Chapter Nine.

The Buck Starts Here The Federal Reserve's Amazing Power to Print and Destroy Money BACK IN 1986, Newsweek Newsweek called the Federal Reserve chairman the second most powerful man in America. In 2008 and 2009, you could delete the word called the Federal Reserve chairman the second most powerful man in America. In 2008 and 2009, you could delete the word second second as the Fed, under its chairman Ben Bernanke, cut interest rates, propped up banks, lent to cash-strapped companies, and bought hundreds of billions of dollars of mortgages to keep the economy from collapsing. as the Fed, under its chairman Ben Bernanke, cut interest rates, propped up banks, lent to cash-strapped companies, and bought hundreds of billions of dollars of mortgages to keep the economy from collapsing.

The Fed occupies a unique position in the United States. It is a partly public, partly private inst.i.tution whose political independence rivals the Supreme Court's. It is populated by technocratic central bankers who, regardless of party affiliation, see themselves as united in their mission of low inflation and steady growth. They speak their own nerdy dialect, "Fedspeak," saying things like monetary accommodation monetary accommodation instead of instead of low interest rates. low interest rates. They revel in goofy inside jokes. A sign in the Fed's barber shop reads, "Your growth rate affects my money supply." They revel in goofy inside jokes. A sign in the Fed's barber shop reads, "Your growth rate affects my money supply."

Spandex Money The United States struggled for years over whether to have a central bank. Alexander Hamilton, the first secretary of the Treasury, convinced Congress to create the First Bank of the United States in 1791 to handle the infant republic's monetary affairs, over the objections of then-Secretary of State Thomas Jefferson who feared the concentration of so much economic power in one place. Hostility to the bank persisted and in 1811 Congress let its charter lapse. The Second Bank of the United States began life in 1816, but Andrew Jackson, a populist opposed to the power of money interests, vetoed the renewal of its charter, which expired in 1836.

The event that finally led to the Fed's creation was The Panic of 1907.

.Without a central bank, private and state-owned banks could issue their own currencies, convertible in theory on demand to gold. In practice, one bank's dollar might be worth more than another's if investors had more faith in its stability. Banks seldom kept enough gold to redeem all the currency they issued; they would borrow from other, usually bigger, banks to handle contingencies. But if many banks faced the same demand at once, there wouldn't be enough gold to go around. As a result, many banks failed. Customers fearing others would follow, would then rush to convert their notes to gold, triggering more failures. Such panics were commonplace.

The event that finally led to the Fed's creation was the Panic of 1907, which began with a run on several banks that had lost money when customers speculated in the stock market. John Pierpont Morgan, the head of the bank that bore his name, convened New York's leading bankers in his personal library and persuaded them to meet all the demands for cash then besieging the city's troubled banks. To prevent a repeat, Congress, at the prodding of banks, pa.s.sed the Federal Reserve Act in 1913.

The act said that the Fed's job was to furnish an "elastic currency." This does not mean it's supposed to print $20 bills on spandex; rather, it means expanding and shrinking the money supply as needed. This gives the Fed two powerful roles: 1. Lender of Last Resort. Lender of Last Resort. A bank that has run out of money to repay its creditors can borrow from the Fed. (In Chapter Eleven, I will show how the Fed does this.) A bank that has run out of money to repay its creditors can borrow from the Fed. (In Chapter Eleven, I will show how the Fed does this.)2. Carrying out Monetary Policy. Carrying out Monetary Policy. By manipulating the supply of dollars to banks, the Fed can raise or lower interest rates with the goal of holding down inflation and preventing recessions, a set of responsibilities called By manipulating the supply of dollars to banks, the Fed can raise or lower interest rates with the goal of holding down inflation and preventing recessions, a set of responsibilities called monetary policy. monetary policy. (In Chapter Ten, I discuss this in detail.) (In Chapter Ten, I discuss this in detail.)The Fed, over the long run, can't make the economy grow more quickly or produce more jobs; that depends on population and productivity. But in the short run, monetary policy gives it tremendous influence over the business cycle. Higher interest rates dampen spending by households and businesses and thus economic growth, eventually, restraining prices and wages. Conversely, lower interest rates stimulate spending and, with time, put upward pressure on prices and wages.

Yet, despite these powers and its leaders' earnest idealism, the Fed's efforts to steer the economy by fulfilling those two roles are often upended by bubbles, busts, inflation, deflation, oil embargoes, technology revolutions, and more, as an overview of its history reveals.

