Fed's Fixes Fund Future Failures?

The recent flurry of activity by the Federal Reserve is bold, daring, and unprecedented – but is it good?  After years of gradually increasing the federal funds rate, the Fed has responded to recent recessionary economic indicators by slashing the federal funds rate, lowering the discount rate, and financially backing the purchase of one private financial institution by another.  These actions have stymied markets and kept the “recession” from getting much worse, but we have to ask what effect these expansionary monetary policies will have on future inflation.  Sure, it may help us out now, but what happens when ailing banks expect the fed to bail them out in the future?  What happens if people’s long-term inflation expectations are raised by the Fed’s lending rampage?

First, a little background.  The federal funds rate is the rate at which the Fed lets banks lend money to each other.  The discount rate is the rate at which the Fed lends banks money.  The discount rate is usually higher than the federal funds rate, and is used in times of emergency.  The Federal Reserve is in charge of keeping America’s financial system running smoothly, and its biggest goal is avoiding a bank run, where everyone begins to doubt the banks’ ability to pay them back and runs to collect their money from the bank, which in turn causes the bank to lose its liquidity and become unable to pay its customers.  This also causes the bank to try to collect outstanding loans from individuals and other banks, worsening the situation and lowering the money supply.  After the 2001 downturn, the Fed lowered the discount rate, which allowed banks to borrow money directly from the Fed rather than from other banks, who had liquidity problems of their own.  To oversimplify things, when banks are in danger of defaulting, the Fed uses several tools (including the federal funds and discount rate) to make sure there’s enough money for everyone.

It seems that we have a great system – whenever banks get into trouble, the Fed bails them out and sets the economy back on track!  Of course, the real picture is not so simple.  One drawback to increased expansionary policy is long-term inflation expectations.  Ever since the 1980’s, the Federal Reserve has acted in a consistent way, gradually tightening the money supply in good times and loosening it in bad times.  If the Fed followed an expansionary monetary policy enough, people would begin to expect consistently higher prices in the future as a result of all the new money flooding the system, and they would change their individual actions based on the assumption that future inflation would be significantly higher than today’s rates.  From this point of view, the recent Fed actions could possibly increase long-term inflation expectations because people assume the Fed will stop at nothing to increase liquidity for troubled banks in the future.  Then again, if this is a one-time response to a serious recession, then the future will prove Bernanke right.

My main problem with this specific crisis (and the Fed’s reaction) is the increase of moral hazard that accompanies any future financial meltdown.  Let’s take, for example, the recent fiasco with Bear Stearns.  Bear Stearns ultimately failed because some very smart people at the firm made some very stupid decisions.  The bought the riskiest bundles of mortgages from the banks in the hopes of making more and more money (which worked fine as long as housing prices kept booming and people could re-finance mortgages), only to have to write of billions and billions of dollars when it all came crashing down.  If it had been in another business in another time, Bear Stearns would have become bankrupt, and the people who caused its downfall would have learned their lesson.  However, Bear Stearns’ dilemma is reflective of a wide range of financial institutions, and its insolvency (along with similar firms) could create the type of financial panic the Fed is so eager to avoid.  Thus, people who made unwise decisions will be rewarded with a $29 billion swap of risky sub-prime mortgages for premium Treasury bonds (the fact that this happened to Bear Stearns is insignificant – Bear Stearns is only a representative of a wider problem).  While the Fed acted to prevent a financial crisis, it must keep in mind its effect on future financial institutions which might have less incentive to behave responsibly, expecting a bail-out from the Fed because of their importance to the financial system.