However, governments in these countries found themselves unable to substantially respond to the emerging crisis with public money for the banking sector and countercyclical fiscal policy, due to lack of fiscal space and high debt. Financial markets then began to fragment along national lines and cross-border funding dried up, exacerbated by defensive risk management by banks and ring-fencing of liquidity by supervisors in the core countries. Lack of liquidity, coupled with capital depletion from domestic losses, precipitated a renewed credit crunch. Countries were trapped in a “bad equilibrium” caused by the three-way link between sovereigns, banks and domestic firms and households. Falling credit aggravated the ongoing recession, increased loan losses and further weakened bank balance sheets, which in turn pushed sovereign borrowing costs higher. Fiscal policy, under the pressure of losing market access altogether, took mainly the more expedient route of higher taxes, which led instead to lower growth and therefore renewed market jitters, somewhat defeating its original purpose. The fourth stage of the crisis was triggered by investors in both Europe and the rest of the world. Faced with a downward growth spiral, many investors reached the conclusion that the only way out for crisis-hit countries, given the institutional design of the euro area, was for them to exit from it. This would, it was believed, allow them to depreciate their currencies and regain monetary sovereignty. Fearing redenomination into lower-value currencies, investors sold off domestic public and private debt, further widening spreads and exacerbating bad equilibria within vulnerable economies.
This included a new program to purchase an additional $ billion a month of agency mortgage-backed securities (MBS). The FOMC reiterated in October that it will continue its purchases of agency MBS, undertake additional asset purchases, and employ its other tools as appropriate until there is a substantial improvement in the outlook for the labor market in a context of price stability. Monetary policy works in large part through its effect on financial markets and financial conditions. The impact on economic activity depends on the extent to which policy actions are effectively transmitted to key sectors of the economy. While actions such as MBS purchases help ease financial conditions more broadly, a key channel through which monetary policy affects the economy is through the housing and mortgage markets. An easing of policy lowers the secondary market rate at which mortgage-backed securities trade, which puts downward pressure on the primary mortgage interest rate. A lower primary mortgage rate enables borrowers to refinance their existing loans at lower rates, and increases demand for home purchases, supporting house prices and household wealth, which in turn may increase household access to credit. We have seen this channel in operation since the September FOMC meeting. Yields on newly issued agency MBS have declined about 45 basis points and the Freddie Mac survey 30-year primary rate has declined 23 basis points to 3.32 percent.