Bernanke's public thoughts

For almost a year and a half the global financial system has been
under extraordinary stress--stress that has now decisively spilled
over to the global economy more broadly. The proximate cause of the
crisis was the turn of the housing cycle in the United States and the
associated rise in delinquencies on subprime mortgages, which imposed
substantial losses on many financial institutions and shook investor
confidence in credit markets. However, although the subprime debacle
triggered the crisis, the developments in the U.S. mortgage market
were only one aspect of a much larger and more encompassing credit
boom whose impact transcended the mortgage market to affect many other
forms of credit. Aspects of this broader credit boom included
widespread declines in underwriting standards, breakdowns in lending
oversight by investors and rating agencies, increased reliance on
complex and opaque credit instruments that proved fragile under
stress, and unusually low compensation for risk-taking.

The abrupt end of the credit boom has had widespread financial and
economic ramifications. Financial institutions have seen their
capital depleted by losses and writedowns and their balance sheets
clogged by complex credit products and other illiquid assets of
uncertain value. Rising credit risks and intense risk aversion have
pushed credit spreads to unprecedented levels, and markets for
securitized assets, except for mortgage securities with government
guarantees, have shut down. Heightened systemic risks, falling asset
values, and tightening credit have in turn taken a heavy toll on
business and consumer confidence and precipitated a sharp slowing in
global economic activity. The damage, in terms of lost output, lost
jobs, and lost wealth, is already substantial.

The global economy will recover, but the timing and strength of the
recovery are highly uncertain. Government policy responses around the
world will be critical determinants of the speed and vigor of the
recovery. Today I will offer some thoughts on current and prospective
policy responses to the crisis in the United States, with a particular
emphasis on actions by the Federal Reserve. In doing so, I will
outline the framework that has guided the Federal Reserve's responses
to date. I will also explain why I believe that the Fed still has
powerful tools at its disposal to fight the financial crisis and the
economic downturn, even though the overnight federal funds rate cannot
be reduced meaningfully further.

The Federal Reserve's Response to the Crisis
The Federal Reserve has responded aggressively to the crisis since its
emergence in the summer of 2007. Following a cut in the discount rate
(the rate at which the Federal Reserve lends to depository
institutions) in August of that year, the Federal Open Market
Committee began to ease monetary policy in September 2007, reducing
the target for the federal funds rate by 50 basis points.1 As
indications of economic weakness proliferated, the Committee continued
to respond, bringing down its target for the federal funds rate by a
cumulative 325 basis points by the spring of 2008. In historical
comparison, this policy response stands out as exceptionally rapid and
proactive. In taking these actions, we aimed both to cushion the
direct effects of the financial turbulence on the economy and to
reduce the virulence of the so-called adverse feedback loop, in which
economic weakness and financial stress become mutually reinforcing.

These policy actions helped to support employment and incomes during
the first year of the crisis. Unfortunately, the intensification of
the financial turbulence last fall led to further deterioration in the
economic outlook. The Committee responded by cutting the target for
the federal funds rate an additional 100 basis points last October,
with half of that reduction coming as part of an unprecedented
coordinated interest rate cut by six major central banks on October 8.
In December the Committee reduced its target further, setting a range
of 0 to 25 basis points for the target federal funds rate.

The Committee's aggressive monetary easing was not without risks.
During the early phase of rate reductions, some observers expressed
concern that these policy actions would stoke inflation. These
concerns intensified as inflation reached high levels in mid-2008,
mostly reflecting a surge in the prices of oil and other commodities.
The Committee takes its responsibility to ensure price stability
extremely seriously, and throughout this period it remained closely
attuned to developments in inflation and inflation expectations.
However, the Committee also maintained the view that the rapid rise in
commodity prices in 2008 primarily reflected sharply increased demand
for raw materials in emerging market economies, in combination with
constraints on the supply of these materials, rather than general
inflationary pressures. Committee members expected that, at some
point, global economic growth would moderate, resulting in slower
increases in the demand for commodities and a leveling out in their
prices--as reflected, for example, in the pattern of futures market
prices. As you know, commodity prices peaked during the summer and,
rather than leveling out, have actually fallen dramatically with the
weakening in global economic activity. As a consequence, overall
inflation has already declined significantly and appears likely to
moderate further.

