Bernanke's creativity

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As one of the nation's most distinguished monetary economists, Federal Reserve Chairman Ben Bernanke spent a quarter century studying the Fed's role in the Great Depression before joining the Federal Reserve Board as a governor in 2002. At a November 2002 conference celebrating Milton Friedman's 90th birthday, here is how Mr. Bernanke concluded his scholarly speech about the Great Depression and Mr. Friedman's analysis of that epochal event: "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna [Schwartz, the co-authors of the classic, "A Monetary History of the United States, 1863-1960"]: Regarding the Great Depression. You're right, we [at the Fed] did it. We're very sorry. But thanks to you, we won't do it again."

Since last summer, Mr. Bernanke and his Fed colleagues have become so determined to make sure that "we won't do it again" that their unprecedented actions have frequently required the most sober-minded business publications to invoke the superlative degree to describe the Fed's latest revolutionary policies. Reporting on the Fed's announcement of one such policy, the Financial Times informed its readers on March 11 that "the Federal Reserve took its most radical step yet to improve liquidity in financial markets." Six days later, following a Fed decision even more momentous, the Wall Street Journal matter-of-factly reported: "The Federal Reserve announced one of the broadest expansions of its lending authority since the 1930s in an effort to stem a credit crisis that is engulfing the financial system and threatening a deep recession."

To appreciate the magnitude of the Fed's actions, let's review how Mr. Bernanke and his colleagues have ratcheted up their innovative policy responses as the credit crisis has deepened. Keep in mind that these often-revolutionary actions are above and beyond the Fed's extraordinary response via its traditional monetary-policy channel, through which the Fed has reduced the inflation-adjusted overnight fed-funds rate by a staggering 5 percentage points (from 3.25 percent in September to a negative 1.75 percent today) over a six-month period.

The financial and credit markets first encountered severe strain in the middle of last summer. However, on the heels of economic reports showing that the economy had expanded at a 3.4 percent annual rate during last year's second quarter and more than 400,000 jobs had been created during the previous three months, the Fed decided at its Aug. 7 meeting not to lower the fed-funds rate, which is the interest rate commercial banks charge each other for mostly overnight loans. Markets revolted. The Fed tried to soothe their nerves on Aug. 10 by issuing a press release inviting "depository institutions" (i.e., commercial banks) to borrow funds directly from the Fed at its discount window, which carried a 1 percentage-point premium above the fed-funds rate. A week later, in a highly unusual move, the Fed unilaterally cut that premium in half and extended the "term financing" for discount-window borrowings from one day to "as long as 30 days, renewable by the borrower." The Fed pointedly noted that collateral could include home mortgages.

Commercial banks avoided the discount window because of the stigma attached to it. So, the Fed on Dec. 12 announced an extraordinary policy [a "temporary Term Auction Facility" (TAF)] whereby banks could bid twice a month for 28- to 35-day loans by pledging the kinds of collateral acceptable at the discount window. TAF auctions began in allotments of $20 billion, which were later raised to $30 billion and then $50 billion. When the Fed increased its monthly TAF total to $100 billion on March 7 (the day the Labor Department reported that private-sector employment had declined in February for the third month in a row), the Fed also announced it would be pouring an additional $100 billion of liquidity into the system through 28-day term repurchase agreements.

Four days later, on March 11, the Fed established yet another unorthodox mechanism [the Term Securities Lending Facility (TSLF)] to inject liquidity into the overstressed financial markets. In an unprecedented move, the Fed would begin lending up to $200 billion in Treasury securities for 28 days to primary dealers (i.e., investment banks), which could use so-called Schedule 1 securities as collateral. (In a little-noted change announced March 20 by the Federal Reserve Bank of New York, which "engaged in extensive consultation with market participants," the Fed agreed to lower the collateral quality to include inferior Schedule 2 securities.)

On March 14, in yet another action that had not been conducted since the Great Depression, the Fed agreed to provide a 28-day loan to JPMorgan Chase, which would then loan the funds to the cash-strapped Bear Stearns investment bank.

Two days later, on Sunday March 16, to prevent the imminent bankruptcy of Bear Stearns, the Fed approved JPMorgan's takeover of Bear for $2 a share, which was later raised to $10. (Last year Bear Stearns sold for more than $150 a share.) To induce the takeover, the Fed has agreed to absorb losses up to $29 billion on questionable securities held by Bear Stearns, putting taxpayer funds at risk. In yet another breathtaking move, the Fed also opened its discount-window lending operation to primary-dealer investment banks.

These are not normal times, and the Fed clearly has been reacting accordingly. Whether its unprecedented actions will be enough to ameliorate the credit crisis and prevent a deep recession remains to be seen. Mr. Bernanke's promise that "we won't do it again" will not be broken for lack of effort or creativity.