a u se s o f th e tu rm o il—lax u n d e rw ritin g s ta n d a r d s , c o m p le x fin a n c ia l p ro d u c ts, a n d e x c e s siv e le v e ra g e . T h e n e x t C ongress a n d th e in co m in g A d m in istra tio n a r e s u re to s e e k s tr ic te r re g u la tio n a n d m o re g o v e rn m e n t o v e rsig h t. T h e p riv a te s e c to r is a lre a d y ta k in g a c tio n on its ow n. F in an c ial in s titu tio n s h a v e s ta r t e d to re in in risky p ra c tic e s , an d m an y o f th e p ro b le m a tic fin a n c ia l p ro d u c ts o f th e p a s t h av e d is a p p e a re d . T h e F e d e ra l R e serv e h as tig h te n e d up re g u la tio n s th a t ap p ly to m o rtg a g e loan p ro d u c ts a n d u n d e rw ritin g s ta n d a rd s . G o v e rn m e n t a n d p riv a te a c tio n s , I’m co n v in c e d , w ill m a k e stro n g e f f o rts a t having o u r fin a n c ia l m a rk e ts b e c o m e m o re tr a n s p a r e n t a n d less c o m p le x . As w e w o rk to w a rd t h a t f u tu r e , l e t ’s n o t f o r g e t w h a t re so u rc e s w e h av e to w o rk w ith . And w h e n I ta lk a b o u t re s o u rc e s , I am n o t re fe rrin g to all o f th e fu n d s a d v a n c e d by th e F e d e ra l R e serv e an d th e T re a su ry . I am re fe rrin g to th e tr u e re so u rc e s o f o u r co u n try : o u r p e o p le , o u r b u sin e ss e n te r p r is e s , an d o u r in g e n u ity . T h e se a r e th e re s o u rc e s w e c a n all h a v e c o n fid e n c e in. M oney p ro v id es a m e a n s of e x c h a n g e , b u t it is n o t th e tr u e s o u rc e o f o u r w e a lth . As w e stru g g le to re p a ir o u r fin a n c ia l sy ste m , w e sh o u ld n o t lo se c o n fid e n c e in th e f o rc e s t h a t h a v e w o rk e d to o u r a d v a n ta g e th r o u g h o u t o u r h isto ry . T h ey a r e in ta c t, a n d th e y w ill e n d u r e . O ne o f o u r fo u n d in g f a th e r s , J a m e s M adison, u n d e rs to o d th is . In a s p e e c h h e g av e to th e V irginia C o n v en tio n in 1 7 8 8 , h e sa id , “T he c irc u la tio n o f c o n fid e n c e is b e t t e r th a n th e c irc u la tio n o f m o n e y .” J u s t as c o n fid e n c e w as p a ra m o u n t th e n , so i t is to d a y as w e ll. W e all know t h a t o u r e c o n o m y is ta k in g so m e v e ry h a rd knocks, b u t in f a c t it is o u r u n d erly in g re s o u rc e fu ln e s s as a n a tio n t h a t gives m e g r e a t c o n fid e n c e in o u r a b ility to b o u n c e b ac k . And t h a t ’s w o rth re m e m b e rin g w h e th e r you a r e on W all S tr e e t, Main S tr e e t, o r rig h t h e r e on E ast N inth S tre e t. [1 ] T h e follow ing is p rim a rily d raw n fro m R o b e rt B ru n er an d Sean C arr, The Panic of 1907: Lessons Learned from the M arket’s P erfect Storm, 2 0 0 7 . [2 ] Using A ugust 9 , 2 0 0 7 as a s t a r t d a t e o f th e e x tr e m e v o la tility . [3 ] Wall S treet Journal, O ct. 9 , 2 0 0 8 — h ttp : / / o n lin e .w s i.c o m / a r tic le / S B 1 2 2 3 5 1 0 7 1 8 1 9 9 1 7 4 3 3 .h tm l? m o d = to d ay s us opinion Careers | Diversity | Privacy | Terms of Use | Contact Us | Feedback | RSS Feeds http://www.clevelandfed.org/For_the_Public/News_and_Media/Speeches/2008/Pianalto_20081114.cfm[4/29/2014 2:02:08 PM]
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