ISABELLE MALINGlobal Financial Markets and Institutions Independent Study

Research Paper December 8th, 2014  

U.S. Monetary Policy in Response to the 2007/2008 Financial Crisis: The

Success and Implications of Quantitative Easing

I. Introduction

Since the beginning of the Global Financial Crisis in 2007,

the U.S. Federal Reserve has undertaken a series of unprecedented

conventional and unconventional measures to provide liquidity to

the economy and banking system and stabilize the economy and asset

prices, in some cases stepping far beyond its traditional dual

mandate of price stability and full employment. Over the past

seven years, most observers would agree that these steps had a

profound impact on both macroeconomic performance and asset prices,

helped avoid debilitating deflation, and set into motion a series

of chain reactions in exchange rates which subsequently had an

additional feedback effect on asset prices globally. With the Fed

now having officially ended this historic effort, it remains to be

seen if any unintended economic consequences ensue globally,

especially as other key central banks seem to have lagged behind

the Fed in both the boldness, creatively and the speed of their

policy responses. Ultimately, as a result of changes in monetary

policy the United States remains one of the few large economies for

which the macroeconomic outlook remains optimistic, albeit

cautiously, heading into 2015.

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II. Literature Overview

In the article “Quantitative Easing-Uncharted Waters for

Monetary Policy” by James Bullard (2010), we can borrow the

significance of unconventionality of the Fed’s monetary policy in

response to the financial crisis. His analysis includes comparative

quantitative easing strategies of other major economic entities,

including the Bank of England. Additionally, Bullard proposes two

provisions for policy makers that are strongly advised in order for

such policies to be successful. First; communication with the

public concerning the temporary nature of such policies, and

second; it is crucial that increases in asset purchases are

reversed within a timely manner as economic conditions show signs

of improvement. Adhering to these guidelines will deter rises in

expected inflation which, left unchecked, cause rises in actual

inflation and disrupt the expansionary impact of the policy

actions.

In the article “Lessons from the Taper Tantrum” by Christopher

J. Neely (2014), we can borrow the notion of how sensitive the

markets are, and the extent to which they are effected by the

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slightest indication of policy change. Neely articulates the

immediate effect that announcements of quantitative easing have on

asset prices, such as exchange rates, equity and commodity prices,

bond yields…etc. Neely also details how important these asset price

effects are for policy success.

III. Central Analysis and Discussion

Background and Timeline of Federal Reserve Policy Actions

In the summer of 2007, the U.S. financial system began to buckle,

when the prices of asset-backed and mortgage-backed securities,

tied primarily to sub-prime mortgages, but also other credit-and

real estate-sensitive assets, began to fall in price, in response

to rising residential mortgage delinquencies and falling home

prices. To calm the markets, the U.S. Federal Reserve began a

series of aggressive interest rate cuts (both Fed Funds targets and

discount rate) to provide liquidity and restore confidence to the

banking system, as many banks held these securities (and their

derivatives) on their balance sheets.1 For the balance of 1997,

these conventional measures were largely successful in achieving

1 Issue addressed in speech of then Chairman of the Federal Reserve Ben Bernankeat the Federal Reserve Bank of Kansas City’s Annual Economic Symposium in August2009.

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this short-term goal. Beginning in early 2008, it became clear that

these measures did little to improve mortgage credit metrics and

home prices continued to worsen, resulting in a freezing of credit

and inter-bank funding markets. This illiquidity culminated with

the Federal Reserve’s arranged rescue of investment bank Bear

Stearns in March 2008. Following this dramatic, unprecedented

intervention, the Fed continued on a glide path towards cutting

rates to zero, as the crisis in the funding and credit markets

began to spill into the real economy causing a recession by the

fall of 2008.

The financial crisis dramatically escalated in September 2008, when

within a two week span, the U.S. government needed to arrange

rescues of systemically important banks Lehman Brothers, and

Merrill Lynch, along with the nation’s largest insurer, AIG, and

the nation’s two critical government-sponsored engines of the

mortgage market, Fannie Mae and Freddie Mac (Saunders & Cornett,

2012, p. 134). Having exhausted the conventional policy measures of

managing monetary policy through interest rate actions, and facing

the most significant decline in GDP since the Great Depression, the

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Federal Reserve began unconventional measures to restore liquidity

to the banking system. The Federal Reserve for the first time in

its history was willing to embrace the unconventional and

controversial policy of quantitative easing, the outright purchase

of (in this case Mortgage-based) securities directly on its balance

sheet, without removing the excess liquidity from the banking

system.2 In doing so, this QE1 beginning in November 2008 resulted

in the Fed buying $600 billion of MBS, and in the process

increasing its total balance sheet from about $750 billion in U.S.

