POLICY

Policy



Main Features of Monetary Policy

The macroeconomic policy response to this recession was unprecedented in its size and scope. Monetary policy in 2008, under Chairman Bernanke, was the most expansionary since World War II (WWII). The Fed's emphasis remained on the stability of the banking sector and to a lesser extent on inflationary concerns as total spending in the economy declined. As with Japan during the 1990s, concern was expressed over the appearance of deflation further reducing Fed worries over inflation.

Traditionally, monetary policy is first seen as the Federal Reserve Board, acting through the Federal Open Market Committee (FOMC), altering credit conditions in the economy using open-market operations. Predictably, following 9/11 and the 2001 recession, the Fed lowered the Fed funds rate to 1% by mid-2003. Alan Greenspan, Fed chairman, made clear his policy goal was overall stimulus of the economy. However, 30-year fixed rate mortgage rates, which had been 8% in 2000, fell below 6% during the same period. Therefore, further stimulus was given to the U.S. housing market, whose growth appeared to be feeding on itself. By mid-2006, monetary restraint had pushed the Fed funds rate back to 5.25%. Against this background, Greenspan was criticized for following traditional easy, monetary policy in a weak economy that nonetheless was experiencing a residential and commercial real estate boom.

When the housing price bubble began to lose air in 2005 and 2006, the Fed began to take new and dramatic action. In December 2007, new Fed Chairman Ben Bernanke created the Term Auction Facility (TAF), the first of seven entirely new lending operations that would provide liquidity (money) to a variety of financial institutions and markets that had stopped working efficiently. Lenders had decided significantly to reduce traditional lending as the “credit crunch” spread. There was no longer any market for MBS or other high-risk alternatives. The Fed even allowed short-term borrowing by financial institutions that were able to use some higher grade MBS as collateral and finally agreed to purchase some MBS itself. All through 2008, the Fed kept creating new auctions and programs of providing credit to the economy. The Fed also pursued traditional easy monetary programs. At the end of 2007, the Fed funds rate was 4.25%. By the end of 2008, it was 0% (officially a range of 0% to 0.25%). The immediate question this zero-interest rate policy posed was had the United States run out of monetary policy options just as they NBER announced a recession had started in December 2007. Certainly fiscal policy could be used to stimulate spending, but had monetary policy run aground?

While the Fed was lowering the nominal Fed funds rate to zero, it simultaneously pursued a program of “quantitative” monetary ease. The Fed accomplished this in two ways. The first was a continuation of traditional monetary expansion. The monetary base doubled in 2008, increasing from $855 billion in December 2007 to over $1,728 billion by December 2008. This expansion was not needed to lower the Fed funds rate to zero; rather, ...