Foreword: A Policymaker's Reflections
"The most important element of this whole era has been encountering the zero lower bound and then trying to decide what to do, if anything, given that you can no longer lower interest rates in response to poor economic circumstances. … That has been the challenge of our times."
—James Bullard, President and CEO
State of Affairs in 2008
Hitting the Zero Lower Bound
In the spring of 2008, James Bullard was finishing the interview process to become the 12th president of the Federal Reserve Bank of St. Louis upon the retirement of William Poole.
At that time, Bullard was the Bank's deputy director of research for monetary analysis. He had been with the Bank, known for its monetarist academic research and maverick reputation within the Federal Reserve System, since 1990.
"I think one thing to keep in mind is that the financial crisis had already started and was already ongoing at that time, and I think some of the revisionist history forgets this," he recalled. "But for the Fed, it really started in August 2007, because that's when the Libor-OIS spread blew out, which was a signal that banks didn't trust each other anymore."
The Libor-OIS spread began rising substantially in August 2007, which signaled the beginning of the financial crisis.
SOURCES: Reuters, British Bankers' Association and Bullard's calculations.
In response to the financial crisis, the Fed established the Term Auction Facility (TAF) program in December 2007 to provide short-term liquidity to depository institutions. In addition, the FOMC lowered the policy rate several times over the first few months of the crisis.
But then came the implosion and rescue of the Bear Stearns investment firm in March 2008, only two weeks before Bullard officially took over the reins from Poole on April 1.
The Intensifying Financial Crisis
The Fed's exigent step of providing term financing to facilitate JPMorgan Chase’s acquisition of Bear Stearns marked the symbolic start of the worst financial crisis to occur in the U.S. since the Great Depression. It also marked the beginning of the FOMC's unprecedented and uncharted monetary policymaking that was deployed to keep the U.S. financial system and economy intact.
"The timing of my coming into this role was just shortly after Bear Stearns," Bullard said. "And what it really meant was that most of what I knew about ordinary central banking was going out the window just as I moved on to the FOMC."
It also set the stage for a different kind of welcome call from Fed Chairman Ben Bernanke on the day that Bullard officially became president.
"When you're named president, it's all very secret," Bullard recalled. "On the day you take office, the chair calls you at 10:30 in the morning. I knew Ben Bernanke from my research days and had talked with him many times. I thought it would be kind of a pep talk. But, no, it was all the details of the Bear Stearns deal and the mezzanine tranches, and how the Fed was going to get paid back, and all this kind of thing.
"It showed the intensity of the crisis even at that moment," he added. "That was the context of my taking the job."
The Notorious Summer of 2008
The intensity only ratcheted up from there, as the summer of 2008 turned into fall, and more signs of systemic threats to global financial stability appeared.
A retrospective speech given about five years after the crisis reflects Bullard's thinking during that time: "The gist was, as of August 2008, it was still possible to argue that we would muddle through. And I felt all during this period that we would muddle through, as a staff person, and even after I was named president, and I told people I thought we would muddle through."1 He added, "It sounds crazy looking at it today because it turned out to be such a disaster, but there actually is a pretty good argument to be made that during the summer of 2008, you could still view the world that way."
He noted that the financial crisis had been ongoing for a year at that point, and real gross domestic product (GDP) data at the time suggested that the U.S. was not in recession. He also noted that virtually all economic forecasts of the day, including those of Fed staff, pointed to continued modest economic growth for the rest of 2008—not to a full-blown crisis that would cripple economic growth, lead to interest rates at the zero lower bound and cause what is now known as the Great Recession. The tremors that had arisen in the booming housing market were expected to dissipate, as the depths of the losses to come from the subprime mortgage market crisis had not yet bubbled to the surface. Furthermore, the positive effects from lower interest rates were expected to take hold during the fall of 2008.
"A popular argument at the time was that, 'We've already done a lot, and now that'll get us through the rest of the way, and we'll avoid recession,'" he said.
By that time, however, another concern was brewing: The price of oil had doubled since the summer of 2007. Higher oil prices contributed to a decline in vehicle sales and a drop in business confidence, among other economic effects.
"So, you had this oil price shock. The economy usually doesn't react well to that kind of a shock, so maybe it's not surprising that the economy actually turned out to be deteriorating in the second half of 2008," he noted. "The slower economic growth made the crisis much worse than it otherwise would have been."
The real (inflation-adjusted) price of oil nearly doubled between the summers of 2007 and 2008. This oil price shock contributed to slower U.S. economic growth in the second half of 2008.
SOURCES: U.S. Energy Information Administration, The Wall Street Journal, Bureau of Labor Statistics and Bullard's calculations.
The Collapse of Lehman and AIG
In business since 1850, Lehman Brothers was a major global financial services firm and the fourth-largest investment bank in the U.S. It was one of the first Wall Street firms to expand into the mortgage origination business. However, by 2008, it had suffered tremendous losses from holding large positions in subprime and other lower-rated mortgage tranches. It went bankrupt on Sept. 15, 2008.
AIG, or the American International Group, was a global insurance giant and a major seller of credit debt swaps. It had close to $1 trillion in assets before it crashed and almost failed a few days after Lehman. On Sept. 16, 2008, the Fed, with the support of the U.S. Treasury, authorized the New York Fed to lend up to $85 billion to AIG through a revolving credit facility.
The collapse of Lehman Brothers and the bailout of AIG continued to send U.S. and international financial markets into a tailspin, which was then compounded by wave after wave of other economic shocks—the U.S. housing market crash and ongoing foreclosure crisis; the placement of Fannie Mae and Freddie Mac into government conservatorship; and the failures of IndyMac and Washington Mutual, the first of many large- and small-bank failures to come.
The Zero Lower Bound
A perfect storm had been set for an extraordinary time of unconventional monetary policymaking to prevent a worldwide economic crash, and Bullard's background at the St. Louis Fed would help him not only to define and deliberate, but also to challenge or champion, the novel moves the FOMC would make during the next 10 years. He would also call for a new way of thinking as interest rates hit the zero lower bound and as inflation remained below target despite the recovery of the economy after the crisis.
"The most important element of this whole era has been encountering the zero lower bound and then trying to decide what to do, if anything, given that you can no longer lower interest rates in response to poor economic circumstances," he said. "It was previously considered a very remote or unlikely scenario, and so that has been the challenge of our times."