government bonds and notes, to about $1.75 trillion in bank debt,

mortgage-backed securities, and treasuries in a matter of only six

months. By the summer of 2010, the Fed’s balance sheet had peaked

at $2.1 trillion, a level the Fed chose to retain, by buying

additional securities in the open market of about $30 billion per

month, to maintain the size of the portfolio around $2 trillion,

and thus not remove liquidity from the economy and the banking

system.3

2 Bullard, J. (2010). Quantitative Easing—Uncharted Waters for Monetary Policy. The Regional Economist.3 Ricketts, L. R., & Walker, C. J. (2014). The Rise and (Eventual) Fall in the Fed's Balance Sheet. The Regional Economist.

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By the late summer of 2010, the Federal Reserve Chairman Bernanke

began signaling that further QE may be necessary to ensure the

continuation of economic growth and reduce unemployment, and signal

to the global capital markets (which began to shudder again in the

summer of 2010 when Greek government bond yields, and those of

other perceived weak European nations began to increase

dramatically) that the Federal Reserve would remain in an

accommodative stance. This “QE2” led to $600 billion of bond

purchases ending in the second quarter of 2011.4

In the summer of 2011, U.S. treasury markets were rattled by the

surprise downgrade of the U.S. government’s credit rating from

AAA5, which sent global stock market plummeting and exacerbated the

European government bond markets, which had stabilized following

the fears of the summer of 2010. In September, as Euro bonds yields

gapped out, and Greece essentially defaulted on its bonds shortly

thereafter, the Fed announced its most aggressive action yet: QE3.

The Fed would be willing to buy $40 billion per month in MBS with

4 Board of Governors of the Federal Reserve System press release, October 6th 2008 5 United States of America Long-Term Rating Lowered to 'AA+' Due to Political Risks, Rising Debt Burden; Outlook Negative. (2011, Aug 05). PR Newswire.

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no limit or targeted end date.6 This amount was more than doubled

to $85 billion per month in December 2011, at the height of the

European sovereign debt and bank funding crisis.

By the Spring of 2013, recognizing the consistent steady decline of

unemployment in the United States, and the European Central Bank’s

(ECB) successful restoration of liquidity in the bank funding

markets through its LTRO program, the Fed had the confidence to

announce a “tapering” of the level of monthly purchases, from $85

billion per month, to eventually zero by the Fall of 2014.7 With QE

now officially ended, the Fed is communicating a desire to begin an

undetermined policy tightening campaign with a target start date of

summer of 2015, depending on the strength of economic data in the

coming months.8

Implications of Fed Monetary Policy Actions on the U.S. Economy and Financial System

During the Global Financial Crisis.

6 Board of Governors of the Federal Reserve System press release, September 13th20127 Neely, C. J. (2014). Lessons from the Taper Tantrum. Economic Synopses, (2). Research.stlouisfed.org8 Harding, R. (2014, October 29). Fed Eyes First Rate Rise After End to QE. Financial Times. Ft.com

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At the beginning of the Financial Crisis, the Fed’s aggressive

interest rate cuts were heralded as sufficiently proactive,

reassuring investors about banking system and capital markets

liquidity, and that the Fed would continue to take whatever actions

necessary to avoid the spread of issues affecting esoteric corners

of the capital markets into the real economy. However, the

resulting reduction of mortgage credit flowing to the system from

the increasingly skittish banking industry, and the collapse of

specialized shadow banking vehicles and hedge funds overexposed to

these ABS, MBS and derivative securities, further pushed down

already falling house prices and further impaired the collateral

backing ABS and MBS and their collateral debt obligations. However,

because of the complexity of the problem, and the failure of

policymakers and market participants to recognize the inter-

connectedness between the structured credit and securitization

markets and the balance sheets of the largest banking

organizations, the markets and economy largely shrugged off the

events of the summer of 2007 and carried on to new highs in the

fall of 2007.

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By early 2008, the securitization markets continued to weaken, and

the Fed stepped up interest rate cuts in January 2008 in response,

an action that bought short term calm to the markets. However, by

March 2008, financial institutions began to worry about the credit

worthiness of some of their counterparties, which resulted in a

freezing up of the short-term repo funding markets, and resulted in

plunging stock prices at brokers and banks heavily exposed to MBS.

