For example, the technology stocks associated with initial public offerings were very difficult to short because the available supply or “float” was small – a high proportion of the shares in the companies were held by the original venture capital investors and subject to lock-up periods before the shares could be lent out to short sellers or sold. Similarly, housing is notoriously difficult to short. The option of selling one’s home in order to rent is expensive not only in terms of time and effort, but also in terms of transaction costs. And, shorting complex structured finance products was difficult because there were no standardized instruments; the securities rarely traded and were very difficult to value. It was not until the development of the ABX indexes – which allowed investors to buy and sell credit default swaps on pools of structured finance obligations – that investors had a vehicle that allowed them to short subprime mortgagebacked securities more easily. 6 Asset bubbles often come to an end when the basic belief system is contradicted by events. This can happen very naturally as a matter of course because economic fundamentals deteriorate, or because there is a change in rules or regulations that disrupts the balance between supply and demand. In the technology boom, this might occur because each company cannot get to the market first. So even if there is a first-mover advantage, not everyone will be able to take advantage of it.
If China’s economy has a hard landing, there really aren’t many sources of strength left in the global economy. Let me move now to what this all means for Fed policy. As I noted earlier, our statutory mandate is to achieve maximum employment and price stability.5 We are far short of maximum employment. And I expect inflation to fall this year below the 2 percent level that we view as consistent with our mandate. This is clearly a situation in which we have to keep applying monetary policy stimulus vigorously. The Fed’s monetary policy body is called the Federal Open Market Committee, or FOMC. As you know, the Fed influences the economy through its ability to affect interest rates. In December 2008, when the recession was hitting with full force, the FOMC lowered the federal funds rate, the rate banks pay to borrow from each other on overnight loans, close to zero. It’s been there ever since. Given the weakness in the economy, standard monetary policy guidelines indicate that the federal funds rate should have gone deep into negative territory. But, of course, it’s not possible for interest rates to go much below zero. So the Fed has had to look for alternative ways to stimulate the economy. For example, we’ve purchased over one-and-three-quarters trillion dollars of longer-term securities issued by the U.S. government and mortgage agencies. This raises the prices on these securities, which lowers their yields. And lower yields on longer-term Treasury securities tend to push down other longer-term interest rates.