In its early years, the Fed sought to merely meet farmers' and industry's demand for credit without influencing the overall temper of economic activity. When farmers needed money to bring the harvest in, the Fed expanded the money supply so that banks could meet their needs. Then, when the farmers repaid their loans, the money supply contracted. By the 1920s, though, the Fed had gotten more ambitious, seeking to influence nationwide economic activity and inflation with interest rates.

In its history, the Fed has made two monumental mistakes. The first began in the late 1920s. Worried that speculation in the stock market was creating a dangerous bubble, it jacked up interest rates. This sharply slowed the economy down. In October of 1929, the overheated stock market finally crashed. The Fed initially cut interest rates but then stood by as banks in the United States and around the world collapsed, unleashing a devastating contraction of credit. Precisely why remains a matter of debate. Its ability to hold down interest rates and expand credit was inhibited by a fear that foreigners would respond by dumping their dollars and demanding gold in return, draining the Fed's essential supply of the metal, though it had plenty. Regardless of the cause, the Great Depression bottomed out in 1933 when Franklin Delano Roosevelt used a bank holiday to close dying banks and recapitalize the remainder, and devalued the dollar against gold.

From the late 1940s to the late 1960s, the Fed kept growth strong, recessions short, and inflation generally low. By the late 1960s, though, its effort to keep the economy at full employment led to its second monumental mistake. It repeatedly failed to raise interest rates enough to stop inflation from ratcheting higher. Inflation and recession ensued in the 1970s. In reaction to those failures, in 1978, Congress imposed its current mandate on the Fed: full employment, stable prices, and moderate long-term interest rates. In 2010, it added financial stability.

Before the crisis, Congress paid the Fed the ultimate compliment by ignoring it.

.The modern era of the Fed began in 1979 with the appointment of Paul Volcker as chairman. He promptly raised interest rates and induced two severe recessions, breaking the back of inflation. The years spanning from 1982 to 2007 became known as the "Great Moderation," a period marked by generally low inflation, declining unemployment rates, and mild, infrequent recessions. Central bankers thought they'd uncovered the holy grail of economic success-deliver low inflation and the economy will grow and everything else would take care of itself. By 2006, when Ben Bernanke succeeded Alan Greenspan as chairman, things were going so swimmingly that Congress paid the Fed the ultimate compliment: It ignored it. When someone asked a senator what he thought of Bernanke's nomination, he replied, "for what?" Seriously.

The Fed is a compromise between federally appointed officials in Washington and autonomous reserve banks controlled by private bankers.

.Less than two years after Bernanke took office, the Great Moderation and the Fed's aura of technocratic competence ended with the financial crisis and recession of 2007-2009. The Fed shares the blame for the crisis, because of its prior lax regulation of banks and mortgages and, according to some, holding interest rates as low as it did, contributing to speculation and the housing boom.

Once the crisis was underway, Bernanke, as he later described it, "was not going to be the Federal Reserve chairman who presided over the second Great Depression." Using the same willingness to experiment that he admired in Roosevelt, he pushed the limits of the Fed's powers to lend to all and sundry, slash interest rates, and buy up bonds. Another Depression was avoided but at a price: Bernanke's aggressive actions have stirred up long-dormant suspicions of central bank power.

Who's in Charge?

The Fed's governance reflects a compromise at its birth in 1913 between populists who wanted power to rest with federally appointed officials in Washington, and conservatives who wanted it to rest with autonomous reserve banks controlled by private bankers. The system split power between a politically appointed board in Washington and 12 regional reserve banks.

In 1935, the structure was overhauled to shift power from the 12 reserve banks to the governors. That structure persists today. The seven-member board of governors sets all Fed policy except monetary policy. For example, it interprets and applies laws governing banks. The president nominates and the senate confirms governors, including the chairman and two vice-chairmen, one of whom oversees bank supervision.

The 12 regional reserve banks are stationed across the United States and are charged with supervising local banks, distributing cash, and processing checks. The boundaries of the districts they oversee defy geographic logic; two banks are based in Missouri partly because it was the home state of the speaker of the House in 1913. Reserve bank presidents (except New York's) are appointed by their banks' boards of directors, who represent the public. The most important reserve bank is New York, whose 380-strong markets group carries out the daily financial transactions that alter interest rates, lend to banks, and occasionally push the dollar up or down.

This hybrid public-private structure insulates the Fed from political pressure, but not completely. Lyndon Johnson and Richard Nixon both pressured Fed chairmen to keep interest rates low, with some success. Ronald Reagan appointed governors who sought to corral the power of Paul Volcker. George H.W. Bush sought to influence Alan Greenspan by briefly withholding reappointment (it didn't work). Congress plays the game too, by refusing to confirm the president's governor nominees or by threatening to clip the Fed's wings. In 2010, for example, led by Ron Paul, a Texas populist, Congress subjected the Fed's emergency actions to Congressional audit.