The Fed's monetary easing has been reflected in significant declines
in a number of lending rates, especially shorter-term rates, thus
offsetting to some degree the effects of the financial turmoil on
financial conditions. However, that offset has been incomplete, as
widening credit spreads, more restrictive lending standards, and
credit market dysfunction have worked against the monetary easing and
led to tighter financial conditions overall. In particular, many
traditional funding sources for financial institutions and markets
have dried up, and banks and other lenders have found their ability to
securitize mortgages, auto loans, credit card receivables, student
loans, and other forms of credit greatly curtailed. Thus, in addition
to easing monetary policy, the Federal Reserve has worked to support
the functioning of credit markets and to reduce financial strains by
providing liquidity to the private sector. In doing so, as I will
discuss shortly, the Fed has deployed a number of additional policy
tools, some of which were previously in our toolkit and some of which
have been created as the need arose.

One important tool is policy communication. Even if the overnight
rate is close to zero, the Committee should be able to influence
longer-term interest rates by informing the public's expectations
about the future course of monetary policy. To illustrate, in its
statement after its December meeting, the Committee expressed the view
that economic conditions are likely to warrant an unusually low
federal funds rate for some time.2 To the extent that such statements
cause the public to lengthen the horizon over which they expect
short-term rates to be held at very low levels, they will exert
downward pressure on longer-term rates, stimulating aggregate demand.
It is important, however, that statements of this sort be expressed in
conditional fashion--that is, that they link policy expectations to
the evolving economic outlook. If the public were to perceive a
statement about future policy to be unconditional, then long-term
rates might fail to respond in the desired fashion should the economic
outlook change materially.

Other than policies tied to current and expected future values of the
overnight interest rate, the Federal Reserve has--and indeed, has been
actively using--a range of policy tools to provide direct support to
credit markets and thus to the broader economy. As I will elaborate,
I find it useful to divide these tools into three groups. Although
these sets of tools differ in important respects, they have one aspect
in common: They all make use of the asset side of the Federal
Reserve's balance sheet. That is, each involves the Fed's authorities
to extend credit or purchase securities.

The first set of tools, which are closely tied to the central bank's
traditional role as the lender of last resort, involve the provision
of short-term liquidity to sound financial institutions. Over the
course of the crisis, the Fed has taken a number of extraordinary
actions to ensure that financial institutions have adequate access to
short-term credit. These actions include creating new facilities for
auctioning credit and making primary securities dealers, as well as
banks, eligible to borrow at the Fed's discount window.3 For example,
since August 2007 we have lowered the spread between the discount rate
and the federal funds rate target from 100 basis points to 25 basis
points; increased the term of discount window loans from overnight to
90 days; created the Term Auction Facility, which auctions credit to
depository institutions for terms up to three months; put into place
the Term Securities Lending Facility, which allows primary dealers to
borrow Treasury securities from the Fed against less-liquid
collateral; and initiated the Primary Dealer Credit Facility as a
source of liquidity for those firms, among other actions.

Because interbank markets are global in scope, the Federal Reserve has
also approved bilateral currency swap agreements with 14 foreign
central banks. The swap facilities have allowed these central banks
to acquire dollars from the Federal Reserve to lend to banks in their
jurisdictions, which has served to ease conditions in dollar funding
markets globally. In most cases, the provision of this dollar
liquidity abroad was conducted in tight coordination with the Federal
Reserve's own funding auctions.

Importantly, the provision of credit to financial institutions exposes
the Federal Reserve to only minimal credit risk; the loans that we
make to banks and primary dealers through our various facilities are
generally overcollateralized and made with recourse to the borrowing
firm. The Federal Reserve has never suffered any losses in the course
of its normal lending to banks and, now, to primary dealers. In the
case of currency swaps, the foreign central banks are responsible for
repayment, not the financial institutions that ultimately receive the
funds; moreover, as further security, the Federal Reserve receives an
equivalent amount of foreign currency in exchange for the dollars it
provides to foreign central banks.

