Fed’s Lacker Says Crisis in 2007 Worsened by Rescue Policy

Federal Reserve Bank of Richmond President Jeffrey Lacker said the financial system was weakened further as it began to fall into crisis in 2007 and 2008 by an “ambiguous rescue policy.”

The Richmond Fed president has been one of the biggest critics of an expanded safety net which he says reduces market discipline and creates more risk by raising expectations of bailouts. The Fed used multiple tools to aid financial institutions during the crisis, including opening a funding facility for corporate commercial paper and offering direct support for the Bear Stearns Cos. and American International Group Inc.

Richmond Fed researchers estimate that as of December 31, 2011, that 57 percent of financial sector liabilities benefit from perceived government support, up from 45 percent over a decade ago.

“It seems quite plausible to me that the signal sent by the Fed’s lending actions in August 2007 dampened the willingness of troubled institutions, such as Bear Stearns and Lehman Brothers, to seek safer solutions to the strains they were facing -- whether by raising capital, selling assets or reducing reliance on short-term funding,” Lacker said in a speech at his alma mater, Franklin & Marshall College in Lancaster, Pennsylvania.

Government Support

Lacker said perceptions of government support had built over decades which may have underpinned the dependence of investment banks such as Bear Stearns on low-cost short-term funding such as repurchase agreements.

“When Bear lost funding in mid-March, the critical fear was that without government support, investors would pull away from other investment banks as well,” Lacker said. “Backstop lending was thus necessitated by expectations of backstop lending.”

Lacker, responding to reporters’ questions after the speech, said evidence of a credit market bubble arising from the Fed’s current policy of holding long-term interest rates low with asset purchases is “ambiguous and inconclusive.” Lacker also indicated that he didn’t favor using monetary policy to attack speculative excesses in financial markets.

“We should be really cautious and humble about coming to conclusions about credit markets being out of adjustment,” he said.

December Dissent

Lacker was a Federal Open Market Committee voting member last year and dissented against both parts of the Fed’s stimulus program in December.

At that meeting, and again in January, Fed officials said they will hold the benchmark lending rate near zero until inflation is forecast to rise to more than a 2.5 percent annual rate and so long as the unemployment rate remains above 6.5 percent. U.S. central bankers also expanded quantitative easing, adding $45 billion in Treasury purchases to their program of $40 billion in monthly MBS purchases.

Lacker viewed the asset purchases as “unlikely to add to economic growth without unacceptably increasing the risk of future inflation,” minutes from the meeting said. He was concerned that linking the federal funds rate to indicators on jobs and prices “would inhibit the effectiveness of the Committee’s communications and increase the potential for inflationary policy errors.”

The unemployment rate rose to 7.9 percent last month, and the 12-month rate of inflation fell to 1.3 percent in December pushing the economy further away from the Fed’s objectives of stable prices and maximum employment.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net;

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net

Press spacebar to pause and continue. Press esc to stop.

Bloomberg reserves the right to remove comments but is under no obligation to do so, or to explain individual moderation decisions.

Please enable JavaScript to view the comments powered by Disqus.