To keep monetary policy as independent as possible, it's the exclusive domain of the 12-member Federal Open Market Committee (FOMC). All seven members of the board of governors and the New York Fed president sit on the FOMC. The four remaining seats rotate annually among the 11 other reserve bank presidents. Though only five presidents vote, all 12 partic.i.p.ate in FOMC meetings so it is commonly thought of as having 19 members: 12 voting and 7 nonvoting.

The Bottom Line * The Fed stands alone in its economic sway and its independence. It can print and destroy money at will to protect the financial system from panics and to manage the business cycle.* The Fed is a compromise between political accountability and private independence. Its politically appointed governors and privately appointed reserve bank presidents make up the Federal Open Market Committee, which sets monetary policy at meetings eight times a year.

Chapter Ten.

White Smoke over the Washington Mall The Making of Monetary Policy and the Fine Art of Fed Watching MORE THAN ALMOST any other event on the economic calendar, meetings of the Federal Open Market Committee (FOMC) have the potential to rattle the markets. No wonder, then, that they are so closely watched.

One such rattling occurred in February of 1994. For more than a year before, the Fed had kept its short-term interest rate target at a low 3 percent in an effort to nurse the economy back to health. Alan Greenspan, the chairman, had concluded the time had come to raise rates, but he was worried that the markets might not be ready for it. To the rest of the FOMC gathered at the Fed's headquarters overlooking the Washington Mall, Greenspan proposed starting with a quarter of a percentage point increase. It would cool the economy and the market down a bit, ensuring inflation didn't rear its ugly head. Others, though, believed that more forceful action was needed to head off inflation and called for a half-point increase. Greenspan, worried that the news would catch Wall Street flat-footed, pleaded with them to reconsider: "I've been around a long time watching markets behave and I will tell you that if we do [half a point] today, we have a very high probability of cracking these markets."

Greenspan carried the day. Yet even the quarter-point increase came as a shock. Stocks and bonds tanked on the news. It was a jarring reminder of the power this little-known group of people has over our financial fates.

Inside the FOMC Meeting For all their market-moving potential, meetings of the FOMC are staid affairs generally bereft of drama. Eight times a year, the 19 members of the FOMC gather in Washington for a one- or two-day meeting. The Fed chairman sits at the center of the table, the other 18 members (a.s.suming there are no vacancies) sit on either side, their nameplates riveted on the back of their seat. The meeting usually begins with a briefing on the financial market developments, which is delivered by the head of markets at the New York Fed. Then, the staff presents the Greenbook, which is its forecast of the economy, and then the reserve bank presidents take turns reviewing conditions in their districts. Next, the staff's director of monetary affairs, also called the FOMC secretary, presents the Bluebook, a list of policy options members could take that day. (A summary is circulated in advance of the meeting.) After these presentations, all FOMC members discuss their view of the national economy and what they think the Fed should do. Finally, the chairman makes a recommendation and calls a vote. After the meeting wraps up, members help themselves to a buffet lunch. At 2:15 PM, the committee issues its statement.

FOMC members can be cla.s.sified as hawks or doves. Hawks generally prefer tighter policy than their peers, are more vocal, and are more likely to cast a dissenting vote. Why are hawks so much more outspoken than doves? It's a matter of professional pride. A central banker would rather be known for his toughness on inflation than his concern for unemployment. "Only hawks get to go to central banker heaven," Robert McTeer, a Dallas Fed president, once said. Doves are more likely to worry about unemployment, and to think that inflation worries are overdone. A central banker with dovish tendencies is like a wine critic who drinks Merlot out of a box. Nothing wrong with it, but best kept behind closed doors.

An FOMC member who is one of the 12 reserve bank presidents (other than New York's) is more likely to dissent than one of the governors. That's because governors share offices, staff, and a sense of solidarity with the chairman. Still, unlike in the Supreme Court, close FOMC votes are unheard of. Inflation and unemployment can animate economics geeks for hours but are much less divisive than the things the Supreme Court grapples with like abortion, freedom of speech, and the rights of suspected terrorists. The Fed traditionally prefers consensus so the chairman, unlike the Chief Justice of the Supreme Court, carries the day by default. More than two dissents is rare; four in the same direction would be a revolt. Laurence Meyer, a former governor, once joked that there are two red chairs at the table. Only members in red chairs get to dissent.