Liquidity provision by the central bank reduces systemic risk by
assuring market participants that, should short-term investors begin
to lose confidence, financial institutions will be able to meet the
resulting demands for cash without resorting to potentially
destabilizing fire sales of assets. Moreover, backstopping the
liquidity needs of financial institutions reduces funding stresses
and, all else equal, should increase the willingness of those
institutions to lend and make markets.

On the other hand, the provision of ample liquidity to banks and
primary dealers is no panacea. Today, concerns about capital, asset
quality, and credit risk continue to limit the willingness of many
intermediaries to extend credit, even when liquidity is ample.
Moreover, providing liquidity to financial institutions does not
address directly instability or declining credit availability in
critical nonbank markets, such as the commercial paper market or the
market for asset-backed securities, both of which normally play major
roles in the extension of credit in the United States.

To address these issues, the Federal Reserve has developed a second
set of policy tools, which involve the provision of liquidity directly
to borrowers and investors in key credit markets. Notably, we have
introduced facilities to purchase highly rated commercial paper at a
term of three months and to provide backup liquidity for money market
mutual funds. In addition, the Federal Reserve and the Treasury have
jointly announced a facility that will lend against AAA-rated
asset-backed securities collateralized by student loans, auto loans,
credit card loans, and loans guaranteed by the Small Business
Administration. The Federal Reserve's credit risk exposure in the
latter facility will be minimal, because the collateral will be
subject to a "haircut" and the Treasury is providing $20 billion of
capital as supplementary loss protection. We expect this facility to
be operational next month.

The rationales and objectives of our various facilities differ,
according to the nature of the problem being addressed. In some
cases, as in our programs to backstop money market mutual funds, the
purpose of the facility is to serve, once again in classic central
bank fashion, as liquidity provider of last resort. Following a
prominent fund's "breaking of the buck"--that is, a decline in its net
asset value below par--in September, investors began to withdraw funds
in large amounts from money market mutual funds that invest in private
instruments such as commercial paper and certificates of deposit.
Fund managers responded by liquidating assets and investing at only
the shortest of maturities. As the pace of withdrawals increased,
both the stability of the money market mutual fund industry and the
functioning of the commercial paper market were threatened. The
Federal Reserve responded with several programs, including a facility
to finance bank purchases of high-quality asset-backed commercial
paper from money market mutual funds. This facility effectively
channeled liquidity to the funds, helping them to meet redemption
demands without having to sell assets indiscriminately. Together with
a Treasury program that provided partial insurance to investors in
money market mutual funds, these efforts helped stanch the cash
outflows from those funds and stabilize the industry.

The Federal Reserve's facility to buy high-quality (A1-P1) commercial
paper at a term of three months was likewise designed to provide a
liquidity backstop, in this case for investors and borrowers in the
commercial paper market. As I mentioned, the functioning of that
market deteriorated significantly in September, with borrowers finding
financing difficult to obtain, and then only at high rates and very
short (usually overnight) maturities. By serving as a backup source
of liquidity for borrowers, the Fed's commercial paper facility was
aimed at reducing investor and borrower concerns about "rollover
risk," the risk that a borrower could not raise new funds to repay
maturing commercial paper. The reduction of rollover risk, in turn,
should increase the willingness of private investors to lend,
particularly for terms longer than overnight. These various actions
appear to have improved the functioning of the commercial paper
market, as rates and risk spreads have come down and the average
maturities of issuance have increased.

In contrast, our forthcoming asset-backed securities program, a joint
effort with the Treasury, is not purely for liquidity provision. This
facility will provide three-year term loans to investors against
AAA-rated securities backed by recently originated consumer and
small-business loans. Unlike our other lending programs, this
facility combines Federal Reserve liquidity with capital provided by
the Treasury, which allows it to accept some credit risk. By
providing a combination of capital and liquidity, this facility will
effectively substitute public for private balance sheet capacity, in a
period of sharp deleveraging and risk aversion in which such capacity
appears very short. If the program works as planned, it should lead
to lower rates and greater availability of consumer and small business
credit. Over time, by increasing market liquidity and stimulating
market activity, this facility should also help to revive private
lending. Importantly, if the facility for asset-backed securities
proves successful, its basic framework can be expanded to accommodate
higher volumes or additional classes of securities as circumstances
warrant.

