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Contents
Page No.
1. Federal Reserve System 2
1.1 Overview 2
1.2 History 2
1.3 Characteristics 4
1.4 Functions 4
1.5 Structure 6
1.6 Objectives 9
2. Monetary Policy 11
2.1 Tools for Influencing Monetary Policy 11
2.2 Monetary Policy in Practice 13
3. Tackling Financial Crisis 15
3.1 The Financial Crisis 15
3.2 Zero Lower Bound 16
3.3 Quantitative Easing 18
3.4 Forward Guidance 19
3.5 The “Exit Strategy”: Normalization of Monetary Policy after QE 21
4. Current Policy Stance 23
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1. FEDERAL RESERVE SYSTEM
1.1 Overview
The Federal Reserve System (FED or is the central banking system of the United States. It was
established in 1913, with the enactment of the Federal Reserve Act. By creating the Federal
Reserve System, Congress intended to eliminate the severe financial crisis that had periodically
swept the nation, especially the sort of financial panic that occurred in 1907. According to this
Act, FED evolved over time into an independent entity to attend to the nation’s credit and
monetary needs without undue influence from political pressure or situation. In keeping its
independence within the government, the system works without appropriations from Congress.
The current structure of the system has three major components established by the original act.
The system consists of a Board of Governors, twelve regional Federal Reserve Banks throughout
the nation and the member banks.
1.2 History
1775-1791: U.S. Currency
To finance the American Revolution, the Continental Congress printed the new nation's first paper
money. Known as "continentals," the fiat money notes were issued in such quantity they led to
inflation, which, though mild at first, rapidly accelerated as the war progressed. Eventually, people
lost faith in the notes, and the phrase "Not worth a continental" came to mean "utterly worthless
1791-1811: First Attempt at Central Banking
At the urging of then Treasury Secretary Alexander Hamilton, Congress established the First Bank
of the United States, headquartered in Philadelphia, in 1791. It was the largest corporation in the
country and was dominated by big banking and money interests..
1816-1836: Second Try
By 1816, the political climate again inclined towards the idea of a central bank. But Andrew
Jackson, elected president in 1828, disapproved of it. His attack on its banker-controlled power
touched a popular nerve with Americans, and when the Second Bank’s charter expired in 1836, it
was not renewed.
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1836-1865: The Free Banking Era
State-chartered banks and unchartered “free banks” took hold during this period, issuing their own
notes, redeemable in gold or specie. Banks also began offering demand deposits to enhance
commerce. In response to a rising volume of check transactions, the New York Clearinghouse
Association was established in 1853 to provide a way for the city’s banks to exchange checks and
settle accounts.
1863: National Banking Act
During the Civil War, the National Banking Act of 1863 was passed, providing for nationally
chartered banks, whose circulating notes had to be backed by U.S. government securities. An
amendment to the act required taxation on state bank notes but not national bank notes, effectively
creating a uniform currency for the nation.
1873-1907: Financial Panics Prevail
Although the National Banking Act of 1863 established some measure of currency stability for
the growing nation, bank runs and financial panics continued to plague the economy. In 1893, a
banking panic triggered the worst depression the United States had ever seen, and the economy
stabilized only after the intervention of financial mogul J.P. Morgan.
1907: A Very Bad Year
In 1907, a bout of speculation on Wall Street ended in failure, triggering a particularly severe
banking panic. J.P. Morgan was again called upon to avert disaster. By this time, most Americans
were calling for reform of the banking system, but the structure of that reform was cause for deep
division among the country’s citizens. Conservatives and powerful “money trusts” in the big
eastern cities were vehemently opposed by “progressives.” But there was a growing consensus
among all Americans that a central banking authority was needed to ensure a healthy banking
system and provide for an elastic currency.
1908-1912: The Stage is Set for Decentralized Central Bank
The Aldrich-Vreeland Act of 1908, passed as an immediate response to the panic of 1907,
provided for emergency currency issue during crises. It also established the national Monetary
Commission to search for a long-term solution to the nation’s banking and financial problems.
1912: Woodrow Wilson as Financial Reformer
Though not personally knowledgeable about banking and financial issues, Woodrow Wilson
solicited expert advice from Virginia Representative Carter Glass, soon to become the chairman
of the House Committee on Banking and Finance, and from the Committee’s expert advisor, H.