Punch Bowls and Ham Sandwiches William McChesney Martin, a former Fed chairman, famously described the Fed's role as taking away the punch bowl just when the party gets going. FOMC deliberations are consumed by figuring out just how much punch to supply. If everyone is having a good time spending money, the Fed cools things down by taking the punch bowl away, that is, by raising interest rates. The opposite is also true: If spending is moribund, it is the Fed's job to supply as much punch as necessary to get the people to come to party in the first place.

Calibrating the punch supply involves several delicate judgments: * How far is the economy operating from its productive capacity, which is its potential output? In other words, how big is the output gap? output gap? A related question is how far is unemployment from its natural rate? A related question is how far is unemployment from its natural rate?* How far is inflation from the Fed's preferred level?* What's the outlook for these two things given the forecast for growth, unemployment, and the public's expectations of inflation?.

The Fed doesn't have an inflation target, but FOMC members' long-term forecast of inflation, now 1.7 to 2 percent, serves the same purpose.

.As I described in Chapter Five, both potential growth and the natural rate of unemployment are rather hard to nail down. And any Fed chairman who wanted to keep his job would think twice before a.s.serting publicly that any specific level of unemployment was acceptable or natural. Fortunately, the Fed makes it possible for a careful reader to discern its estimates of both potential growth and the natural rate of unemployment. Four times a year, the Fed publishes the collective forecasts of FOMC members for major economic indicators. Their long-run forecast of growth roughly corresponds to their estimate of potential growth (around 2.5 percent) while their long-run forecast of unemployment corresponds to their estimate of the natural rate of unemployment (around 5 percent).

What's the Fed's preferred inflation level? Some central banks make it easy to figure this out by publishing a numerical inflation target, usually 2 percent (or a range around 2 percent). The Fed doesn't have a target, but FOMC members' longer-run forecast of inflation serves the same purpose. That range has lately been 1.7 to 2 percent. So if inflation is more than 2 percent or headed over 2 percent, they may want the economy to operate below potential for awhile to nudge it down. If inflation is much below 1.7 percent, they'd welcome a few years of above-potential growth to get it back up.

One thing the Fed doesn't dwell on is the money supply; in the view of its leadership and its staff, it is not much use for predicting inflation or economic growth. The Fed did explicitly target the money supply from 1979 to 1982. Currently, though, entire meetings regularly transpire with no mention of the money supply-despite that sign in the barber shop.

The growth, unemployment, and inflation picture helps the FOMC decide where to set interest rates. Generally, the further below its capacity the economy is operating, the lower it will keep interest rates in an effort to get it back up. The higher inflation is relative to its preferred level, the higher it will keep interest rates. The Fed's job sounds simple, right? Estimate the output gap, check on inflation, set interest rates, go golfing. May as well replace the Fed with a ham sandwich.

It's harder than it sounds. Monetary policy works with long and variable lags because loan, wage, and price contracts take a while to change. Nothing the Fed does today will affect unemployment or inflation in the next few months. The quarterback throws to where the receiver will be when the ball arrives, not where he is when the ball is thrown. Similarly, the Fed aims its actions at where the economy and inflation are headed over the next one to three years. If inflation is 2 percent today but the economy is straining its capacity, the Fed needs to raise rates now to keep inflation from rising next year. If inflation is 3 percent but a recession has sent unemployment up sharply, it can cut interest rates, expecting the output gap to get inflation down. If inflation is close to zero then it will keep rates low until the economy is booming so strongly that inflation rises.

All these decisions are p.r.o.ne to error. Potential is unknowable, the future is a guess, and the past isn't much easier given frequent data revisions. People are unpredictable: If rates rise, they may buy fewer homes, or they may buy more if they think even higher rates are on the way.

Since the Fed can never get things exactly right, it must constantly weigh whether it wants to err on the side of being too tight or too easy. For example, as Chapter Five shows, it's easier (though by no means fun) to correct an error that leads to inflation than one that leads to deflation. On a winding mountain road, it is better to sc.r.a.pe your fender on the side of the mountain than to drive through the guardrail and into the canyon.

The Technocrat in Charge The Fed's consensus-based governance is also a result of being run by chairmen who, while political appointees, are technocrats rather than partisans and lead through the persuasiveness of their argument rather than the force of their personality. That is true of Ben Bernanke who was an accomplished monetary policy scholar at Princeton University when George W. Bush appointed him a Fed governor in 2002. He briefly served as chairman of Bush's Council of Economic Advisers in 2005. In February of 2006, he succeeded Alan Greenspan as Fed chairman.