The Federal Reserve's third set of policy tools for supporting the
functioning of credit markets involves the purchase of longer-term
securities for the Fed's portfolio. For example, we recently
announced plans to purchase up to $100 billion in government-sponsored
enterprise (GSE) debt and up to $500 billion in GSE mortgage-backed
securities over the next few quarters. Notably, mortgage rates
dropped significantly on the announcement of this program and have
fallen further since it went into operation. Lower mortgage rates
should support the housing sector. The Committee is also evaluating
the possibility of purchasing longer-term Treasury securities. In
determining whether to proceed with such purchases, the Committee will
focus on their potential to improve conditions in private credit
markets, such as mortgage markets.

These three sets of policy tools--lending to financial institutions,
providing liquidity directly to key credit markets, and buying
longer-term securities--have the common feature that each represents a
use of the asset side of the Fed's balance sheet, that is, they all
involve lending or the purchase of securities. The virtue of these
policies in the current context is that they allow the Federal Reserve
to continue to push down interest rates and ease credit conditions in
a range of markets, despite the fact that the federal funds rate is
close to its zero lower bound.

Credit Easing versus Quantitative Easing
The Federal Reserve's approach to supporting credit markets is
conceptually distinct from quantitative easing (QE), the policy
approach used by the Bank of Japan from 2001 to 2006. Our
approach--which could be described as "credit easing"--resembles
quantitative easing in one respect: It involves an expansion of the
central bank's balance sheet. However, in a pure QE regime, the focus
of policy is the quantity of bank reserves, which are liabilities of
the central bank; the composition of loans and securities on the asset
side of the central bank's balance sheet is incidental. Indeed,
although the Bank of Japan's policy approach during the QE period was
quite multifaceted, the overall stance of its policy was gauged
primarily in terms of its target for bank reserves. In contrast, the
Federal Reserve's credit easing approach focuses on the mix of loans
and securities that it holds and on how this composition of assets
affects credit conditions for households and businesses. This
difference does not reflect any doctrinal disagreement with the
Japanese approach, but rather the differences in financial and
economic conditions between the two episodes. In particular, credit
spreads are much wider and credit markets more dysfunctional in the
United States today than was the case during the Japanese experiment
with quantitative easing. To stimulate aggregate demand in the
current environment, the Federal Reserve must focus its policies on
reducing those spreads and improving the functioning of private credit
markets more generally.

The stimulative effect of the Federal Reserve's credit easing policies
depends sensitively on the particular mix of lending programs and
securities purchases that it undertakes. When markets are illiquid
and private arbitrage is impaired by balance sheet constraints and
other factors, as at present, one dollar of longer-term securities
purchases is unlikely to have the same impact on financial markets and
the economy as a dollar of lending to banks, which has in turn a
different effect than a dollar of lending to support the commercial
paper market. Because various types of lending have heterogeneous
effects, the stance of Fed policy in the current regime--in contrast
to a QE regime--is not easily summarized by a single number, such as
the quantity of excess reserves or the size of the monetary base. In
addition, the usage of Federal Reserve credit is determined in large
part by borrower needs and thus will tend to increase when market
conditions worsen and decline when market conditions improve. Setting
a target for the size of the Federal Reserve's balance sheet, as in a
QE regime, could thus have the perverse effect of forcing the Fed to
tighten the terms and availability of its lending at times when market
conditions were worsening, and vice versa.

The lack of a simple summary measure or policy target poses an
important communications challenge. To minimize market uncertainty
and achieve the maximum effect of its policies, the Federal Reserve is
committed to providing the public as much information as possible
about the uses of its balance sheet, plans regarding future uses of
its balance sheet, and the criteria on which the relevant decisions
are based.4

Exit Strategy
Some observers have expressed the concern that, by expanding its
balance sheet, the Federal Reserve is effectively printing money, an
action that will ultimately be inflationary. The Fed's lending
activities have indeed resulted in a large increase in the excess
reserves held by banks. Bank reserves, together with currency, make
up the narrowest definition of money, the monetary base; as you would
expect, this measure of money has risen significantly as the Fed's
balance sheet has expanded. However, banks are choosing to leave the
great bulk of their excess reserves idle, in most cases on deposit
with the Fed. Consequently, the rates of growth of broader monetary
aggregates, such as M1 and M2, have been much lower than that of the
monetary base. At this point, with global economic activity weak and
commodity prices at low levels, we see little risk of inflation in the
near term; indeed, we expect inflation to continue to moderate.