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Parker Willis, formerly a professor of economics at Washington and Lee University. Throughout
most of 1912, Glass and Willis labored over a central bank proposal, and by December 1912, they
presented Wilson with what would become, with some modifications, the Federal Reserve Act.
1913: The Federal Reserve System is Born
From December 1912 to December 1913, the Glass-Willis proposal was hotly debated, molded
and reshaped. By December 23, 1913, when President Woodrow Wilson signed the Federal
Reserve Act into law, it stood as a classic example of compromise—a decentralized central bank
that balanced the competing interests of private banks and populist sentiment.
1.3 Characteristics
The U.S Federal Reserve System has several features that distinguish it:
1. Setting apart centralized authority into many divisions.
2. Ownership and control by member banks
3. Optional membership in the Fed of some banks
Federal Reserve System is a decentralized central bank. Its authority is vested in the Board of
Governors and the presidents of twelve Regional Reserve banks (district banks).
FED is also considered to be an independent entity from government because its decisions do not
have to be ratified by the President or anyone else in the executive branch of government. The
System is, however, subject to oversight by the U.S. Congress. It must work within the framework
of the overall objectives of economic and financial policy established by the government. It is
independent, moreover, because it finances its own operation.
FED does not have right to solely approve or disapprove the monetary policy or relevant legal
issues. It must rely on the FOMC and district banks to carry out the banking policies developed at
the national level. Especially, stocks are owned by the bank members, not the Government. In the
U.S only chartered banks, which only satisfy required conditions, are accepted to join the Fed’s
member banks.
1.4 Functions
i. Serving Government
a. Federal Government’s Banker.
The Fed maintains a checking account for the Treasury Department and processes
payments such as social security checks and IRS refunds.
b. Government Securities Auctions
The Fed serves as a financial agent for the Treasury Department and other
government agencies. The Fed sells, transfers, and redeems government securities.
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Also, the Fed handles funds raised from selling T-bills, T-notes, and Treasury
bonds.
c. Issuing Currency
The district Federal Reserve Banks are responsible for issuing paper currency, while
the Department of the Treasury issues coins.
ii. Serving Bank
a. Check Clearings
Check clearings is the process by which banks record whose account gives up
money, and whose account receives money when a customer writes a check.
b. Supervising Lending Practices
To ensure stability in the banking system, the Fed monitors bank reserves
throughout the system.
c. Lender of Last Resort
In case of economic emergency, commercial banks can borrow funds from the
Federal Reserve. The interest rate at which banks can borrow money from the Fed
is called the discount rate
iii. Regulating the Banking System
The Fed generally coordinates all banking regulatory activities.
a. Reserves
Each financial institution that holds deposits for its customers must report daily to
the Fed about its reserves and activities.
The Fed uses these reserves to control how much money is in circulation at any one
time.
b. Bank Examinations
The Federal Reserve examines banks periodically to ensure that each institution is
obeying laws and regulations.
Examiners may also force banks to sell risky investments if their net worth, or total
assets minus total liabilities, falls too
iv. Regulating the Money Supply
The Federal Reserve is best known for its role in regulating the money supply. The Fed
monitors the levels of M1 and M2 and compares these measures of the money supply with
the current demand for money.
a. Stabilizing the Economy
The Fed monitors the supply of and the demand for money in an effort to keep inflation
rates stable.
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1.5 Structure
In establishing the Federal Reserve System, the United States was divided geographically into 12
Districts, each with a separately incorporated Reserve Bank. District boundaries were based on
prevailing trade regions that existed in 1913 and related economic considerations, so they do not
necessarily coincide with state lines.
The structure of the Federal Reserve System is based on five components: the Board of Governors
of the Federal Reserve System, the Federal Open Market Committee, the Federal Reserve Banks,
member banks, and advisory committees.
The Three Key Federal Reserve Entities
i. Board of Governors
The Board of Governors, frequently called the Federal Reserve Board, represents the ultimate
authority of the Federal Reserve System. Located in Washington, D.C., the board consists of seven
members, mostly professional economists, appointed by the President of the United States and
confirmed by the Senate. Governors serve 14-year, staggered terms to ensure stability and
continuity over time. The chairman and vice-chairman are appointed to four-year terms and may
be reappointed subject to term limitations.