Bernanke didn't much care for the New Deal but he admired Roosevelt's willingness to try anything to get the economy going. Bernanke has shown a similar willingness to experiment.

.Bernanke is a leading scholar of the Great Depression. In Essays on the Great Depression, Essays on the Great Depression, he wrote, "I am a Great Depression buff, the way some people are Civil War buffs." He blames the Depression on the Fed's misguided attachment to orthodoxy, which caused it to stand by as the economy collapsed. Bernanke didn't much care for the New Deal but he admired Roosevelt's willingness to try anything to get the economy going. Bernanke showed a similar willingness to experiment in tackling the crisis and recession of 2007-2009. he wrote, "I am a Great Depression buff, the way some people are Civil War buffs." He blames the Depression on the Fed's misguided attachment to orthodoxy, which caused it to stand by as the economy collapsed. Bernanke didn't much care for the New Deal but he admired Roosevelt's willingness to try anything to get the economy going. Bernanke showed a similar willingness to experiment in tackling the crisis and recession of 2007-2009.

Bernanke is introverted. His voice sometimes quavers when he speaks in public and he doesn't much care for the conventions of public life. Examples of his disregard for fashion, such as wearing beige socks with a dark suit in Bush's Oval Office, are legendary. Though nominally a Republican, Bernanke's ideology defies cla.s.sification. By 2009, his approval ratings were higher among Democrats than Republicans. Obama reappointed him to a second term that expires in 2014, while his parallel term as governor expires in 2020.

Nowadays it is hard to shut the Fed up: It spews forth a virtually continuous gusher of information and commentary.

Fedspeak What the Fed says is almost as important as what it does. It wasn't always that way. Before the 1990s, the Fed followed the credo of Montagu Norman, a Bank of England governor: "Never explain, never apologize." It rarely disclosed changes in interest rates; therefore, investors deciphered such changes from the Fed's market operations. It believed that talking caused unnecessary volatility, and if it discussed what it might do, it would bind its hands if a different course of action proved necessary.

Starting in the early 1990s, this fondness for opacity changed. The Fed now believes that talking actually harnesses the markets to its own ends. Fret aloud about inflation and bond yields will rise, doing some of the work the Fed would otherwise have to do. In fact, it's hard to shut the Fed up: It spews forth a virtually continuous gusher of information and commentary. The most important is the statement that the FOMC releases at the end of each meeting. It usually provides the interest rate decision, a description of the economy and its outlook, a hint of where interest rates will go next, and how the FOMC members voted.

Three weeks after each meeting, the Fed releases detailed minutes disclosing more of the reasoning and debate behind the decision, without naming who said what. A full transcript follows five years later. Four times a year, the minutes include the FOMC members' forecasts. Between meetings, members give speeches. Several times a year, the chairman testifies to Congress; in February and July this testimony is accompanied by a lengthy Monetary Policy Report. Officials also give interviews, often off the record, to reporters who then try to infer the Fed's next move.

With all this Fedspeak, the Fed's actions are less likely to shock people. Indeed, when after a long hiatus the Fed prepared to raise rates in 2004, it went to absurd lengths to avoid the sort of surprise that occurred in February 1994. A few weeks before the increase, one Fed official foreshadowed the event in a Bob Dylan spoof called "The Rates They Are A-Changin'." Rates They Are A-Changin'."

All the FOMC's deliberations, study, and chatter usually boil down to a relatively simple decision: What will be its target for the Federal Funds rate, the rate that banks charge on one-day loans to each other? The Fed Funds rate is a benchmark for all other short-term rates: the bank prime rate, commercial paper, Treasury bills, and floating-rate mortgages. It also ripples through to long-term bond yields and mortgage rates, although the effect is more muted, because bond investors lend for years, not just a few days or weeks. It can also affect stock prices and the dollar. With this one modest interest rate lever, the Fed sways an array of financial conditions, and thus the entire economy.

Into the Weeds Once the FOMC selects a target for the Fed Funds rate, it can't just order banks to borrow or lend at the target rate. It has to manage market conditions to make the rate at which banks exchange money actually meet that target. It does this through open market operations. open market operations. To understand how these work, start with the fact that banks are required to keep a portion of customers' deposits readily available as currency and coins in their vaults or ATMs, or as reserves. Banks use reserves to settle payments with each other and with the Treasury, for example as customers cash Social Security checks or pay their taxes. As a result, the daily flow of such payments may leave one bank with more reserves than it needs, and another with less. The first can lend its excess to the second in the Fed Funds market. To understand how these work, start with the fact that banks are required to keep a portion of customers' deposits readily available as currency and coins in their vaults or ATMs, or as reserves. Banks use reserves to settle payments with each other and with the Treasury, for example as customers cash Social Security checks or pay their taxes. As a result, the daily flow of such payments may leave one bank with more reserves than it needs, and another with less. The first can lend its excess to the second in the Fed Funds market.

