Monetary Policy: Contemporary Issues - I ECO 473 - Dr. Dennis Foster W.A. Franke College of Business

Monetary Policy: Contemporary Issues Heading into crisis II The bank failures III Fed inaction & action IV What has the Fed accomplished? V The problem with policy VI The Austrians & rethinking policy

What does the Fed Want? A healthy & strong economy with low unemployment and low inflation. I. Heading into crisis Policy? Stimulate spending by reducing interest rates. Why? They are Keynesians. Effect? Creates housing boom.

Federal Funds rate of interest, 1995 to 2004

Median home prices, 1999 to 2006

Home sales, 1999 to 2006 Sept. 2005

The Bear Stearns Story $133.20 - 52 week high prior to collapse. 2007 - Lost billions in collapsing subprime market; slowly recovering. March 2008 - Assets/equity = 35 Lots of assets in MBS. Spring 2008 - Clients pulling out funds. 3/10/08 - Turned down for $2 b. loan Continued loss of confidence in Bear all week. 3/13/08 – Cash  from $10 b. to $2 b. II. The bank failures $400 b. Assets

The Bear Stearns Story Tried to get LOC w/JPM for $25 b. 3/14/08 – Fed lends $13 b. for 3 days. JP Morgan deal - $2 per share! Fed creates Maiden Lane LLC Fed loans ML $30 b. JPM “sells” bad assets to ML. 3/24/08 - New stock deal - $10/share. Cost to the Fed? Was Bear TBTF? Yes! What about Lehman?

The Three Failures: IndyMac WaMu Lehman Spun off from Countrywide. Not a “mac” Overleveraged on “Alt A” loans. WaMu Shut down 100’s of offices 2007-08. Sub-prime victim. Final 10 days lost $17 b. in cash w/d Lehman Brothers Losses = $7 b. in Q2 & Q3 Final day: $1 b. in cash $32 b. Assets $300 b. Assets $640 b. Assets

Stock prices collapse for IndyMac WaMu Lehman Bros. 18 months

Stock prices collapse for IndyMac WaMu Lehman Bros. 12 months

Stock prices collapse for IndyMac WaMu Lehman Bros. 8 months

Did the Fed see this coming? "At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained." -March 2007 "It is not the responsibility of the Federal Reserve – nor would it be appropriate – to protect lenders and investors from the consequences of their financial decisions." -October 2007 "House prices have risen by nearly 25 percent over the past two years… [T]hese price increases largely reflect strong economic fundamentals." -October 2005 "We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize…” -July 2005 "The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so." -June 2008 "The Federal Reserve is not currently forecasting a recession." -January 2008 III. Fed inaction & action

What did the Fed do? Quantitative Easing. Raise the money supply Buy Treasuries. Buy MBS. Boost short term lending. Raise the money supply Lower interest rates. "One myth that’s out there is that what we’re doing is printing money. We’re not printing money." -December 2010

Monetary Policy: Contemporary Issues ECO 473 - Dr. Dennis Foster W.A. Franke College of Business