Monetary policy of the Fed during the economic crisis

Monetary policy is a process by which the central bank of a country controls the money supply in that country. The fundamental goals of the monetary policy are to stabilize prices and reduce unemployment rates among others. The monetary authority often uses tools of monetary policy to adjust the supply of money in a country. These tools mainly target the interest rate in pursuit of promoting economic growth and stability in the country. Depending on the situation on the ground, the monetary policy applied can be expansionary or contractionary. Expansionary policies aim at reducing unemployment rates by increasing money in circulation whereas contractionary policies aim at lowering the inflation rate by reducing money in circulation. The Fed refers to the central bank of the United States (U.S), and is the body that controls monetary policy in the U.S. This is mainly done by the Federal Open Market Committee (FMOC). During the summer of 2007 financial crisis came up in the U.S. The reasons that led to the crisis are traceable as pointed out by Brunnermeir (77). According to Gourinchas (27) there was excess demand for safe debt instruments which made the financial sector to come up with pseudo-triple-A assets which are vulnerable to the financial crisis. Crisis in 2007-09 “reflected panic in wholesale funding markets that left banks unable to roll over short-term debt” (Wheeler 89). Once the crisis hit, it also became rapidly obvious that the policy interest rate was not a sufficiently powerful instrument to offset the contraction in aggregate demand and stabilize output. With federal funds rate rapidly approaching the zero nominal bound, traditional monetary policy had to be supplemented by vigorous fiscal policy as well as non-conventional monetary policy. Aggressive reaction to financial crises should be taken by the central banks (Wheelock 89). President Obama nominated Ben Bernanke for the second term as the chairman of the Board of Governors of the Fed to assist in preventing the economic crises.

Open market operation

This is a monetary policy tool that uses government securities to solve the problems money supply in an economy. The Fed buys or sells U.S treasury securities in the secondary market which ensures a desired level of bank reserves has been produced. Buying of securities from the public serves as an expansionary monetary policy as it increases the amount of money in the banks. This increases the amount of money in circulation. Selling treasury securities on the other hand decreases the amount of money in circulation since people will now hold their wealth in terms of securities and not cash balances.

The Fed increased the level of temporary open market operations on 9^th August 2007. This helped in increasing money in circulation which stimulated economic activities (tobias and Hyun 1). The Fed further announced its intention to repurchase of securities ‘repos’ in 28 days cumulating to $100 billion (Thornton 16). It also created Term Securities Lending Facility (TSLF) with an intention to lend $200 billion worth of treasury securities to primary dealers.

Reserve requirement

This implies the fraction of demand deposit accounts and fixed deposits that must be held as reserves at the Federal Reserve Banks. They are non-interest bearing reserves. An increase in reserve requirements discourages borrowing by banks hence individuals thereby restraining economic activities. A decrease in reserve requirements ratio encourages borrowing by the banks. This avails enough cash to banks for lending to individuals which in turn stimulates economic activities.

The Fed decided to reduce the reserve ratio to encourage borrowing.

Discount rate

This is the interest rate at which the Fed lends money to the financial institutions as their lender of last resort.These are secured short term loans which aim at providing money to the depository institutions which require them. Increasing the discount rate will discourage borrowing from the Fed. This will translate to low amounts of cash that could be used to lend to the general public. As a result, the banks will increase their lending rates which will discourage borrowing by the public. This restrains economic activities. To stimulate the economic activities, the Fed should lower the discount rates which will make the bank to offer cheap loans to individuals.

On the onset of financial crises in August 2007, the FOMC reduced the discount rates and extended term loans to banks.This was to encourage borrowing by institutions from discount window. Credit terms were extended to 30 days in August 2007 and further increased by 60 days by March 2008 (Ceccetti 19). The Fed reduced the federal funds target and the discount rate. By December 2008, the target had decreased to 0%-0.25% which is the current range.

Figure 3, which plots the monetary base, the federal funds rate, and the FOMC’s federalfunds rate target weekly over the period January 2006 through April 2012, shows that the massive increase in the monetary base was accompanied by a decline in the federal funds rate to near zero long before the FOMC reduced its federal funds rate target to that level. Indeed, the 10last three reductions in the FOMC’s federal funds rate target were the endogenous responses of the FOMC to a supply-induced decline in the federal funds rate. This is illustrated in Figure 4 which shows the effective federal funds rate, the federal funds rate target, and the 1-month OIS rate daily from January 2, 2007 through February 28, 2009. The vertical line denotes September 15, 2008. Prior to that date, the federal funds rate declined immediately on the announcement of a target change—reflecting the open mouth operations discussed in Section 2. Moreover, the 1-month OIS rate declined ahead of the target change, reflecting the fact that target changes were anticipated somewhat before they occurred. After Lehman, however, the federal funds rate declined in advance of target changes and the OIS rate lagged rather than led changes in the federal funds rate.

Conclusion

During the summer of 2007 the U.S. experienced severe financial crisis. This was characterized by increased home prices levels and decline of mortgage quality as well as spread of asset-backed security beyond its usual levels. Banks had held few asset-backed securities whose valuation posed difficulties to bankers. Due to large losses by the banks, they became reluctant in lending. Some financial intermediaries had difficulties in getting short-term financing which is essential for their daily operations. Policy makers had to intervene and try to make things work better for the economy. They created Term Auction Facility to change the way they used to lend to commercial banks since traditional interest rate instruments were not effective (Ceccetti 26). They went ahead to offer loan on Treasury securities in exchange for lesser grade instruments. In addition, they started making loans directly to investment banks. As a result of these interventions, the economy began to grow again by the second half of 2009, thanks to the Fed.

References

Brunnermeier, Markus, 2009, “Deciphering the Liquidity and Credit Crunch 2007-2008,”

Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 77-100, winter.

Ceccetti, S. Monetary Policy and the Financial Crisis of 2007-2008, April 2008. Retrieved from http://fmwww.bc.edu/ec-j/Sems2008/Cecchetti.pdf

Tett, Gillian, “US banks quietly borrow $50bn from Fed via new credit facility” Financial Times, 19February 2008, pg. 1.

Thornton, Daniel. The Federal Reserve’s Response to the Financial Crisis: What It Did and What It Should Have Done. Working Paper 2012-050A http://research.stlouisfed.org/wp/2012/2012-050.pdf

Tobias Adrian and Hyun Song Shin. “The Changing Nature of Financial Intermediation and the Financial Crisis of 2007-2009.” (2010):  Federal Reserve Bank of New York Staff Reports, no. 439, Revised April.