Federal Reserve Moves to Stabilize Market
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JEFFREY BROWN: The Federal Reserve’s moves today were just part of a worldwide effort to reassure markets concerned about the availability of credit. All together, central banks have pumped some $326 billion into the global financial system in the past 48 hours.
Two men who’ve faced the challenge of responding to troubled markets join us now. Laurence Meyer was a governor of the Federal Reserve from 1996 to 2002. He was appointed by President Clinton. He’s now vice chairman of the economic consulting firm Macroeconomic Advisers.
Glenn Hubbard chaired President Bush’s Council of Economic Advisers from 2001 to 2003. He’s now dean of the Columbia Business School.
Well, Glenn Hubbard, let me start with you. Why don’t you explain what the Fed, other central bankers are doing? What does it even mean to pump extra cash into the financial system?
GLENN HUBBARD, Chairman, President’s Council of Economic Advisers: Sure. The Federal Reserve joined the European Central Bank and other central banks in adding liquidity to financial markets to make sure that prices reflected underlying risks. The Federal Reserve’s action, I think, was very, very important in restoring market confidence, as was the Fed’s statement today. The European Central Bank led the way yesterday.
JEFFREY BROWN: What does it mean, Mr. Meyer, to put money in? Where does that money come from, and where does it go?
LAURENCE MEYER, Former Governor, Federal Reserve: Well, it creates deposits at the Federal Reserve by lending, by lending to these primary dealers, for example.
JEFFREY BROWN: Primary dealers meaning…
LAURENCE MEYER: Large banks and broker-dealers.
JEFFREY BROWN: So that, what, so they can lend to each other? What is the problem that they’re trying to fix?
LAURENCE MEYER: So they can lend to each other, and so that they can, more generally, so that the lending can take place between banks and other institutions who lend to each other in the money market. And what happened was that that got disrupted because of a very abrupt re-pricing of risk in the economy. They became less willing to lend to each other.
The federal funds rate, which is such an important base rate in the economy, the Fed has a target for it at 5.25 percent, but it was trading at 6 percent. So the Fed had to come in, be very aggressive, injecting reserves, so it pushed that effective federal funds rate back down to its target.
Accurate pricing of risk
JEFFREY BROWN: Â Mr. Hubbard, explain more about this idea risk and re-pricing of risk. I think it sounds simple, but it's at the heart of what we keep talking about in all of this. Explain it a little more for us.
GLENN HUBBARD: Well, exactly. I think many economists believe that risks had not been accurately priced in recent times, that risk premia -- that is, the spread you would get for bearing risk -- were very, very low by historical standards.
What we've seen is a pricing where the risky assets would now require much higher rates of return. We saw this in this market for so-called subprime mortgages, but it's really filtered throughout markets for risky debt into higher-grade mortgages and into the leveraged loan market.
JEFFREY BROWN: And staying with you, how does this happen? How do we get in a situation where the risk factor is out of balance? How do smart people in the financial world not make the equation right so that we tip over into a kind of bubble here?
GLENN HUBBARD: Well, it can happen in a number of ways. First of all, there's been enormous global liquidity in financial markets chasing returns, putting downward pressure on yields and on risk premia. Also, people can learn more about risk characteristics. There's been a change in views in the past few months about how risky subprime lending is and other forms of lending. So it really is about learning over time.
JEFFREY BROWN: How do you explain how this happens?
LAURENCE MEYER: Well, I think there are some fundamental forces that have been in play over the last 20 years. The economy is more stable; there are longer expansions, shorter contractions. So there are some fundamentals that support that credit risk spread should be narrowed.
But things go in cycles, and they get overdone. Long-term rates were very low; credit spreads were very low. People were searching for yield, looking for more exotic, going out to the fringes, and taking on more risk and becoming complacent about that risk.
I think, in some sense, it was inevitable at some point that credit spreads were going to widen. It just happened quickly, very abruptly. And sometimes when it happens so abruptly, people get worried about the riskiness of people who were there, who, you know, they're borrowing and lending, and they pull back very sort of aggressively from that.
Credit risk more widespread
JEFFREY BROWN: And so is the impact felt throughout the economy, or just with financial institutions at this time?
LAURENCE MEYER: Oh, no, so what's happened -- I mean, first, it started in the very narrow segment of the economy, subprime borrowers. If it just stayed there, relatively little problems. It spread quickly to the high-yield part of the market involved with leveraged buyout, which were very -- you know, firms took on a lot of debt to do this, and those became more risky.
But then it spread throughout, in terms of credit risk spreads are higher across the board now. Now, it hasn't got much impact on the overall financial conditions because treasury yields, so you got the risk spreads have opened up relative to the treasury, but then the treasury yields have fallen, so that borrowing rates for most investment-grade borrowers at this point haven't increased much, and equities, we should remember, up 6 percent for the year, OK?
