Question

1. Discuss the Federal Reserve's unconventional policy tools that they employed during the 2008 crisis. Make sure you discuss the following:

   • How did they differ from the normal policy approach of the Fed prior to 2008?

   • Now compare this to the Fed's actions during the current CoVID-19 crisis. What has the Fed done this time that is different from the 2008 crisis?

   • What might be perceived as "dangerous" by those that are interested in prudence from the Federal Reserve?

   • What has been the effect on the financial markets of the Fed's actions?

Answer 1

Unconventional policy tools are used when conventional policy tools are expected to take too long to become effective and thus to have fast recovery, unconventional policy tools such as negative interest rates, asset purchases, extended liquidity operations are deployed.

Now the federal reserve employed more explicit forward guidance unconventional tools and did large scale asset purchases. These were essentially used to push down the yields on long term bonds and boost asset prices which led to increase in spending.

The normal policy approach of the Fed prior to 2008 was using conventional measures such as lowering interest rates, which the Fed did use during the crisis as well, and the interest rates were reduced to zero. The fed also did not use an explicit forward guidance tool prior to the crisis. An explicit forward guidance tool entails more information about future policy.

In this current crisis, the Fed has reduced the interest rates as it has just a margin of 160 bps vs. 500 bps in 2008. The Fed printed money in 2008, but not as much as it is doing currently. This time around the Fed is introducing a lot more quantitative easing which is printing cash. This time the Fed is acting quickly vs. during the last crisis when it took long to respond to the crisis. This time around huge forebearance is being given to coordination of swap lines between several major banks.

Printing huge amounts of cash might be considered dangerous as the value of money declines as it is not linked to gold anymore. It also leads to increase in chances of higher inflation if money is not directed to only those firms which are in need of it.

The fed's actions have stabilised the financial markets as the US has provided timely and quick intervention in the market, by ensuring there is enough liquidity. The stock market did plummet in March 2020, but it rose once liquidity enhancing measures were undertaken and economy boosting measures materialized.