In response to these deteriorating conditions, the Fed launched an

innovative program to provide a kind of short-term funding facility

to non-bank investment banking firms known as the TSLF, which

served as a kind of Fed window for investment banks to ensure

against a run on market-based short-term funding sources. For Bear

Stearns, this action came too late: its capital markets funding

sources largely cut off, the Federal Reserve Bank of New York, in

conjunction with the U.S. Treasury, coordinated JP Morgan’s rescue

of Bear Stearns in March 2008, and sent a strong signal to the

capital markets that the Fed and Treasury would act in concert to

ensure against the failure of large systemically important

financial firms, despite the deteriorating condition of the

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holdings on their balance sheets.9 In this case, Fed action was

criticized in some corners as encouraging a type of “moral hazard"

in the system and embracing an implied policy that some firms were

“too big to fail.”10

Despite the worsening of the underlying collateral backing MBS and

ABS throughout the spring and summer 2008, the aggressiveness of

the Fed and Treasury’s response to the crisis led to a recovery of

investor confidence and the stock market. Furthermore, ultra-low

levels of interest rates, in a reasonably healthy economy,

encouraged carry trades by market participants, the use of

extremely low borrowing costs to buy financial assets with

financial leverage. This phenomenon resulted in skyrocketing

commodity prices, due to excess speculation, and oil prices in

particular soaring to $142 per barrel by July 2008 (Saunders &

Cornett, 2012, p. 31).

9 Federal Reserve Bank of New York. (2008, March 24). Statement on Financing Arrangement of JPMorgan Chase's Acquisition of Bear Stearns [Press release]. Newyorkfed.org10 Morgenson, G. (2008, March 16). Moral hazard tossed out as Fed saves Bear Stearns. The New York Times. nytimes.com

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With the news of the failure of a of one of the West Coast’s

largest mortgage banks, IndyMac, in July of 2008, and the

subsequent swoon in the stock prices of mortgage government-

sponsored entities (GSE) Fannie Mae and Freddie Mac, the stock

markets began shuddering again before stabilizing in August 2008,

following a GSE capital raise and statements by U.S. Treasury

Secretary Henry Paulson that the government wanted a “bazooka” of

extraordinary powers to address the brewing crisis head on11.

Late August saw two unexpected new developments: the seizure of the

corporate commercial paper markets; and the failure of (and

subsequent government guarantee backing) the money market mutual

fund industry, the largest holders of corporate commercial paper.

Immediately following Labor Day, the U.S. Treasury put Fannie Mae

and Freddie Mac in conservatorship to stabilize the GSE-backed

mortgage market, but in doing so wiped out the preferred stock of

the GSE’s held in large quantities by U.S. banks.12 But even this

action was insufficient to restore capital market stability, as the11Barr, C. (2008, September 06). Paulson Readies the 'Bazooka' Fortune. Fortune.com12 U.S. Department of the Treasury. (2010, September 15). Assistant Secretary forFinancial Institutions Michael S. Barr before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprise of House Committee on Financial Services [Press release]. Treasury.gov

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government was unable to fund a suitor to rescue Lehman Brothers in

mid-September 2008. Lehman’s failure triggered a global stock

market crash, a complete seizure of the securitization markets, the

shutdown of the global corporate bond market, and the lack of

willingness of banks to extend credit in any form (Saunders &

Cornett, 2012, p. 27). Importantly, the fallout from the failure to

rescue Lehman, resulted in the Fed, Treasury and FDIC to move

quickly and effectively to rescue AIG and Washington Mutual in the

next two weeks and avoid similar chaos (p. 26). Ultimately, the

U.S. Congress at the Fed and the Treasury’s urging directly

injected $700 billion in new preferred capital in banks through the

Troubled Asset Relief Program (TARP) into the banking system,

preserving private ownership of banks, restoring confidence of

investors and lending counterparties and paving the way for a more

robust stress test, completed in May 2009, which resulted in the

further strengthening of bank capital levels through private common

equity issuance (p. 33) This aggressive policy response has

resulted in few questions of banking system solvency over the past

five years, allowing the bank system to heal over time.

