(Bloomberg Markets) -- How the Federal Reserve handled past crises offer clues for how it will get out of the present one. Read Tom Orlik and David Wilcox's analysis in the accompanying The Big Take. Watch the full collection of interviews here.
From the Federal Reserve’s creation in 1913 to its response to the Covid pandemic in 2020, lessons from crises have shaped the evolution of the world’s most important central bank.
I. The Founding of the Fed
The Panic of 1907 started in October when speculators who’d tried to corner the market for stock in a copper mining company began suffering huge losses. Within days, news emerged of links between the speculators and the Knickerbocker Trust, one of the loosely regulated financial companies that channeled funds from household savers to stock investors. That prompted a run of depositors rushing to withdraw funds from the trust.
Out of cash and out of options, Knickerbocker suspended operations, triggering a full-blown financial crisis as depositors of other trusts desperately tried to withdraw their money. One measure of the market stress: The interest rate that stock investors were charged for overnight loans jumped to 100%, from 9.5%. James Pierpont Morgan—head of the bank that still bears his name—stepped in to end the panic.
That episode was the catalyst for the founding of the Federal Reserve. The US needed a stable financial system, backed by a central bank with funds available to prevent crises. “People began to realize that to have what was about to become the leading industrialized country in the world with a primitive financial system, without a central bank, no longer played,” says Roger Lowenstein, author of America’s Bank: The Epic Struggle to Create the Federal Reserve.
Six years later, in 1913, the Fed was founded to serve as the backstop to America’s financial markets and economy. When crisis struck in 2008 and again in 2020, it was the awesome resources of the central bank, not the limited funds of a private company, that stood between the US and financial chaos.
II. The Great Depression
Starting in mid-1928, stock prices went on a tear, and the Fed unwittingly helped pump up the bubble. To protect the value of the British pound under the gold standard, Bank of England Governor Montagu Norman persuaded the Fed to keep US interest rates low. That helped stabilize Britain’s currency, but it also turbocharged US lending and the prices of financial assets. From the middle of 1928 to its peak in September 1929, the Dow Jones Industrial Average soared 90%.
Officials were unable to agree on a plan of action. The Federal Reserve Bank of New York favored raising rates to increase the cost of credit, but Fed board members in Washington argued for more targeted action: asking banks to curb lending. The bubble finally popped. The Dow declined 13% on Black Monday alone and by November had fallen about 50% from its peak.
The real damage occurred over the next few years. Banks failed in droves, taking household savings and business loans with them. The Fed abdicated its responsibility to prevent financial panics. New York Fed President George Harrison wouldn’t even make a “reassuring statement” to support bank stability, for fear the next lender collapse would undermine his credibility.
The failure was so complete that it provoked a total rethink. The Banking Act of 1935 took aim at the Fed’s broken governance, centralizing control in Washington. The gold standard—that “ barbarous relic” which prevented the exchange-rate and monetary policy adjustments necessary for economies to recover—began to lose its hold. And the laissez-faire prescriptions of classical economics gave way to the active demand management of Keynesianism.
“The central dilemma the Fed had was that it had two incompatible goals, an exchange-rate goal and a domestic financial stability goal, and they never understood that these were in terrible conflict,” says Liaquat Ahamed, the author of Lords of Finance, a history of the period. Today, Ahamed says, the Fed’s dilemma is between the rates needed to spur economic growth and those required to prevent speculative bubbles in financial markets.
III. The Treasury-Fed Accord
After the US entered World War II, the Fed joined the war effort. On April 29, 1942, it committed to capping interest rates so the Treasury could borrow more cheaply. But enforcing the caps meant the Fed had to give up controlling the money supply—and therefore inflation and employment as well.
After the war, President Harry Truman sought to maintain the caps to ensure that investors in war bonds wouldn’t lose money, as had happened to many bondholders after World War I. But inflation surged at the start of the Korean War, and the Fed wanted to be able to raise rates.
In December 1950, Truman wrote to Fed Chair Thomas McCabe, saying: “I hope the Board will realize its responsibilities and not allow the bottom to drop from under our securities. If that happens that is exactly what Mr. Stalin wants.” After weeks of tough negotiations, agreement was reached. On March 4, 1951, the Treasury and the Fed issued a joint statement granting the Fed operational independence to set interest rates without concern for the government’s cost in financing the debt.
Fighting inflation requires an independent Fed, free of political interference. Maintaining that independence in the face of a president and Congress that often have other priorities is an ongoing challenge. In August 2019, President Donald Trump made Truman’s Stalin comments look tame when, in a tweet to his millions of followers, he asked whether Fed Chair Jerome Powell or Chinese President Xi Jinping was the “bigger enemy” of the US.
