Federal Reserve policy in the great recession.

• Author: Meltzer, Allan H.
• Position: Essay

Overresponse to short-run events and neglect of longer-term consequences of its actions is one of the main errors that the Federal Reserve makes repeatedly. The current recession offers many examples of actions that some characterize as bold and innovative. I regard many of these actions as inappropriate for an 'allegedly independent central bank because they involve credit 'allocation, fill the Fed's portfolio with an unprecedented volume of long-term assets, evade or neglect the dual mandate, distort the credit markets, and initiate other actions that are not the responsibility of a central bank.

The Fed's Misguided Credit Policy and Bailouts

Purchasing more than $1 trillion of long-term mortgages is credit allocation. How can the mortgage-related securities be sold later when inflation rises while the housing market remains troubled? The Fed has no plan. Selling Treasury securities to finance mortgage or other purchases is a fiscal operation. The monetary base doesn't change, and the purchase reduces the interest payment made to the Treasury. Selling two-year Treasuries to finance purchases of longer-term bonds also doesn't change reserves or money. It is debt management and should be left to the Treasury.

Bailing out Bear Steams and accepting $30 billion of low-quality assets in March 2008 is high on the list of mistaken actions in this recession. That reminded financial markets that too-big-to-fail (TBTF) not only remained part of operating policy but that the policy now included nonbanks and medium-sized financial firms. The bailout policy kept in place and even extended support for banks and others that earned high returns on risky assets but shifted many of the losses to taxpayers.

Without warning, the Fed and the Treasury changed TBTF policy in October, allowing Lehman Brothers to fail. That policy did not continue. Days later, the Fed bailed out American International Group by investing $180 billion in the failing company. These shifts in policy greatly increased uncertainty about what would happen next. Financial firms and others responded by greatly increasing the demand for cash. The Fed responded appropriately by acting as lender of last resort to financial markets at home and abroad by increasing the supply of cash assets.

What occurred next is a model of what a well-run central bank should not do. The Fed explained that the increase in cash assets was almost entirely short-term assets. These would decline over time and would be withdrawn. That didn't happen. The Fed replaced the short-term assets with longer-term assets and undertook credit allocation to stimulate the housing market by buying mortgage-related securities. It explained that these holdings would decline over time as borrowers paid interest and some principal. Again, that didn't happen. The Fed purchased long-dated Treasury securities to prevent its balance sheet from shrinking.

Near-Term Focus and Neglect of Longer-Term Consequences

The excessive concern about the near-term makes the Fed give too much attention to the daily yammering that is called financial market commentary. Much of the commentary is self-serving. In the summer of 2010, the commentators warned repeatedly that deflation and a recession were likely. The Fed responded with a new round of quantitative easing by adopting QE2, a bond purchase program. Market speculators bought long-term bonds ahead of the program and profited. If the Fed had waited a few more months it would have found that forecasts of deflation and renewed recession were wrong.

Did the Fed's response prevent the predicted outcomes? Unlikely, because after the Fed announced purchases of $600 billion of long-term Treasury debt their massive excess reserves rose $500 billion. The dollar fell against most currencies. Several countries purchased dollars to slow exchange rate appreciation, absorbing most of the remaining $100 billion...