However, at some point, when credit markets and the economy have begun
to recover, the Federal Reserve will have to unwind its various
lending programs. To some extent, this unwinding will happen
automatically, as improvements in credit markets should reduce the
need to use Fed facilities. Indeed, where possible we have tried to
set lending rates and margins at levels that are likely to be
increasingly unattractive to borrowers as financial conditions
normalize. In addition, some programs--those authorized under the
Federal Reserve's so-called 13(3) authority, which requires a finding
that conditions in financial markets are "unusual and exigent"--will
by law have to be eliminated once credit market conditions
substantially normalize. However, as the unwinding of the Fed's
various programs effectively constitutes a tightening of policy, the
principal factor determining the timing and pace of that process will
be the Committee's assessment of the condition of credit markets and
the prospects for the economy.

As lending programs are scaled back, the size of the Federal Reserve's
balance sheet will decline, implying a reduction in excess reserves
and the monetary base. A significant shrinking of the balance sheet
can be accomplished relatively quickly, as a substantial portion of
the assets that the Federal Reserve holds--including loans to
financial institutions, currency swaps, and purchases of commercial
paper--are short-term in nature and can simply be allowed to run off
as the various programs and facilities are scaled back or shut down.
As the size of the balance sheet and the quantity of excess reserves
in the system decline, the Federal Reserve will be able to return to
its traditional means of making monetary policy--namely, by setting a
target for the federal funds rate.

Although a large portion of Federal Reserve assets are short-term in
nature, we do hold or expect to hold significant quantities of
longer-term assets, such as the mortgage-backed securities that we
will buy over the next two quarters. Although longer-term securities
can also be sold, of course, we would not anticipate disposing of more
than a small portion of these assets in the near term, which will slow
the rate at which our balance sheet can shrink. We are monitoring the
maturity composition of our balance sheet closely and do not expect a
significant problem in reducing our balance sheet to the extent
necessary at the appropriate time.

Importantly, the management of the Federal Reserve's balance sheet and
the conduct of monetary policy in the future will be made easier by
the recent congressional action to give the Fed the authority to pay
interest on bank reserves. In principle, the interest rate the Fed
pays on bank reserves should set a floor on the overnight interest
rate, as banks should be unwilling to lend reserves at a rate lower
than they can receive from the Fed. In practice, the federal funds
rate has fallen somewhat below the interest rate on reserves in recent
months, reflecting the very high volume of excess reserves, the
inexperience of banks with the new regime, and other factors.
However, as excess reserves decline, financial conditions normalize,
and banks adapt to the new regime, we expect the interest rate paid on
reserves to become an effective instrument for controlling the federal
funds rate.

Moreover, other tools are available or can be developed to improve
control of the federal funds rate during the exit stage. For example,
the Treasury could resume its recent practice of issuing supplementary
financing bills and placing the funds with the Federal Reserve; the
issuance of these bills effectively drains reserves from the banking
system, improving monetary control. Longer-term assets can be
financed through repurchase agreements and other methods, which also
drain reserves from the system. In considering whether to create or
expand its programs, the Federal Reserve will carefully weigh the
implications for the exit strategy. And we will take all necessary
actions to ensure that the unwinding of our programs is accomplished
smoothly and in a timely way, consistent with meeting our obligation
to foster full employment and price stability.

Stabilizing the Financial System
The Federal Reserve will do its part to promote economic recovery, but
other policy measures will be needed as well. The incoming
Administration and the Congress are currently discussing a substantial
fiscal package that, if enacted, could provide a significant boost to
economic activity. In my view, however, fiscal actions are unlikely
to promote a lasting recovery unless they are accompanied by strong
measures to further stabilize and strengthen the financial system.
History demonstrates conclusively that a modern economy cannot grow if
its financial system is not operating effectively.