Choosing the right person to lead the Fed—to make the right calls on policy and insulate the central bank from political influence—isn’t easy. McCabe had no advanced training or experience in economics, yet he facilitated a crucial step in the establishment of a modern version of Fed independence.
IV. The Volcker Shock
In 1979, inflation was raging out of control, and the public was deeply angry. President Jimmy Carter reshuffled his cabinet, moving Fed Chair G. William Miller to lead the Treasury. He then nominated Paul Volcker to take Miller’s place as chair of the Federal Reserve.
Two months later, on Sept. 30, Volcker attended the International Monetary Fund’s annual meeting in Belgrade. He watched former Fed Chair Arthur Burns’s lecture explaining that central banks were impotent to control inflation because society simply wouldn’t tolerate the recession that would be necessary.
Volcker left the conference early and returned to Washington to put the finishing touches on a new approach. One week later he convened a rare off-schedule Saturday meeting of the Federal Open Market Committee (FOMC). The program they adopted was the central banking version of shock and awe, designed to break the inflationary psychology that had gripped the country.
Read more: The Fed’s Past Crises Hold Secrets to Tackling Future Recessions
The victory would be neither quick nor cheap. It would provoke protests and the highest unemployment rates since the Great Depression. But it would also lay the foundation for the Great Moderation, an unusually tranquil period in the macroeconomy characterized by solid income growth, shallow recessions, and strong stock price gains.
Burns “did not internalize correctly how much damage one would do in the long term to the economy by losing track of price stability and letting inflation get out of control,” says Athanasios Orphanides, a professor at the Massachusetts Institute of Technology and one of the co-authors of the definitive history of monetary policy during the period.
Volcker understood that central banks have the ultimate responsibility for controlling inflation, and he was prepared to take the aggressive action required to do it. Today, Powell would never argue that the Fed doesn’t have responsibility for controlling inflation, no matter its cause and no matter how costly it might be to bring back down.
V. The 1987 Stock Market Plunge
On Monday, Oct. 19, barely two months after Alan Greenspan took office as Fed chair, the Dow Jones Industrial Average plunged 23%—almost twice the size of the drop in 1929 that heralded the start of the Great Depression.
The following day, at 8:41 a.m. in Washington—before the stock market opened at 9:30 a.m.—a one-sentence statement was issued in Greenspan’s name: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.”
The Fed backed up that statement with action, making open-market purchases to ensure there would be adequate liquidity in the banking system and lending reserves to banks through the discount window. New York Fed President E. Gerald Corrigan, worried that the financial system might seize up, got on the phone with key institutions to persuade them to keep payments flowing. Over the course of the next few months, the federal funds rate was cut by a cumulative 0.75 percentage point.
The Fed’s efforts prevented a financial meltdown. Taken together, they were so successful that barely a ripple is detectable in the macro data from late 1987 and early 1988. But the episode has a problematic legacy. By encouraging market participants to trust that the Fed would cushion the fallout from any downturn, the central bank has stoked moral hazard—a greater tendency by financial institutions to engage in risky behavior on the theory that if things go badly, the Fed will step in.
“I do think there are moral hazard issues,” says Donald Kohn, one of the Fed officials who advised Greenspan in 1987. “But when the system is in the process of freezing up, the damage to the economy could be so vast that it’s up to the central bank … to supply the liquidity necessary to make those markets work.”
VI. Sept. 11
Following his customary routine, Fed Vice Chair Roger Ferguson Jr. arrived early at his Washington office and perused the morning papers. He was the only member of the Fed’s Board of Governors on the premises that day.
Shortly after 9 a.m., he received a phone call from his wife: “Turn on your TV.” A plane had flown into one of the towers at New York’s World Trade Center. Soon a second plane would slam into the other tower. A third hit the Pentagon at 9:37 a.m.; the resulting column of smoke was visible from Fed headquarters. And a fourth, possibly meant for the US Capitol, instead crashed near Shanksville, Pa.
By far the greatest cost that day was the loss of almost 3,000 lives. A blow had also been dealt to the infrastructure supporting US financial markets. More broadly, there was a crisis of confidence: Could the nation withstand such a brazen attack?
Among Ferguson’s first actions was to reassure the public that the Fed’s infrastructure was up and running and would be used to meet liquidity needs. Messages broadcast over the Fedwire clearing system and to the general public provided assurance the central bank was operational and the discount window available to fill any shortfall in funding.
