Question

As a response to the economic slowdown following the financial crisis, the Fed cut the Federal funds rate to near 0 by the end of 2008, and tried to provide further monetary stimulus through “unconventional” policies. In a short paragraph, describe some of these unconventional tools that were used by the Fed during this period, and explain how these tools could increase demand even when the Fed funds rate stays constant at zero.

Answer 1

The Federal Reserve System, the US Central Bank, is the largest policy-making body in charge of the fight against recessions. It is also one of the organizations responsible for overseeing banks and maintaining the integrity of the financial system. Consequently, starting in 2008 and continuing for several subsequent years, the Fed was on the front lines of combating interconnected crises in the banking system and the real economy.

In its war on the crisis, the Fed has deployed a wide range of tools including the traditional tricks of monetary policy plus a range of unconventional measures. It's been in the public eye as never before, and been subjected to an unprecedented level of political criticism.

The Fed's main tactics were:

• Interest rate cuts
• Targeted assistance to ailing financial institutions
• Quantitative easing (or Large-Scale Asset Purchases)
• Forward guidance about interest rates

Despite the Fed's efforts, unemployment remained quite elevated for years after the onset of the crisis. As a result, the central bank found itself charged with both excessive complacency and excessive activism.

Starting in September 2007, the Fed started to reduce interest rates gradually until June 2008. At that point, even though the economic condition was still worsening, the threat of increasing inflation – fuelled by high energy and agricultural commodity prices – forced them to slow down the rate cuts cycle. Beginning in September 2007, the Fed started to reduce interest rates gradually until June 2008.  At the June meeting, the August meeting, and even the September 2008 meeting held the day after Lehman Brothers went bankrupt, the Fed held its policy rate steady at 2 percent.

The main reason is the existence of cash. In the normal course of events, cash — paper currency and coins — is a small element of the money supply and an even smaller share of overall transactions. Mostly people get paid via direct deposit, make large purchases with credit or debit cards, mail checks, or use online bill pay services for recurring payment, etc. This is largely a question of convenience, but it also reflects the fact that money in a bank account pays interest while cash does not. This is a good reason to avoid stockpiling large quantities of cash as long as interest rates are positive. But if rates became negative, the situation would flip. It would make more sense to have stacks of hundred-dollar bills than to keep money in a bank account. Trying to force negative rates, in other words, could lead to large withdrawals of bank capital. This would intensify the financial crisis and potentially place an immense cost of productivity on the economy through the failure of a convenient electronic payment system. Worst of all, after we have completed a tough transition to a cash economy, interest rates will still be essentially trapped at zero. This problem is called the zero bound, and an economy that has lots of unemployment while at the zero bound is said to be in a liquidity trap.

With rates at zero, the Fed has been seeking a number of unorthodox monetary policy measures. Since they are unorthodox, they appear to be more divisive both socially and academically. Since they're divisive, the Fed tends to hesitate to deploy them on a large scale, making them less successful, arguably. But the questionable efficacy of these tactics further exacerbates public and professional doubts about them. It's a tough problem.

Consequently, the Fed encouraged Congress to pass the Troubled Asset Relief Program (TARP), a major bailout of the financial system. It also allowed the surviving standalone investment banks Goldman Sachs and Morgan Stanley to reclassify as bank holding companies for regulatory purposes, which gave them access to cheap overnight lending. Last, it launched an alphabet soup of special lending programs. The basic idea was to lend money very cheaply to every financial institution around to prevent additional bankruptcies.

Another tool has been quantitative easing, a term the Fed itself rejects. They call it Large-Scale Asset Purchases. Whatever you call it, it means buying up lots of longer-term debt issues by the federal government and Fannie Mae and Freddie Mac. Last but not least, they have taken advance instructions about how long interest rates are expected to remain small. The theory is that if people assume the near-zero interest rates of today can continue for a long time, that will make them more likely to borrow and spend than if they think the low rates of today will quickly vanish.

One of the main tools has been targeted assistance to financial institutions. The Fed (and policymakers outside the Fed) made the judgment that the collapse of Lehman Brothers showed that major bank failures were extremely costly.