So they're down, you know, 5 percent or so from their peak, but it was a record peak. So right now the situation from a macro spillover sort of standpoint is still relatively contained, but the Fed had to deal with this sort of very dramatic liquidity squeeze that was going on this week.
JEFFREY BROWN: So, Mr. Hubbard, you were saying at the top here that you thought that the Fed and other central bank moves were good ones. Do you see an immediate response? I mean, do we see it, for example, in the Dow Jones even today not being off that much?
GLENN HUBBARD: Well, I think the Fed's job really isn't to target the day-to-day stock market prices, but the Fed acted, as did other central banks, to make sure that there weren't developments that could lead to a financial crisis. And I think that did lead to positive market responses.
I think the Fed's statement today that it would provide liquidity to the financial system was a very important one. And I believe that central banks around the world did contribute to this financial stability.
We're likely to see continuing volatility in markets as risks get re-priced; that is a fundamental in the economy. But I don't see it spreading to larger economic dislocations, in part because I think of the central bank's actions.
JEFFREY BROWN: How much, Mr. Hubbard, do you see it already impacting economic -- the business community or the economy in the U.S. and worldwide at this point?
GLENN HUBBARD: Well, that's really a forward-looking question. As Larry said, the yields on safe assets, on treasury assets, have actually declined, so that net borrowing costs haven't risen much for investment-grade borrowers.
Where we're seeing borrowing costs rise and rise significantly are in risky business borrowers and for many consumers. And so the question will be, over the next six months, how will retail sales fare for consumers? And how will investment spending fare? Those are the wild cards.
Impact on other countries
JEFFREY BROWN: The international component here, Mr. Meyer, we always hear all the time now about how 're all connected. Is there a leader here, or is it a big circle? In other words, does this start in the U.S. and spread internationally, or does it start elsewhere and come back to us?
LAURENCE MEYER: Well, I think it's very interesting. Look at some of the problems in Europe. It's because of pressures for people who are holding these subprime credits that have deteriorated so much.
JEFFREY BROWN: In America.
LAURENCE MEYER: Those are subprime -- you know, those are loans to U.S. subprime borrowers, but we have this wonderful ability to diversify where we securitize these things, we sell them, and a lot of that risk ends up elsewhere, and a lot of it turned out to be in Europe. And so, in that sense, it was a problem that sort of developed in the U.S. that spread through, you know, to Europe through the securitization.
JEFFREY BROWN: And then could it impact other countries even more than it would impact here?
LAURENCE MEYER: Yes, but, I mean, one thing that we should understand that's important here is that the rest of the world has been growing very strongly. So this is a lot of financial turbulence that's going on that spread, but the fundamentals in the rest of the world are very sound. Growth has been very strong, and that's really, I think, very helpful in providing support to the U.S., actually.
And the Fed in its last statement pointed to one of the underlying supports for growth in the U.S. is the strength of the global economy, so I don't think that's about to change. There's a lot of turbulence. I don't think that the underlying macro fundamentals have deteriorated significantly for the rest of the world.
JEFFREY BROWN: Mr. Hubbard, what would you add to the international component here, and how it plays out?
GLENN HUBBARD: I think it's very important to see everything is interconnected. This really isn't just a U.S. problem spreading outside the U.S. The contributions to global liquidity and investments in U.S. markets had largely come from overseas markets. They're all connected.
But the other point I think that's very important is how much risks are spread. The difference between today and looking back, say, 20 years ago is that risks are spread and diversified in very large ways around the world. So even a lot of turbulence, a lot of shocks, tend to generate volatility, perhaps, but not concentrated losses. So we'd be very unlikely to see very large economic dislocations from this.
The Fed on alert
JEFFREY BROWN: Mr. Meyer, you were at the Fed. How does this work? They acted yesterday; they act today. Do they watch carefully every day...
LAURENCE MEYER: Oh, absolutely.
JEFFREY BROWN: ... and they will be pumping in more if necessary?
LAURENCE MEYER: Absolutely. They're on alert. They got the job done today, OK? At the end of the day, they said they were going to be aggressive enough to get that funds rate trading near the target. They got the job done. But it's not like it's over, OK? We're in a very fluid situation. It's a day-to-day thing. They're monitoring closely. They're willing to be aggressive and get that job done.
JEFFREY BROWN: And, Mr. Hubbard, from the perspective of someone who was there as an economic policymaker, is it the same sort of on guard, watching day-by-day?
GLENN HUBBARD: Definitely monitoring what's happening, seeing consumer spending in investment, international capital markets. This will be something that will be keeping policymakers up around the clock.
JEFFREY BROWN: All right, Glenn Hubbard and Laurence Meyer, thank you both very much.
GLENN HUBBARD: Pleasure.
LAURENCE MEYER: Pleasure.