Other actions previewed methods that would be used to combat the 2008 financial crisis. Over the course of two meetings, the federal funds rate was cut by 100 basis points. The Fed also used its balance sheet to support the financial system and guarantee the value of checks that were still in the process of being cleared. Borrowing from the discount window increased from an average of $59 million before the attacks to $45 billion on the day after.
“It was indeed a fateful day,” Ferguson says, “and in some ways I think it ushered in the modern era of Federal Reserve crisis management.”
VII. The Global Financial Crisis and Great Recession
By early 2008, serious cracks had emerged in the US financial system. After a meteoric rise, house prices began to fall. Mortgage defaults increased. In March, securities firm Bear Stearns narrowly avoided collapse when it agreed to be taken over by JPMorgan Chase & Co.—a descendant of the bank that had ended the Panic of 1907.
Later in the year the US and global financial systems nearly cratered. Mortgage insurers Fannie Mae and Freddie Mac were taken over by the Treasury. Lehman Brothers—a larger rival of Bear Stearns—ran aground, as did insurance giant American International Group Inc., or AIG. The Fed found a basis for saving AIG from bankruptcy, but only after concluding that Lehman Brothers was beyond its reach—a failure that sent a cascading alarm through global financial markets. The Fed allowed Goldman Sachs Group Inc. and Morgan Stanley, the two largest US securities firms, to convert rapidly into banks under the central bank’s aegis.
The Fed responded to the crisis with a four-pronged strategy. First, it flooded the banking sector with liquidity. Second, it invoked emergency powers granted to it during the Great Depression to lend to financial institutions other than banks. Third, it quickly cut the funds rate to zero. And fourth, it introduced new tools in its monetary policy repertoire, including forward guidance and asset purchases.
Together these actions stemmed the panic and stabilized markets. But the recovery proved painfully slow, in part because of a premature tightening of fiscal policy. Ben Bernanke, Fed chair during the crisis and author of the new book 21st Century Monetary Policy: The Federal Reserve From the Great Inflation to COVID-19, recommends that the US government enact changes to automatically calibrate fiscal policy to the needs of the economy instead of political whims. “It would be good if Congress would consider putting in some more automatic stabilizers,” he says. Former Fed Chair Ben Bernanke on the central bank’s response to the 2008 crisis.
The Fed’s rescue of financial companies prevented a repeat of the Great Depression. But, as the cries of “Where’s my bailout?” from struggling homeowners showed, it also left unanswered questions. Chief among them: When a crisis hits, who gets bailed out, who doesn’t, and who decides? To an uncomfortable degree, these questions remain unresolved.
VIII. The Covid-19 Pandemic
At his Jan. 29, 2020, press conference, Fed Chair Jerome Powell noted “uncertainties” in the outlook, “including those posed by the new coronavirus.”
It was a head-snapping remark because at that time no deaths from Covid-19 had been recorded in the US. But the situation deteriorated sharply. By March 15, the FOMC had cut the federal funds rate to zero and stated that it expected to hold the rate there until the economy was “on track to achieve its maximum employment and price stability goals.”
The drama was just beginning. Many of the market dysfunctions that had seized the financial system in 2008 again threatened to take hold. In response, the Fed opened the monetary spigots, recycling many pages from its 2008 playbook: It lent trillions of dollars, taking Treasury securities as collateral. It bought Treasuries and mortgage-backed securities in amounts that dwarfed the purchases undertaken during the financial crisis. It met foreign demand for dollars by reactivating swap lines with other central banks.
With backing provided by Congress, the Fed also opened programs to lend to corporations, medium-size businesses, and state and local governments. Combined with powerful fiscal support, the Fed’s actions kept the economic and financial system from collapsing.
The surge in spending helped drive a jump in inflation—a problem that the Fed initially dismissed, wrongly, as “transitory.” The pandemic, stimulus, and war all combined to push prices higher. “There was not one shock, there was a series of shocks,” says Laurence Boone, who was chief economist for the Organization for Cooperation and Development before becoming France’s secretary of state for European affairs earlier this year.
In the fall of 2021 the Fed began pivoting to a more hawkish stance. By July 2022 the FOMC had raised the funds rate to a target range of 2.25% to 2.5%—and told the markets to expect much more to come. And yet inflation is still above 6%, more than triple the Fed’s 2% target. That has raised hard questions about what policymakers could have done better and how they can regain their standing as stewards of stability in the months and years ahead.
Orlik and Wilcox are economists for Bloomberg Economics in Washington.
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