Question

You are on the council of economic advisors team for the president. The country is experiencing recession. The president is asking your team for advice.

Explain in details what kind of monetary policy would the Federal Reserve probably follow if the country was in a severe recession with high unemployment and falling prices. Why?

Describe the details of each tool they will use and impact on the economy as a whole.

Answer 1

Answer :

The U.S. central bank, the Federal Reserve, has a dual mandate: to work to achieve low unemployment and to maintain stable prices throughout the economy. During a recession, unemployment rises, and prices sometimes fall in a process known as deflation. The Fed, in the case of steep economic downturns, may take dramatic steps to suppress unemployment and bolster prices both to fulfill its traditional mandate and also to provide emergency support to the U.S. financial system and economy.

At the onset of a recession, some businesses begin to fail typically due to some combination of real economic shocks or economic bottlenecks that result from the incompatibility of production and consumption activities that results from previously distorted interest rate and credit conditions. These businesses lay off workers, sell assets, and sometimes default on their debts or even go bankrupt. All of these things put downward pressure on prices and the supply of credit to businesses in general, which can spark a process of debt deflation.

Key Points to understand :

• The Federal Reserve has a dual mandate from Congress to maintain full employment and prices stability in the U.S. economy
• To help accomplish this during recessions, the Fed employs various monetary policy tools in order to suppress unemployment rates and re-inflate prices.
• These tools include open market asset purchases, reserve regulation, discount lending, and forward guidance to manage market expectations.
• Most of these tools have already been deployed in a big way in response to the economic challenge imposed by recent public health restrictions on the economy.

Deflation, in the form of falling prices, is not, in general, a harmful process for the economy or a problem for most businesses and consumers by itself. It is, however, widely feared by central banks and the broader financial sector, especially when it involves debt deflation because it increases the real value of debts and thus the risk to debtors. Banks and related institutions are typically among the largest debtors in any modern economy. In order to protect its constituent banks from defaulting on their overextended debts, the Federal Reserve does not hesitate to take action in the name of stability.

The Federal Reserve has a number of tools to attempt to re-inflate the economy during a recession in pursuit of these goals. These tools largely fall into four categories, which we detail below.

Open Market Operations :

The Fed can lower interest rates by buying debt securities on the open market in return for newly created bank credit. Flush with new reserves, the banks that the Fed buys from are able to loan money to each other at a lower fed funds rate, which is the rate that banks lend to each other overnight. The Fed hopes that a drop in interest rates spreads throughout the financial system, reducing rates charged to businesses and individuals.

When this works, the lower rates make it cheaper for companies to borrow, allowing them to continue going into more debt rather than defaulting or being forced to lay off staff. This helps keep employees in their current jobs and suppress the rise in unemployment when a recession hits. Lower interest rates also enable consumers to make more purchases on credit, keeping consumer prices high and likewise extend themselves further into debt rather than live within their means.

The Fed purchases mostly Treasury securities in its normal open market operations but extends this to include other government-backed debt when it comes to quantitative easing.

There are times when interest rates won’t go any lower because banks simply hold on to the newly injected reserve credit for their own use as liquid reserves against their debt obligations. In these cases, the Federal Reserve may choose to simply continue open market operations, buying bonds and other assets to flood the banking system with new credit. This is known as quantitative easing (QE), the direct purchase of assets by the Federal Reserve to inject more money into the economy and expand the money supply.

The Fed has used quantitative easing on several occasions since 2008, including in March of 2020, when the central bank launched an initial $700 billion QE plan aimed at propping up the debts of the financial system on top of most of the nearly $4 trillion in quantitative easing it created during the Great Recession which it has yet to unwind. It is not clear where the upper limit is on the Fed’s ability to continue flooding trillions of new dollars into the system to protect the banks.  

Lowering Capital Requirements : The Fed also can regulate banks to ensure that they are not required to hold capital against potential debt redemption. Historically the Fed was charged with regulating the banks to make sure they maintained adequate liquid reserves to meet redemption demands and remain solvent. During recessions, the Fed could also lower requirements to allow banks greater flexibility to run their reserves down, at the risk that this may increase banks' financial vulnerability. The Fed does not currently require banks to hold any minimum reserves against their liabilities, but many banks hold large excess reserves with the Fed anyway. However, after the 2007-08 financial crisis, the Fed’s campaign of quantitative easing resulted in banks holding massive ongoing balances of reserves in excess of the required reserve ratio. In part because of this, as of March 2020, the Fed eliminated all reserve requirements for banks. This leaves the Fed no further room to use this tool to loosen credit conditions for the impending recession.

Discount Lending : The Fed can directly loan funds to banks in need through what is called the discount window. Historically, this type of lending was carried out as an emergency bailout loan of last resort for banks out of other options, and came with a hefty interest rate to protect the interests of taxpayers given the risky nature of the loans. However, in recent decades the practice of discount lending by the Fed has shifted toward making these risky loans at much lower interest rates in order to favor the interests of the financial sector as much as possible. It has also rolled out a host of new lending facilities similar to discount lending, targeted at supporting specific sectors of the economy or the prices of specific asset classes. As of March 2020, the Fed dropped its discount rate to a record low 0.25% to give extraordinarily favorable terms to the riskiest of borrowers. It may not be possible to lower this rate any further as the economy slips deeper into economic malaise. With discount lending, the Fed is acting in its function as a lender of last resort for banks.

Expectations Management : Expectations management is also known as forward guidance. Much of the economic research and theory on financial markets and asset prices acknowledge the role that market expectations play in the financial sector and the economy more broadly, and this is not lost on the Fed. Doubt as to whether the Fed will act to bail out banks and keep asset prices inflated can lead to pessimism among investors, banks, and businesses on top of the real problems facing the economy. The Fed is currently deploying its full arsenal of expansionary monetary tools. Now it has to manage expectations about just how big the flood of newly created money will be and how long it will last.

Conclusion : During recessions, the Fed generally seeks to credibly reassure market participants through its actions and public announcements that it will prevent or cushion its member banks and the financial system from suffering too heavy losses, by using the tools discussed above. However, with the fed funds rate, the discount rate, and the required reserve ratio already at or near zero as of March 2020, this credibility appears to critically hinge on the Fed’s ongoing ability to engage in unlimited quantitative easing for the foreseeable future, barring the introduction of new and even more non-standard monetary policy.