To lower the Fed Funds rate, the Fed's open market desk in New York buys Treasury securities, or securities backed by Fannie Mae or Freddie Mac, from a bank or the bank's customer. To pay for them, it creates money out of thin air which it deposits in the bank's reserve account with the Fed. This is, de facto, printing money, since the bank is free to swap those reserves for notes and coins. These operations expand the Fed's balance sheet. With more reserves than it needs, the bank lends some out, pushing down the Fed Funds rate.

To raise the Fed Funds rate, the Fed does the opposite: It sells securities from its own portfolio. The bank that buys them pays the Fed out of its reserve account. That money disappears and the Fed's balance sheet shrinks. That bank, to replenish its reserves, borrows from other banks, pushing up the Federal Funds rate.

Traders bet on the Fed's next move using Fed Funds Fed Funds futures, futures, financial contracts traded on the Chicago Board of Trade. As Fedspeak or economic news comes out, one can calculate the probability of a rate change from how this contract changes. financial contracts traded on the Chicago Board of Trade. As Fedspeak or economic news comes out, one can calculate the probability of a rate change from how this contract changes.

Zero: The Final Frontier In December 2008, the Fed hit an ominous milestone. As the U.S. economy spiraled down in the wake of Lehman Brothers' collapse, it concluded the damage to the economy would be so great that it had to cut the Federal Funds rate all the way to zero, or more precisely, to between zero and 0.25 percent. Was there anything left it could do?

Another tactic would be to buy foreign currencies in exchange for newly printed dollars, depressing the dollar's value and helping exports. But by hurting imports, this would come at other countries' expense. So a central bank that has cut short-term rates to zero is, practically speaking, out of bullets.

A soldier out of bullets still has a bayonet. The Fed did the equivalent of reaching for its bayonet. Between 2008 and 2010, it bought $1.75 trillion worth of Treasury bonds and mortgage-backed securities by printing money. Its balance sheet ballooned from under $1 trillion to over $2 trillion and banks' reserves skyrocketed from almost nothing to more than $1 trillion.

As Fedspeak or economic news comes out, one can calculate the probability of a rate change from how the Federal Funds futures contract changes.

.When a central bank shifts its focus to expanding its balance sheet through bond purchases rather than targeting short-term interest rates, it is called quant.i.tative easing. quant.i.tative easing. This stimulates the economy in two ways. This stimulates the economy in two ways.1. When bond prices rise, their yields decline. So the Fed's buying nudged down long-term interest rates, boosting interest-sensitive spending on items like houses.2. Since banks don't earn much on reserves, they may lend them out to make higher-returning loans to businesses and households. That's the rationale used by the Bank of j.a.pan starting in 2001 and the Bank of England in 2009 when they tried the same thing.

In theory, quant.i.tative easing endows the Fed with awesome power. It could buy up every U.S. bond in existence. Yet, in practice, this is the Star Trek of central banking, taking the Fed into strange new worlds with unknown consequences.* Political. Political. One of the major risks of this strategy is that it could cast doubt on the Fed's political independence. When the Fed buys government bonds, it has lent money to the government. This is called One of the major risks of this strategy is that it could cast doubt on the Fed's political independence. When the Fed buys government bonds, it has lent money to the government. This is called monetizing the debt. monetizing the debt. Even though the Fed wasn't forced by politicians to buy the bonds, some experts do worry that this is how the government eventually copes with the national debt: by making the Fed buy it. That won't happen as long as politicians respect the Fed's independence, which George W. Bush, Barack Obama, and even Congress, despite rumblings to the contrary, have so far done. Even though the Fed wasn't forced by politicians to buy the bonds, some experts do worry that this is how the government eventually copes with the national debt: by making the Fed buy it. That won't happen as long as politicians respect the Fed's independence, which George W. Bush, Barack Obama, and even Congress, despite rumblings to the contrary, have so far done.* Inflation. Inflation. The second unknown is whether printing all that money will create inflation. Monetarists who see a tight link between all those extra reserves and inflation certainly think so. But they're probably wrong. That's because, as I noted in Chapter Five, reserves can't cause inflation if they aren't lent and spent. The second unknown is whether printing all that money will create inflation. Monetarists who see a tight link between all those extra reserves and inflation certainly think so. But they're probably wrong. That's because, as I noted in Chapter Five, reserves can't cause inflation if they aren't lent and spent.But reserves do pose a more technical problem. To raise the Federal Funds rate, the Fed ordinarily uses open market operations to reduce the supply of reserves. That's easy in normal times when banks don't have much reserves, but harder when they have $1 trillion, which they will lend them for next to nothing even if the Federal Funds rate target is 2 percent.

