Ep.95- What Else Will the Federal Reserve Do Next? A Study of Monetary Policies From the 2008 Recession
📸 IG handle: DollarSenseLA
This is a paper my classmates and I co-authored for Economics 29 from Dartmouth College back in 2011. The learnings have never been more relevant because the Federal Reserve is facing the same challenge and running the same playbook in 2020. I am so proud to be able to apply something I learned from 9 years ago into practice.
Date: 5/31/2011
Authors: Ryan Mei, Yana Ernazarova, Mahmud Johnson, Jie Gu, Erika Kafwimi
Subject: Monetary Policy in the Financial Crisis and Recession
Overview
This paper examines the United States monetary policy during the financial crisis and recession in 2008. The Federal Reserve resorted to both conventional and unconventional measures to respond to the low aggregate demand in the economy. In the early stage of the recession, the Federal Reserve quickly reduced the federal funds rate to near zero by December of 2008. However, money did not flow from financial intermediaries to borrowers, as the Federal Reserve had initially expected. The Federal Reserve then started exercising alternative policies. These policies include increasing money supply, lending to financial institutions, providing liquidity directly to key credit markets, buying longer-term securities, and policy communications to affect long-term expectations.
Introduction
The financial crisis that started in 2008 has had far-reaching effects on the US economy. In mortgage markets, a sub-prime mortgage crisis “imposed substantial losses on many financial institutions and shook investor confidence in credit markets.”[1] The loss of confidence resulted in intense risk aversion from lending institutions, subsequently resulting in tightened credit lines. The Federal Reserve quickly responded by decreasing the fed funds rate to nearly zero in hopes of stimulating investments. Yet money still did not flow from banks to borrowers because banks held on to large amounts of treasury securities and they were conservative in lending to the borrowers. As a result, the Federal Reserve relied on a number of unconventional monetary policies, in attempts to funnel new money directly to the borrowers or to provide strong incentives for inter-bank lending.
Federal Funds Rate
In the beginning of the recession, the Federal Reserve responded aggressively to the crisis. The primary tool they used to ease the credit market was to decrease the discount and federal funds rates. In August 2007 the fed cut the discount rate[2], which is a rate at which depository institutions such as commercial banks, can borrow from the Fed to maintain its required reserve levels. In September 2007 the Federal Reserve started to ease monetary policy to also cut the Federal Funds Rate. Initially, they lowered the rate by 50 basis points. “As indications of economic weakness proliferated, the Committee continued to respond, bringing down its target for the federal funds rate by a cumulative 325 basis points by the spring of 2008.”2 The federal funds rate has since stayed at between 0 and 25 basis points, with no furthers decrease possible.
The cuts in federal funds rate improved credit market conditions, but investment had still not recovered to pre-crisis levels. Therefore, the Federal Reserve had to turn to other tools to continue the credit market easing.
Lend to Financial Institutions
Prior to the crisis, the interbank loan market allowed banks with unfunded investment opportunities to borrow at very low interest rates from banks with surplus deposits. This immediate access to additional funds gave banks more confidence about making loans. But during the financial crisis institutions feared lending to other institutions who had high default risks due to sub-prime mortgages and other risky assets. As a result, there was a lack of confidence among banks.
The Federal Reserve created the Term Auction Facility, a quasi-anonymous lending facility, to lend to these banks that needed money. Initially, the Fed lowered the cost of lending from its primary credit facility-the discount window. However, banks feared that lending from the Fed would create a perception that they were at the verge of failing and thus decrease the confidence of consumers. To remove the stigma from Discount Borrowing, the Fed created the Term Auction Facility (TAF).
Because healthy banks were as likely to partake in the auction as those in trouble, individual banks were not assumed to be in trouble just because they used the facility. To an extent, the TAF was successful in tackling the stigma of borrowing from the Fed, but only to a small extent. This was due to the rise of counter-party risk: the possibility that the other party would be unable to bargain to the end
Channel Fund Directly to the Borrowers
To stimulate the real economic activity, the Federal Reserve directly purchased assets from borrowers such as corporate bonds, commercial papers, and triple-A rated mortgage-backed securities so that it could directly provide liquidity to key credit markets. During the financial crisis, the banks were not willing to lend money to the borrowers. In Bernanke’s speech at the London School of Economics in 2009, he mentioned that providing liquidity to financial institutions does not address instability directly. Neither does it address the declining credit availability in the commercial paper market or asset-backed securities. Thus, the Fed tried to directly funnel money to borrowers.
The Federal Reserve set up the Commercial Paper Funding Facility and the Term Asset-Backed Securities Loan Facilities to directly purchase assets from consumers. The Commercial Paper Funding Facility (CPFF) purchased $150 billion in commercial papers in September 2008. The Term Asset-Backed Securities Loan Facilities (TALF) allowed the Federal Reserve to purchase over $1 trillion in Mortgage-Backed Securities (MBS) since the beginning of the financial crisis[3].