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Responsibilities
Providing centralized authority.
Establishing regulations.
Supervising activities of the Federal Reserve Banks.
Overseeing and approves merger applications.
Controlling effectively the discount rate.
Calculating Margin Requirements.
Setting Reserve Requirements
ii. Federal Open Market Committee (FOMC)
The Federal Open Market Committee (FOMC) is the Fed's monetary policy making body. The
voting members of the FOMC are the Board of Governors, the president of the Federal Reserve
Bank of New York and presidents of four other Reserve Banks, who serve on a rotating basis. All
Reserve Bank presidents participate in FOMC policy discussions. The chairman of the Board of
Governors chairs the FOMC. Hence, FOMC is considered as an example of the interdependence
built into the Fed's structure. It combines the expertise of the Board of Governors and the 12
Reserve Banks. Regional input from Reserve Bank directors and advisory groups brings the
private sector perspective to the FOMC and provides grassroots input for monetary policy
decisions.
Responsibilities
Monitor District Economy.
Convey regional economic perspectives to the Board of Governors (Beige Book).
Examine and Supervise banks.
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Lend to banks (Discount Window).
Provide financial services to banks and the U.S. Treasury in the region.
Recommend Discount Rate changes.
Nine Board of Directors representing banks, business, and the public
iii. Federal Reserve Banks
The Reserve Banks, also known as district banks, are nongovernmental organizations, set up
similarly to private corporations, but operated in the public interest. The districts are
headquartered in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St.
Louis, Minneapolis, Kansas City, Dallas, and San Francisco. So far, there are totally 25 Reserve
bank branches.
Responsibilities
Clear checks
Issue new currency
Withdraw damaged currency from circulation
Administer and make discount loans to banks in their districts
Evaluate proposed mergers and applications for banks to expand their activities
Act as liaisons between the business community and the Federal Reserve System amine
bank holding companies and state-chartered member banks
Collect data on local business conditions
Use their staffs of professional economists to research topics related to the conduct of
monetary policy
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1.6 Objectives
The Federal Reserve System was created by the United States Congress in 1913 in order to
provide a safer, more flexible banking and monetary system. Over time, this original function
evolved into the broader economic and financial objectives of facilitating the solidity and growth
of the national economy, maintaining a high level of employment, ensuring stability in the
purchasing power of the dollar, and maintaining reasonable balance in transactions with foreign
countries.
As the nation’s central bank, the Federal Reserve contributes to the realization of these objectives
with its ability to influence money and credit in the economy.
The governing body of the Federal Reserve is its Board of Governors, which is located in
Washington, D.C. The seven members of the Board are appointed to fourteen-year terms by the
President, subject to confirmation by the Senate. The Chairman and Vice-Chairman are selected
from Board members for four-year terms, also by the President with Senate confirmation.
Although appointed, the Board is not a part of the Administration; it is an independent agency of
the federal government, though Congress has the authority to change its powers and duties by
legislation.
The members of the Board are part of the Federal Open Market Committee (FOMC). Other
members of the twelve-seat committee include the president of the Federal Reserve Bank of New
York and four additional Federal Reserve Bank presidents, who serve on a rotating basis. The
FOMC directs the Federal Reserve’s open market operations -- the purchasing and selling of U.S.
Treasury and federal agency securities -- which is the Fed’s principal tool for executing monetary
policy.
The United States is divided into twelve Federal Reserve Districts, each with a district Federal
Reserve Bank and its own president and directors. These banks make recommendations to the
Federal Reserve Board for changes in the discount rate, which is the interest rate that financial
institutions are charged to borrow money from the Reserve. Also, these banks hold the reserve
balances for their depository institutions, make loans to those institutions, supply currency, collect
and clear checks, and handle U.S. government debt and cash balances.
In addition to regulating the supply of reserves in its efforts to influence economic activity, the
Fed, in close cooperation with the U.S. Treasury, also has the function of acting for the
government in foreign exchange markets. The Fed watches international developments, such as
interest rate changes abroad, in order to moderate their effects on the U.S. economy.