Luckily, in 2008 the Fed got a new tool to work with: the right to pay interest on excess reserves (IOER). If IOER is 2 percent, banks will keep those reserves at the Fed rather than lend them at less than 2 percent in the Fed Funds market.

* Tempting Speculators. Tempting Speculators. Do zero interest rates entice hedge funds, banks, and others to plough borrowed money into risky investments? A lot of people think that's what happened when the Fed kept low rates from 2002 to 2004, bringing on the subprime crisis. And does it do the same in China and other countries who link their currency to the dollar and thus U.S. interest rates? There may be truth to this, but raising interest rates to combat speculation is a bit like using dynamite to eradicate termites: the remedy may do more damage than the problem. A more surgical response is to use regulations to limit risk-taking. Do zero interest rates entice hedge funds, banks, and others to plough borrowed money into risky investments? A lot of people think that's what happened when the Fed kept low rates from 2002 to 2004, bringing on the subprime crisis. And does it do the same in China and other countries who link their currency to the dollar and thus U.S. interest rates? There may be truth to this, but raising interest rates to combat speculation is a bit like using dynamite to eradicate termites: the remedy may do more damage than the problem. A more surgical response is to use regulations to limit risk-taking.* Exit Strategy. Exit Strategy. When the economy has recovered, the Fed may want to sell those extra bonds. The reserves it created when it first bought the bonds would then disappear. Such selling should push up long-term rates, but by how much is hard to predict. When the economy has recovered, the Fed may want to sell those extra bonds. The reserves it created when it first bought the bonds would then disappear. Such selling should push up long-term rates, but by how much is hard to predict.

Raising interest rates to combat speculation is like using dynamite to eradicate termites.

The Bottom Line * When setting interest rates, the FOMC weighs how far the economy is from its potential, and how far inflation is likely to be from 2 percent. This is harder than it sounds because the economy responds unpredictably and with lags.* At FOMC meetings, Fed officials listen and debate the best path for monetary policy. A few dissent but the chairman always carries the day. The Fed gives out so much information that the result is seldom a surprise but it still moves markets.* The Fed carries out monetary policy by using open market operations to move the Federal Funds rate, charged on loans between banks, up or down.* When the Funds rate fell to zero in 2008 the Fed turned to quant.i.tative easing: buying up bonds to push down long-term interest rates. Quant.i.tative easing has unpredictable political and economic consequences.

Chapter Eleven.

When the World Needs a Fireman America's Lender of Last Resort and the World's Crisis Manager THE COLLAPSE of the Twin Towers on September 11, 2001, tore through the infrastructure of Wall Street. Traders' telephones didn't work. The wires over which banks sent payments to each other were severed. A bank that processed half of Wall Street's Treasury bond trades couldn't confirm what trades had gone through. And the aircraft that shuttled bags of checks between processing centers were grounded. With payments stuck in transit, some banks started to run short on cash while others began to h.o.a.rd what they had.

Roger Ferguson, the only governor at the Fed that day, issued a statement reminding banks that the Fed was open for business. The following day, banks borrowed $46 billion from the Fed. Where did the Fed get the money? Simple: It printed it. More precisely, it used a few keystrokes and voila, the money appeared in the banks' accounts at the Fed. When the damage was repaired and the markets returned to normal, the banks repaid the loans and the money disappeared.

Neat trick, huh? This, however, is not some parlor game. In fact, it is the sort of thing for which the Fed was created-to be the financial system's lender of last resort. Most of the time, this role is ignored. The crisis of 2008 brought that role back to the limelight with a vengeance, as the Fed worked its magic by lending to commercial banks, investment banks, an insurance company, money market mutual funds, and others, all to keep financial inst.i.tutions afloat, maintain the flow of credit to the economy, and thus enable businesses and consumers to keep spending.

Whenever the financial system catches fire, the phones soon ring at the Fed station house.