Communication Policy to Increase Investors’ Confidence
The Federal Reserve’s announcement of an extended period of low rates provides public information on the future course of its monetary policy. During the crisis, the announcement of the Fed’s policy to keep interest rates low for a longer period of time increased investor’s confidence about the future returns on their investments. This communication policy was aimed at driving up expected inflation, driving down real interest rates, decreasing costs of borrowing, and boosting aggregate demand via the investment channel. For example, the spread between mortgage rates and Treasury yields declined substantially after the Fed’s policy announcement, providing low-cost options for homeowners to refinance their homes. Macroeconomic model simulations show that by 2012, unemployment would fall by 1.5 percentage points relative to what it would have been absent the asset purchases.[4]
Purchase of Long-Term Securities
Since 2008, the Federal Reserve has been purchasing long-term securities in order to stimulate economic activity. From late 2008 through November 2010, the Fed purchased over $1.7 trillion in longer-term securities, including mortgage-backed securities (MBS), agency debt, and government debt. The purchase effectively increased the prices and decreased yields on those securities[5]. These asset purchases caused the yield on 10-year Treasury Inflation-Protected Securities to drop by nearly 0.5 percentage points[6]. Such reductions in long-term interest rates directly stimulate investment in the economy by reducing the cost of borrowing. Additionally, the increase in the values of assets such as MBS, corporate bonds, and stocks had the effect of increasing economy-wide spending and increasing household wealth, further boosting aggregate demand. Furthermore, the decline in interest rates tends to create a moderate depreciation of the exchange rate, which increases net exports[7].
Another rationale for the Fed's purchase of longer-term securities was to increase bank lending. With short-term interest rates at zero, the fed cannot increase the money supply any further. In this case, banks see short-term securities and bank reserves as perfect substitutes; they simply use the money they receive from the fed to replace their short-term securities holdings. However, with the Fed's purchase of long-term securities, it stimulates demand for those securities, increasing their prices and decreasing their yields. In this case, banks can no longer afford to sit on their reserves, but instead, purchase more long-term securities or lend out to the public, as they earn returns higher than those on reserves. Invariably, some of the money lent out will be deposited back into the banks, increasing M1 (money supply) and stimulating real economic activity[8].
Recent Interest Rates Debate
Since the European Central Bank raised its refinancing rate to 1.25% in April of 2008, the first increase in nearly three years, there has been increasing debate within the Federal Reserve whether the United States should raise interest rates as well. Federal Reserve Bank of Kansas City President Thomas Hoenig advocates the need to raise the rate to encourage individuals to save and avoid future asset bubbles [9]. However, no policy change will be implemented until later this year or in 2012. Specifically, Bernanke, speaking on April 27 at a press conference, signaled that the central bank will maintain its record monetary stimulus after June and indicated that the need to contain inflation means further easing is unlikely[10]. Since October 2008, the Fed has been paying a 25 basis point interest rate on bank reserves, serving a contraction policy to tighten the economy. When Quantitative Easing II(QE2) ends in June 2011, the combination of a rise in interest rates and the continuous interest rate on bank reserves will serve as an exit strategy for the monetary expansion.
[1] http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm
[2] Bernanke, Ben S. "FRB: Speech--Bernanke, The Crisis and the Policy Response--January 13, 2009." Board of Governors of the Federal Reserve System. Federal Reserve, 13 Jan. 2009. Web. 26 May 2011. <http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm>.
[3] "Credit Easing Policy Tools." Federal Reserve Bank of Cleveland. Federal Reserve Bank of Cleveland, 25 May 2011. Web. 26 May 2011. <http://www.clevelandfed.org/research/data/credit_easing/>.
[4] Chung, Lafforte, Reifschneider, Williams, “Estimating the Macroeconomic Effects of the Fed’s Asset Purchases” (2001). URL: < http://www.frbsf.org/publications/economics/letter/2011/el2011-03.html>
[5] Chung, Lafforte, Reifschneider, Williams, “Estimating the Macroeconomic Effects of the Fed’s Asset Purchases” (2001). URL: < http://www.frbsf.org/publications/economics/letter/2011/el2011-03.html>
[6] Yellen, Janet, “The Federal Reserve’s Asset Purchase Program,” (January 8, 2011). URL: < http://www.federalreserve.gov/newsevents/speech/yellen20110108a.htm>
[7] Ibid.
[8] Carlstrom, Pescatori; “Conducting Monetary Policy When Interest Rates Are Near Zero,” (December 21, 2009). URL: < http://www.clevelandfed.org/research/commentary/2009/1009.cfm>
[9]Martin, Eric. "Hoenig Urges Fed to Raise Interest Rates to Encourage Saving - Businessweek." Businessweek - Business News, Stock Market & Financial Advice. Bloomberg, 7 Apr. 2011. Web. 30 May 2011. <http://www.businessweek.com/news/2011-05-29/hoenig-urges-fed-to-raise-interest-rates-to-encourage-saving.html>
[10]ibid