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With world GDP plunging following the Lehman failure, and interest

rates already near zero, the Fed was essentially out of traditional

policy options to pursue monetary stimulus. By November, the Fed

announced an innovative new funding program called the Term Asset-

Backed Securities Loan Facility (TALF) to stimulate consumer

lending by providing banks essentially similar terms they had

previously been able to get in the traditional (but now closed)

asset-backed securities market, significantly increasing the

availability of financing for investors at a reduced cost (Saunders

& Cornett, 2012, p. 32). And secondly, but far more significant,

the beginning of the largest full-scale program of quantitative

easing for the first time in U.S. history.

Macroeconomic & Financial Market Implications of Quantitative Easing

The Fed’s eventual embrace of the largely “experimental” or

“unconventional” policy Quantitative Easing came only after the Fed

ran out of traditional options in late 2008. This policy had long

been eschewed by strict monetarists as heresy which could result in

irresponsibly loose monetary conditions potentially leading to

hyperinflation and currency debasing. As the world sat at the

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precipice of spiraling deflation in late 2008, the risk seemed

worth taking to Fed Chairman Ben Bernanke, himself a conventional

monetarist but also a renowned scholar of failed (excessively

tight) Fed policy during the Great Depression.13 This unusual

monetary stimulus, combined with aggressive fiscal stimulus, had

the effect of getting the U.S. economy recovering quickly by the

second quarter of 2009, from a historically high drop in 4Q08 and

1Q09.14

Because the rest of the world’s central banks (with the exception

of the Bank of England by late 2010 and the Bank of Japan, which

seems to always be doing QE)15 were not as bold or as decisive as

the Fed, the excessive easing posture of the Fed relative to those

other central banks resulted in many currencies strengthening

against the dollar throughout 2009 and early 2010. With the dollar

weakness, came a resurgence of many commodity prices that had

collapsed during the financial crisis (and thus helped the rest of

the world effectively avoid deflation). Extremely low dollar

13 Hunt, A. R. (2014, January 19). How Bernanke the Scholar Became Fed Iconoclast. Bloomberg. Bloombergview.com14 See Chart 1 in Selected Data Section (VI)15 Ricketts, L. R. (2011, April). Quantitative Easing Explained. Page One Economics. Research.stlouisfed.org

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interest rates encouraged carry trades of short dollar/long

currencies (primarily those of commodity producing countries).

Essentially, the extremely low U.S. rates encouraged global

financial asset reflation.

Additionally, ultra-low rates helped lower mortgage rates (for

those borrowers who still qualified) to very low level and helped

put a floor under plunging U.S. home and commercial property

prices. Because of the Fed’s choice of MBS rather than treasury

buying, mortgage spreads tightened relative to treasuries and drove

mortgage rates even lower, allowing many homeowners to refinance,

lower their mortgage costs, and put extra spending money into the

pockets of U.S. consumers (Saunders & Cornett, 2012, p. 31). Low

rates also allowed corporations to refinance high cost debt, lower

their debt burden, and helping restructure corporate balance sheets

stressed by the effect of the historically deep recession.

The low rates also allowed the U.S. government to fund their

soaring borrowing needs to fund the stimulus at historically low

costs. This funding advantage was important because during 2008 and

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2009 the U.S. government engaged in more than $1 trillion in two

fiscal stimulus programs designed to avoid a free-falling

recession.16 These low borrowing costs mattered significantly to

allow for the stimulus to take effect with little disruptive effect

to U.S. borrowing capacity or interest burden.

Additionally, the long duration of low U.S. interest rates has

another effect known as financial repression. This notion suggests

that when rates on “risk free” treasury securities approach zero

eventually most investors will move out of that asset class into

another offering higher returns (such as stocks, or credit

instruments, or real estate). The flow of higher return seeking

money out of the government bond market (which had no impact on

rates due to the Fed’s buying of those securities) simply went into

other assets raising their prices. Conversely, savers, or investors

required to invest in government bonds, have endured unusually long

periods of very low returns thus frustrating their efforts to

achieve higher targeted rates of return. The effect of financial

repression can be seen in higher price/earnings multiple in the

stock market (the market’s willingness to pay a higher and higher

16 Refers to the Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009

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multiple for the same earnings) and historically tighter credit

spreads in both the investment grade and high yield bond markets,

where investors simply accept a lower premium to take more risk

since the alternative is zero return.17

One criticism of quantitative easing that should be noted is its

potential to create “bubbles,” or significant overvaluation due to

large shifts in demand of certain assets, in this case the

securities market. Since quantitative easing has made the market

risk free rate extremely low, it has distorted the rates of both

government and non-government bonds, making the price of these

bonds higher and reducing the overall yield spread. Therefore,

policies resulting in financial repression have pushed investors

out of government bonds seeking higher returns, which might lead to

overvaluing of those asset classes and creates a bubble.