.The Fed's unique power to lend at will makes it the financial system's crisis manager. When fire breaks out in some corner of the financial system, the phones soon ring at the Fed station house in Washington or at the New York Fed in lower Manhattan, whose president talks regularly with the biggest players on Wall Street and the heads of foreign central banks and finance ministries.

Being crisis manager may not involve lending money; it may mean strong-arming private banks and investors to lend their own money to keep companies or countries from defaulting. The Fed got this role by virtue of its place at the center of world markets and its reputation for nonpartisan professionalism.

The Fed has been called on to play this role with increasing frequency. Although Paul Volcker's defeat of inflation in 1982 ushered in 25 years of tranquil growth, it also led to serial crises.* In the early 1980s, many big U.S. banks were near-insolvent because of souring loans to Latin America. Volcker arranged for those loans to be rolled over until the banks were healthy enough to write them off.* In 1987, the stock market crashed. The Fed cut interest rates and urged banks not to cut off strapped Wall Street brokers.* In 1994, Mexico devalued the peso and narrowly avoided default with the help of loans from the Fed and Treasury.* In 1997, when Korea teetered on the edge of default, New York Fed president William McDonough persuaded U.S. banks to renew their loans.* In 1998, McDonough brokered a rescue of the giant hedge fund Long Term Capital Management.A Rude Awakening Like the Fed's apparent success at taming the business cycle, its crisis-management skills may have lulled us into thinking the economy has become a safer, less violent place. As a result, everyone from the biggest banks to the smallest hedge funds came to a.s.sume that money would always be easy to borrow. "Money always seems free in manias," noted Charles Kindleberger, a market historian in Manias, Panics, and Crashes. Manias, Panics, and Crashes. That a.s.sumption was shattered on August 9, 2007, when a French bank, BNP Paribas, announced that one of its investment funds, which had sustained big losses on subprime mortgages, would suspend repaying investors their money. The event triggered a global scramble for cash as investors, unsure who'd been left holding the mortgage industry's toxic waste, h.o.a.rded their money. Short-term interest rates skyrocketed. That a.s.sumption was shattered on August 9, 2007, when a French bank, BNP Paribas, announced that one of its investment funds, which had sustained big losses on subprime mortgages, would suspend repaying investors their money. The event triggered a global scramble for cash as investors, unsure who'd been left holding the mortgage industry's toxic waste, h.o.a.rded their money. Short-term interest rates skyrocketed.

The Fed needed to find a way to inject money into the financial system. It used open market operations. It lowered the discount rate. It auctioned off loans from the discount window (which I'll explain later). It swapped lines of credit with foreign central banks, enabling them to lend desperately needed dollars to their own banks. In the New York Times, New York Times, Paul Krugman compared Bernanke to television's MacGyver, who "would always get out of difficult situations by a.s.sembling clever devices out of household objects and duct tape." Paul Krugman compared Bernanke to television's MacGyver, who "would always get out of difficult situations by a.s.sembling clever devices out of household objects and duct tape."

On the evening of March 13, 2008, Bear Stearns informed the Securities and Exchange Commission (SEC), which then told Tim Geithner, then president of the New York Fed, that it too was about to run out of cash, and it would have to file for bankruptcy protection the next morning. Unwilling to risk the chaos that would ensue, the Fed the next morning agreed to lend Bear Stearns enough money to stay alive long enough to find a buyer. By law, the Fed ordinarily only lends to commercial banks, so it had to use a loophole in the law to lend to Bear Stearns, an investment bank. It used the same loophole to lend money to American International Group, an insurance company, to keep it from failing, and it used it to buy a.s.set-backed commercial paper, to lend to money market mutual funds, and to buy the commercial paper issued by companies like General Electric.

The Fed can lend as much as it likes. Need $1 billion? Print $1 billion. By early 2009, it had lent $1.5 trillion. Yet this formidable firepower has a big handicap. A loan from the Fed can help a bank that's temporarily illiquid (i.e., short of cash) as long as it is solvent (its a.s.sets are worth more than its debts). But Fed lending cannot save a bank that is insolvent. Insolvent banks must be closed or given new capital. New loans simply delay the inevitable. In 2008, rapidly souring mortgage loans meant many U.S. financial inst.i.tutions were nearly insolvent, or suspected of it, which is why $1.5 trillion didn't stem the panic. The Fed claims it couldn't lend to Lehman Brothers because it was insolvent, though that claim is suspect.

Only when Congress agreed to invest up to $700 billion to recapitalize banks and buy up bad debt did the panic ease.

The Fed has a loophole to lend temporarily to companies other than banks, but it sat unused until 2008.