How Quantitative Easing Came to Be

Bernanke took charge as the Fed awoke in 2008 to the need for a full-on war against "global economic and financial freefall."

In December 2008, Ben S. Bernanke, the self-effacing chairman of the Federal Reserve, declared war against a cascading recession and took charge as general.

Breaking with protocol as the Federal Open Market Committee (FOMC) convened on the afternoon of Dec. 15, Bernanke asked his colleagues’ “indulgence” to speak first. Faced with cutting the benchmark interest rate to zero to fight a worsening crisis policy makers were late to recognize, Bernanke said the FOMC was about to embark on new approaches that contained “deep and difficult issues.”

“We are at a historic juncture, both for the U.S. economy and for the Federal Reserve,” said Bernanke, who left the Fed this year when his term expired Jan. 31. “The financial and economic crisis is severe despite extraordinary efforts not only by the Federal Reserve but also by other policymakers here and around the world.”

Last Friday, the Fed published meeting transcripts that reveal new details about the closed-door deliberations among policymakers as the financial crisis unfolded during 2008. In March, Bernanke invoked Depression-era powers to rescue Bear Stearns Cos. In September, Lehman Brothers Holdings Inc. collapsed in the biggest bankruptcy in U.S. history.

The transcripts show that policymakers had missed many warning signs earlier in the year. By December, as they gathered in the Fed’s board room beneath a bowl-shaped chandelier dangling two stories above, they understood they were in an economic emergency that required innovative, aggressive action.022414_Bloomberg_PQ2

Seated around a 27-foot oval table of Honduran mahogany, policymakers laid out many of the actions they would eventually take to combat the worst recession since the Great Depression. The steps ranged from buying bonds in so-called quantitative easing to providing assurances that monetary policy would stay easy for a long time.

“Between the failure of Lehman Brothers and the December meeting we went from considering whether to move the federal funds rate 25 basis points to asking: ‘Is a trillion dollars of bond purchases enough?’ ” said Michael Gapen, a senior U.S. economist at Barclays in New York, who attended the meeting as a Fed staff member at the time.

“It was an incredible meeting to be at,” he added. “The committee knew it had to make choices.”

The policymakers were shocked into action after Lehman’s bankruptcy triggered a breakdown in financial markets and the economy that they had failed to foresee. Meeting Sept. 16, 2008, a day after Lehman declared it was filing for bankruptcy, Fed officials remained unsure whether the crisis would do lasting damage to the nation’s economy.

“I don’t think we’ve seen a significant change in the basic outlook,” Dave Stockton, the Fed’s top forecaster at the time, said at that meeting. “We’re still expecting a very gradual pickup in GDP growth over the next year.”

Later, the Commerce Department determined that U.S. gross domestic product had collapsed at an 8.3 percent annual rate in the fourth quarter, the sharpest drop since 1958.

At the September meeting, officials discussed the collapse of Lehman, yet left their main interest rate at 2 percent, rebuffing calls by some investors for an immediate cut.

“I think our aggressive approach earlier in the year is looking pretty good,” Bernanke said, referring to a cumulative 225 basis-point (2.25 percentage-point) reduction in the benchmark federal funds rate during the first four months of the year. Even so, he said it was likely that the country was already in a recession, and “I think we are in for a period of quite slow growth.”

 

On the Brink

Earlier in the year, officials had taken quick action as the economic outlook deteriorated, cutting the federal funds rate from 4.25 percent at the beginning of 2008, when San Francisco Fed President Janet Yellen, who is now Fed chair, had warned that the nation was on the “brink of recession.”

In a harbinger of his approach at the end of the year, Bernanke took the lead in pressing for rate cuts as 2008 began. Overriding the preference of his colleagues to confine policy changes to regularly-scheduled meetings, Bernanke pushed through a 0.75 percentage-point rate cut in an emergency gathering convened by conference call at 6 p.m. on Jan. 21, a holiday marking Martin Luther King’s birthday.

“I was reluctant to call this meeting, both because of the holiday and because the Committee did express a preference on January 9 for not moving between regularly scheduled meetings,” he said. “However, I think there are times when events are just moving too fast for us to wait.”

In arguing for a reduction in the funds rate to 3.5 percent, Bernanke invoked work by academic economists Carmen Reinhart and Kenneth Rogoff that suggested the U.S. faced the risk of a severe financial crisis and a deep recession. In subsequent meetings, he pushed for further rate reductions. By April, the rate was down to 2 percent and Bernanke was ready to take a break.

“I think we ought to at least modestly congratulate ourselves that we have made some progress,” Bernanke told his colleagues on April 30. “Our policy actions, including both rate cuts and the liquidity measures, have seemed to have had some benefit.”

The FOMC held the funds rate at 2 percent until October, when it joined the European Central Bank and other major monetary authorities in simultaneous easing of monetary policy.

 

Extreme Stress

“It’s more than obvious that we have an extraordinary situation,” Bernanke told his colleagues on another emergency conference call held Oct. 7. “Virtually all the markets—particularly the credit markets—are not functioning or are in extreme stress.”

At that month’s regular meeting, held Oct. 28-29, Yellen warned the committee that it was time for aggressive action.

“We need to do much more and the sooner, the better,” Yellen told the committee.

In normal times, the committee might wait and see if recent actions were having an effect, she said, “but these are about as far from normal times as we can get.”

“We are in the midst of a global economic and financial freefall, and the confidence of households, businesses, and investors is in shambles,” she said.

In December, Stephen Meyer, who is now a deputy director at the Division of Monetary Affairs, laid out a series of policy strategies and unconventional options that today read like the playbook for the FOMC for the next several years.

The presentation, based on 21 different briefings sent to policymakers before the meeting, involved hours of staff work, said Joe Gagnon, who prepared a note about quantitative easing and canceled a November vacation to make sure the job was done.

Meyer warned the committee that staff and private forecasters were calling for a “sizeable drop” in GDP in the months ahead. With the policy rate at 1 percent in October, the implication was that the committee would probably end up cutting the rate all the way to zero.

Once the Fed had reached that point and still needed some means to provide further stimulus, Meyer spelled out how one form of quantitative easing would work by expanding bank reserves, while another would target longer-term securities to lower borrowing costs. Meyer also said the committee should consider communications policies, such as forward guidance on how long the federal funds rate would stay near zero, and an inflation target.

As the committee’s discussion of its monetary options drew to a close, Bernanke once again asserted his leadership, pushing his fellow policymakers into accepting an interest-rate target of zero to 0.25 percent.

When Richard Fisher, president of the Dallas Fed, said he had counted 11 policy makers in favor of junking the target entirely, Bernanke replied that “it’s my judgment” such a move would cause “a lot of concern and confusion.” He then called for a vote for his proposal. All agreed except Fisher, who dissented, only to reverse himself later and fall in line with his leader.

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