Importantly, the ECB, whose unwieldy governance structure leaves it

philosophically divided in opinion about the appropriateness of QE

as a legitimate monetary policy, has never officially embraced QE

17 See Charts 2 & 3 in Selected Data Section (VI)17

as a strategy18. This hide bound central bank has been willing to

buy government bonds (but only on a sterilized, thus non-

expansionary way) and provide short- and long-term collateralized

funding to its undercapitalized banks, but unwilling to conduct

unsterilized, expansionary bond purchased thus pumping real

liquidity into its lethargic economies. Thus Europe remains the

weakest relative link in the world’s economic picture (along with

always weak Japan).

V. Conclusion

Macroeconomic Implications: Looking Forward

With the U.S. ending QE, the Bank of Japan has ramped it up, and as

the ECB begrudgingly moves towards it (as hawkish Germany enters

recession), the U.S. dollar has strengthened considerably against

most of the world’s currencies. This action, combined with surging

supply levels of oil and other commodities, has resulted in a

global plunge in commodity prices. Dollar strength, results in

lower import inflation and lower gas prices, both benefit the U.S.

consumer, which is still suffering from anemic wage and income

18 Altstedter, A. (2014, October 6). Top Forecaster Sees Weaker Euro on ECB Embracing QE. Bloomberg. Bloomberg.com/news

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growth despite promising reductions of unemployment.19 Dollar

strength can also serve as a headwind for U.S. exports to places

like Europe, and on the currency impact of foreign earnings of U.S.

corporations. Additionally, U.S. manufacturers will get greater

competition from foreign manufacturers who can sell at lower prices

in industries such as autos. Neither of these effects of the change

of U.S. monetary policy can be measured yet, but are concerns

heading into 2015.

VI. Selected Data

Chart 1:

19 Mitchell, J. (2014, October 3). Job Growth Rebounds, but Wages Lag. The Wall Street Journal. Online.wsj.com

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Chart 2:

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Chart 3:

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VI. References

Altstedter, A. (2014, October 6). Top Forecaster Sees Weaker Euro on ECBEmbracing QE. Bloomberg. Bloomberg.com/news

 Barr, C. (2008, September 06). Paulson Readies the 'Bazooka' Fortune.Fortune.com

 Bernanke, B. S. (2009, August 21). Reflections on a Year of Crisis. Speechpresented at Remarks at the Federal Reserve Bank of Kansas City'sAnnual Economic Symposium in Wyoming, Jackson Hole.

 Bullard, J. (2010). Quantitative Easing—Uncharted Waters for MonetaryPolicy. The Regional Economist.

 Federal Reserve Bank of New York. (2008, March 24). Statement on FinancingArrangement of JPMorgan Chase's Acquisition of Bear Stearns [Press release].Newyorkfed.org

 Harding, R. (2014, October 29). Fed Eyes First Rate Rise After End toQE. Financial Times. Ft.com

 Hunt, A. R. (2014, January 19). How Bernanke the Scholar Became FedIconoclast. Bloomberg. Bloombergview.com

 Mitchell, J. (2014, October 3). Job Growth Rebounds, but Wages Lag. TheWall Street Journal. Online.wsj.com

 Morgenson, G. (2008, March 16). Moral hazard tossed out as Fed savesBear Stearns. The New York Times. Nytimes.com

 Neely, C. J. (2014). Lessons from the Taper Tantrum. Economic Synopses,(2).Research.stlouisfed.org

 Ricketts, L. (2011, April). Quantitative Easing Explained. Page OneEconomics.

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 Ricketts, L. R., & Walker, C. J. (2014). The Rise and (Eventual) Fallin the Fed's Balance Sheet. The Regional Economist.Research.stlouisfed.org

 Saunders, A., & Cornett, M. M. (2012). Financial markets and institutions. NewYork: McGraw-Hill/Irwin.

 U.S. Department of the Treasury. (2010, September 15). Assistant Secretary forFinancial Institutions Michael S. Barr before the Subcommittee on Capital Markets,Insurance, and Government Sponsored Enterprise of House Committee on FinancialServices [Press release]. Treasury.gov

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