Great questions! Let me address them one at a time.
Why did the Fed inject liquidity into the financial system in August 2007?
The short answer is that the financial system experienced some serious liquidity shortages in August 2007, and the Fed injected funds to help keep financial markets operating effectively so that they would continue to support ongoing economic activity.
For a longer (and more complete) answer, I’ll refer to a speech by Federal Reserve Chairman Ben Bernanke from October 2007 that clearly explains the sequence of the financial crisis that unfolded in August 2007, starting with how it relates to the mortgage market:
At one time, most mortgages were originated by depository institutions and held on their balance sheets. Today, however, mortgages are often bundled together into mortgage-backed securities or structured credit products, rated by credit rating agencies, and then sold to investors. As mortgage losses have mounted, investors have questioned the reliability of the credit ratings, especially those of structured products. Since many investors had not performed independent evaluations of these often-complex instruments, the loss of confidence in the credit ratings led to a sharp decline in the willingness of investors to purchase these products. Liquidity dried up, prices fell, and spreads widened. Since July, few securities backed by subprime mortgages have been issued.
Investors' reluctance to buy has not been confined to securities related to subprime mortgages. Notably, the secondary market for private-label securities backed by prime jumbo mortgages has also contracted, and issuance of such securities has dwindled.† Even though default rates on such mortgages have remained very low, the experience with subprime mortgages has evidently made investors more sensitive to the risks associated with other housing-related assets as well.
The problems in the mortgage-related sector reverberated throughout the financial system and particularly in the market for asset-backed commercial paper (ABCP). In this market, various institutions have established special-purpose vehicles to issue commercial paper to help fund a variety of assets, including some private-label mortgage-backed securities, mortgages warehoused for securitization, and other long-maturity assets. Investors had typically viewed the commercial paper backed by these assets as quite safe and liquid, because of the quality of the collateral and because the paper is often supported by banks' commitments to provide lines of credit or to assume some credit risk. But the concerns about mortgage-backed securities and structured credit products (even those unrelated to mortgages) greatly reduced the willingness of investors to roll over ABCP, particularly at maturities of more than a few days. The problems intensified in the second week of August after the announcement by a large overseas bank that it could not value the ABCP held by some of its money funds and was, as a result, suspending redemptions from those funds. Some commercial paper issuers invoked their right to extend the maturity of their paper, and a few issuers defaulted. In response to the heightening of perceived risks, investors fled to the safety and liquidity of Treasury bills, sparking a plunge in bill rates and a sharp widening in spreads on ABCP.
Let’s continue the story with a November 2007 speech by St. Louis Fed President William Poole:
As the strains in financial markets intensified, many of the largest banks became concerned about the possibility that they might face large draws on their liquidity and difficult-to-forecast expansions of their balance sheets. They recognized that they might have to provide backup funding to programs that were no longer able to issue ABCP. Moreover, in the absence of an active syndication market for the leveraged loans they had committed to underwrite and without a well-functioning securitization market for the nonconforming mortgages they had issued, many large banks might be forced to hold those assets on their books rather than sell them to investors as planned. In these circumstances of heightened volatility and diminished market functioning, banks also became more concerned about the possible risk exposures of their counterparties and other potential contingent liabilities.
These concerns prompted banks to become protective of their liquidity and balance sheet capacity and thus to become markedly less willing to provide funding to others, including other banks. As a result, both overnight and term interbank funding markets came under considerable pressure. Interbank lending rates rose notably, and the liquidity in these markets diminished. A number of the U.S. ABCP programs that had difficulty rolling over paper were sponsored by or had backup funding arrangements with European banks. As a result, some of these banks faced potentially large needs for dollar funding, and their efforts to manage their liquidity likely contributed to the pressures in global money and foreign exchange swap markets.
In response to these serious liquidity shortages, on August 10, 2007, the Fed released a statement indicating that it would provide liquidity to meet the "unusual funding needs because of dislocations in money and credit markets." To provide additional liquidity, that week the Fed engaged in some temporary open market purchases that injected larger-than-average sums into the market. The fact that they're called "temporary" purchases reflects that the Fed pumped money in through temporary "repurchase" agreements, meaning that when the Fed bought the securities from the dealers to inject funds into the banking system, the dealers agreed to buy the securities back from the Fed after a short time period, usually from one to 14 days. The advantage of using the short-term repurchase agreements to inject funds into the system is that the Fed was providing the financial system with temporary liquidity during a temporary disruption to the financial markets; these were not permanent increases. With these actions the Fed demonstrated its willingness to step in at any moment if money appeared to be in short supply. This was one step toward encouraging market participants to lend out their money more freely. Other central banks, including the European Central Bank, also temporarily injected funds into European financial markets at the same time and for similar reasons.
Where did the Fed get the money that it injected into the market?
