How the Fed tries to keep credit flowing

At no time in the nation’s history has the Federal Reserve System, which was established by Congress in 1913, been so deeply involved in the economy. But before the Fed became so involved in both the national and regional economies in the aftermath of the financial meltdown of 2008, most Americans likely knew about the Fed only as controllers of interest rates, protectors against inflation and with chairmen like Alan Greenspan, who spoke in cryptic language about the state of economic conditions.But today, according to a senior economist at the Federal Reserve Bank of Boston, the Fed is concerned with making sure it has enough “bullets in the gun” to help the economy recover.Chris Foote, who joined the Boston Fed in 2003 and is one of about 20 research economists who work there, said it was the job of the Boston Fed and other reserve banks in the Federal Reserve System to provide emergency liquidity to a banking system on the verge of a breakdown.Since the Fed dropped interest rates to the historically unprecedented level of essentially zero percent, Foote said the Fed “has been finding ways to provide stimulus to the economy without interest rate reductions.”Those steps have also been unprecedented and include jumping into the commercial paper market (short-term loans for companies to use for payroll or other business expenditures), buying up Treasury bonds and mortgage-backed securities to help financial institutions clear off so-called “toxic” debts and to expand direct lending to banks.While Fed economists have traditionally taken take a macroeconomic view of the economy and focus much of their research on areas far removed from day-to-day business issues, the collapse of the housing and financial markets was a wake-up call, Foote said.Foote said he and others who previously weren’t experts on the housing market began studying the market a few years ago, when it became apparent the boom was about ready to bust.“A lot of loans were made on the assumption that housing prices wouldn’t fall,” he said. What other research has found is that foreclosures rates are tied less to the amount of unsound loans than to declining incomes, consumer debt loads and job losses.If credit is a major part of the lifeblood of the economy, have the Fed’s actions helped New England’s economy? Foote said lower interest rates and keeping liquidity levels high can only do so much.“The tight credit market kept reserves from being lent out. We might know the amount of loans (being made) but we don’t know if the issue is demand or supply. In a serious recession, loan demands fall because firms don’t see the benefit of taking on extra debt,” Foote said.Perception problemAccording to Mark Primeau, president and chief executive of Laconia Savings Bank, the largest state-charted bank in New Hampshire, the “economy is brightening,” in part because credit has been available.
Primeau said that for his bank, Fed interest rate policies have provided “lubricant to keep the economy moving.” He added that the zero interest rate has “made borrowing much more affordable. It’s really a good time to look to buy a business, a home, or expand a business.”Primeau agreed with Foote on one of the most important and misunderstood points about the credit market — just because banks have money to lend, there are pragmatic reasons why it isn’t flowing as it did during the economic boom of 2005-2007.“The (perception) problem is this — credit doesn’t create business expansion,” Primeau said.
Essentially, he said, with the down, banks are holding the line on lending standards, and many businesses have been reluctant to take on heavier debt.“Unfortunately, there are companies that are not able to get financed because the demand for their products isn’t there or it’s uncertain whether they can pay back loans,” Primeau said. “We can’t lend on a hope and a prayer, and we often tell people we aren’t the place to come to if you are a startup. You need to go get some venture capital or borrow from friends or relatives.”Tougher standards?New Hampshire Business Sales Inc. of Meredith, a business broker, has seen its income drop dramatically because it has seen activity drop due to the credit market corrections.“We have buyers who are willing to make deals, and we have been sending them to bankers who have courted us to bring them deals, only to be turned down because underwriting standards have become so tough,” said Leon M. Parker, president of New Hampshire Business Sales. “The collateral requirements are currently such that only buyers who don’t need financing are really being seriously considered for financing, regardless of the supposed ‘help’ offered under current SBA programs.”Primeau said Laconia Savings, which has 19 offices around the state, did not change its lending standards during the flush times and hasn’t since. “Our lending is up year by year across the board,” he said. But the same cannot be said, he added, of the giant national banks that did cut back on lending due to their own financial difficulties arising from the nationwide crash of the housing market.Stuart Arnett, a former state economic development director who recently finished a three-year term on the Boston Fed’s community advisory board, said his involvement with the board helped him realize “it truly is a bank.” He said his tenure on the panel was “a great chance to see how it worked” — especially with community development policies in urban areas such as Lowell, Mass., and Hartford, Conn.Arnett said that, at his last meeting, it was clear the Boston Fed was becoming attuned to the vital issue of small business credit and that the Fed was going to keep interest rates at historical lows for the foreseeable future.“Because they are a bank and regulate banking, they will have to stay involved in financing debt,” Arnett said.Primeau agreed, saying the Boston Fed, like the other reserve banks, is so unique because it “regulates our holding capital while also providing credit facilities.”He said the recession changed one perception — it’s not so bad to borrow from the Fed. “It used to be that the Fed was the lender of last resort and that banks didn’t want it known they were going to the Fed,” Primeau said. “The Boston Fed is much more eager to lend to healthy, strong banks and have made credit available to banks to fund good loans.”Laconia Savings, for instance has “a very large line of credit with the Boston Fed. We don’t have to use it but we could use it to help fund growth in loans. They have provided another layer of liquidity for banks,” Primeau said.Arnett, founder of Arnett Development Group in Concord, said he has been impressed by the quality of economic research he saw coming from the Boston Fed, especially the many variables involved in the boom and bust of the housing market. In the wake of the housing downturn, he said, the Boston Fed is confronting the conventional wisdom of widespread home ownership.“Like everyone else, they may be rethinking or challenging the idea that more home ownership is automatically better for neighborhood stability,” Arnett said.Foote at the Boston Fed said one of the lessons learned from the recession was that the financial meltdown “was unique because it really illustrated the macroeconomic importance of the financial system” and the contagion effect it had on almost every individual and economic sector.“The malfunctioning financial system challenged theories of central banking and economic regulation over the last 20 years,” Foote said.Michael Goldberg, an economics professor at the University of New Hampshire, said the long-term impact of the 2008 crash is that it exposed fault lines in how the real economy works as well as how much regulation and government intervention is needed in a free market system.“The contemporary way that economists construct their models have very little to do with the real world, and leadership before the crisis was fundamentally flawed,” Goldberg said.Politicians and policymakers were forced to question the widely held belief that markets are unquestionably efficient, rational and self-correcting, he said.Two competing ideas about markets are emerging, Goldberg explained. One is the rational market approach, which calls for little if any government regulation. The other is the imperfect knowledge model (on which Goldberg devotes much of his research) which assumes markets aren’t perfect and regulators “should stand on guard to dampen excesses.”One thing is historically clear, he said: “We are hard-wired to undergo swings and sometimes those swings will become excessive.”