In the United States, a number of important steps have already been
taken to promote financial stability, including the Treasury's
injection of about $250 billion of capital into banking organizations,
a substantial expansion of guarantees for bank liabilities by the
Federal Deposit Insurance Corporation, and the Fed's various liquidity
programs. Those measures, together with analogous actions in many
other countries, likely prevented a global financial meltdown in the
fall that, had it occurred, would have left the global economy in far
worse condition than it is in today.

However, with the worsening of the economy's growth prospects,
continued credit losses and asset markdowns may maintain for a time
the pressure on the capital and balance sheet capacities of financial
institutions. Consequently, more capital injections and guarantees
may become necessary to ensure stability and the normalization of
credit markets. A continuing barrier to private investment in
financial institutions is the large quantity of troubled,
hard-to-value assets that remain on institutions' balance sheets. The
presence of these assets significantly increases uncertainty about the
underlying value of these institutions and may inhibit both new
private investment and new lending. Should the Treasury decide to
supplement injections of capital by removing troubled assets from
institutions' balance sheets, as was initially proposed for the U.S.
financial rescue plan, several approaches might be considered. Public
purchases of troubled assets are one possibility. Another is to
provide asset guarantees, under which the government would agree to
absorb, presumably in exchange for warrants or some other form of
compensation, part of the prospective losses on specified portfolios
of troubled assets held by banks. Yet another approach would be to
set up and capitalize so-called bad banks, which would purchase assets
from financial institutions in exchange for cash and equity in the bad
bank. These methods are similar from an economic perspective, though
they would have somewhat different operational and accounting
implications. In addition, efforts to reduce preventable
foreclosures, among other benefits, could strengthen the housing
market and reduce mortgage losses, thereby increasing financial
stability.

The public in many countries is understandably concerned by the
commitment of substantial government resources to aid the financial
industry when other industries receive little or no assistance. This
disparate treatment, unappealing as it is, appears unavoidable. Our
economic system is critically dependent on the free flow of credit,
and the consequences for the broader economy of financial instability
are thus powerful and quickly felt. Indeed, the destructive effects
of financial instability on jobs and growth are already evident
worldwide. Responsible policymakers must therefore do what they can
to communicate to their constituencies why financial stabilization is
essential for economic recovery and is therefore in the broader public
interest.

Even as we strive to stabilize financial markets and institutions
worldwide, however, we also owe the public near-term, concrete actions
to limit the probability and severity of future crises. We need
stronger supervisory and regulatory systems under which gaps and
unnecessary duplication in coverage are eliminated, lines of
supervisory authority and responsibility are clarified, and oversight
powers are adequate to curb excessive leverage and risk-taking. In
light of the multinational character of the largest financial firms
and the globalization of financial markets more generally, regulatory
oversight should be coordinated internationally to the greatest extent
possible. We must continue our ongoing work to strengthen the
financial infrastructure--for example, by encouraging the migration of
trading in credit default swaps and other derivatives to central
counterparties and exchanges. The supervisory authorities should
develop the capacity for increased surveillance of the financial
system as a whole, rather than focusing excessively on the condition
of individual firms in isolation; and we should revisit capital
regulations, accounting rules, and other aspects of the regulatory
regime to ensure that they do not induce excessive procyclicality in
the financial system and the economy. As we proceed with regulatory
reform, however, we must take care not to take actions that forfeit
the economic benefits of financial innovation and market discipline.

Particularly pressing is the need to address the problem of financial
institutions that are deemed "too big to fail." It is unacceptable
that large firms that the government is now compelled to support to
preserve financial stability were among the greatest risk-takers
during the boom period. The existence of too-big-to-fail firms also
violates the presumption of a level playing field among financial
institutions. In the future, financial firms of any type whose
failure would pose a systemic risk must accept especially close
regulatory scrutiny of their risk-taking. Also urgently needed in the
United States is a new set of procedures for resolving failing nonbank
institutions deemed systemically critical, analogous to the rules and
powers that currently exist for resolving banks under the so-called
systemic risk exception.

Conclusion
The world today faces both short-term and long-term challenges. In
the near term, the highest priority is to promote a global economic
recovery. The Federal Reserve retains powerful policy tools and will
use them aggressively to help achieve this objective. Fiscal policy
can stimulate economic activity, but a sustained recovery will also
require a comprehensive plan to stabilize the financial system and
restore normal flows of credit.