The Fed finances both permanent and temporary purchases of Treasury securities on the open market by creating a liability against itself and crediting the account of those whom it buys the securities from; this is how the supply of money (also referred to as “balances”) is increased.1 As of August 29, 2007, the Federal Reserve System held $819.7 billion in securities, repurchase agreements, and loans on its books; total U.S. Treasury securities held outright were $784.6 billion, and repurchase agreements totaled $33.8 billion.2 The publication Purposes and Functions of the Federal Reserve System describes this process:
Purchasing securities or arranging a repurchase agreement increases the quantity of balances because the Federal Reserve creates balances when it credits the account of the seller’s depository institution at the Federal Reserve for the amount of the transaction; there is no corresponding offset in another institution’s account. Conversely, selling securities or conducting a reverse repurchase agreement decreases the quantity of Federal Reserve balances because the Federal Reserve extinguishes balances when it debits the account of the purchaser’s depository institution at the Federal Reserve; there is no corresponding increase in another institution’s account. In contrast, when financial institutions, business firms, or individuals buy or sell securities among themselves, the credit to the account of the seller’s depository institution is offset by the debit to the account of the purchaser’s depository institution; so existing balances held at the Federal Reserve are redistributed from one depository institution to another without changing the total available.
How did all this affect the federal funds rate?
You may know that the Fed achieves its target federal funds rate by engaging in open market operations. For example, when it wants to lower the target federal funds rate to ease credit conditions in the economy, it purchases Treasury securities on the open market, infusing the economy with cash and pushing the fed funds rate lower. Usually a Fed injection of money into the financial system is discussed in association with an easing of monetary policy, or in other words a reduction in the target federal funds rate. Given that the Fed provided billions of dollars in liquidity in August 2007 to ensure the stability of markets, a reasonable question might be how the Fed did that while keeping the fed funds rate constant.
In mid-August the Fed observed that the "effective" fed funds rate on loans was trading higher than its target at that time (5.25 percent). This was unusual, because the effective fed funds rate usually trades quite close to its target. This occurred because the overall tightness in liquidity described above led to an increased demand for bank reserves in the federal funds market, which pushed the rate above its target. So, the Fed’s infusion of liquidity pushed the fed funds rate from being above its target rate to being below its target rate – essentially the Fed’s actions stabilized the fed funds rate at a level more appropriate for the unusual situation.
Chart 1 gives a visual representation of what happened, and shows the amount of temporary open market purchases that took place over the week starting August 8, 2007, and for comparison, a couple of days before the unusually large infusion as well as the average for the same week of the previous year. The purple bars are the sum of the Fed’s temporary open market operations, the red line represents the target fed funds rate at the time, and the blue line represents the closing effective fed funds rate on the given day:
Source: Federal Reserve Bank of New York
The Fed injected $24 billion on August 9, 2007. In comparison, after September 11, 2001, it injected about $81 billion, but for much the same reason: to provide liquidity to the financial system and to avoid a shortage in the availability of funds.
In this way you can see that the Fed’s injection of liquidity equalized market forces in order to keep the federal funds rate at its target. This, combined with a 50-basis-point reduction in the discount rate on August 17 and an extension of its typical financing terms to up to 30 days, provided an important psychological reassurance to markets that the Fed would continue to provide liquidity in the future if necessary. By mid-October, Chairman Bernanke described some of the ways in which the market turmoil had abated:
Since mid-August the functioning of financial markets has improved to some degree, supported not only by liquidity provision but also by the monetary policy [decision to cut the target fed funds rate by 50 basis points] in September…. Interest rate spreads on [asset-backed commercial paper] have fallen by more than half from their recent peaks, and overall commercial paper outstanding has edged up this month after declining sharply over August and September. Interbank term funding markets have improved modestly, though spreads there remain unusually wide. Some progress has been made in bringing pending [leveraged buyout]-related loans to market, albeit at discounts and with tightened terms. Risk spreads in corporate bond markets have narrowed somewhat, the issuance of speculative-grade bonds has restarted, and investment-grade issuance has been strong. Volatility in many asset markets has declined toward more-normal levels. Perhaps most important, in many markets investors are showing an increased capacity and willingness to differentiate among assets of varying quality.
I hope this answers your questions! Remember that reading current speeches by Federal Reserve governors and Bank presidents is one good way to gain an understanding about recent economic developments. You can find these speeches here:
1. Contrary to popular belief, the Fed does not increase the money supply by printing money and shipping it to banks to put in circulation. Actually, the Fed doesn’t print money at all! The Bureau of Engraving and Printing has that job, and the Federal Reserve distributes it to banks when it is needed to meet demand. However, its primary means of increasing the money supply is through open market operations.
2. For information on what the Fed does with these Treasury securities, see the May 2006 Dr. Econ.
† Jumbo mortgages are those mortgages for which the principal value does not conform to the limit set annually by Fannie Mae and Freddie Mac for loans they will purchase; the amount for 2007 is $417,000. Jumbo loans are thus a type of "nonconforming" loan. Prime loans are those made to borrowers with good credit records.
Bernanke, Ben. 2007. “The Recent Financial Turmoil and its Economic and Policy Consequences.” Presentation at the Economic Club of New York, New York, New York.
Federal Reserve Board of Governors Press Release. August 10, 2007.
Pool, William. 2007. “Market Healing.” Presentation at Marquette University, Milwaukee, Wisconsin.