The Fed also shares supervisory and regulatory functions with other federal banking agencies. It
supervises state-chartered banks that are members of the Federal Reserve System as well as all
bank holding companies. The Fed also acts as the banker for the federal government, sets margin
requirements for the purchase or carrying of equity securities, and establishes and enforces rules
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which protect consumers in financial operations. Still, the Fed’s most important function is its
control over banking reserves.
Not all banks are members of the Federal Reserve System. National banks chartered by the federal
government must belong to the system; state banks may also be members. Since 1980, however,
all depository institutions (which include commercial banks, savings banks, savings and loans,
credit unions, and foreign-related banking institutions) are required to maintain reserves with the
Federal Reserve System. They may also borrow funds from the Reserve as necessary.
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2. MONETARY POLICY
The term monetary policy refers to the actions that the Federal Reserve undertakes to influence
the amount of money and credit in the U.S. economy. Changes to the amount of money and credit
affect interest rates (the cost of credit) and the performance of the U.S. economy. To state this
concept simply, if the cost of credit is reduced, more people and firms will borrow money and the
economy will heat up.
The goals of monetary policy are to promote maximum employment, stable prices and moderate
long-term interest rates. By implementing effective monetary policy, the Fed can maintain stable
prices, thereby supporting conditions for long-term economic growth and maximum employment.
Goals of Monetary Policy
The goals of monetary policy are amended in the dual mandate in the Federal Reserve Act, and
other legislation indicates goals of policy:
i. Price stability (by maximum purchasing power)
ii. Employment stability ( by maximum employment)
There are two factors to achieve the employment goal. First, low and stable inflation rate retention
maximizes the economy growth rate in order to maximize the sustainable employment. Secondly,
FED can enhance this goal by timely adjustments in its policy stance to adapt the economic
changes.
By implementing effective monetary policy, the Fed can maintain stable prices, thereby
supporting conditions for long-term economic growth and maximum employment.
2.1 Tools for Influencing Monetary Policy
The Fed has three main tools at its disposal to influence monetary policy.
i. Open-Market Operations
The Fed constantly buys and sells U.S. government securities in the financial markets, which in
turn influences the level of reserves in the banking system. These decisions also affect the volume
and the price of credit (interest rates). The term open market means that the Fed doesn't
independently decide which securities dealers it will do business with on a particular day. Rather,
the choice emerges from an open market where the various primary securities dealers compete.
Open market operations are the most frequently employed tool of monetary policy.
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ii. Setting the Discount Rate
This is the interest rate that banks pay on short-term loans from a Federal Reserve Bank. The
discount rate is usually lower than the federal funds rate, although they are closely related. The
discount rate is important because it is a visible announcement of change in the Fed's monetary
policy and it gives the rest of the market insight into the Fed's plans.
iii. Setting Reserve Requirements
This is the amount of physical funds that depository institutions are required to hold in reserve
against deposits in bank accounts. It determines how much money banks can create through loans
and investments. Set by the Board of Governors, the reserve requirement is usually around 10%.
This means that although a bank might hold $10 billion in deposits for all of its customers, the
bank lends most of this money out and, therefore, doesn't have that $10 billion on hand.
Furthermore, it would be too costly to hold $10 billion in coin and bills within the bank. Excess
reserves are, therefore, held either as vault cash or in accounts with the district Federal Reserve
Bank Therefore, the reserve requirements ensure that depository institutions maintain a minimum
amount of physical funds in their reserves.
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2.2 Monetary Policy in Practice
How are monetary policy decisions made? The members of the Board of Governors and the
presidents of the 12 Federal Reserve Banks gather at the Board’s office in Washington, D.C., for
eight regularly scheduled meetings of the FOMC each year to discuss economic and financial
conditions and deliberate on monetary policy. If necessary, FOMC participants may also meet by
video conference at other times. The Federal Reserve Bank of New York carries out the policy
decisions made at FOMC meetings primarily by buying and selling securities as authorized by the
FOMC.
At its meetings, the FOMC considers three key questions: How is the U.S. economy likely to
evolve in the near and medium term, what is the appropriate monetary policy setting to help move
the economy over the medium term to the FOMC’s goals of 2 percent inflation and maximum
employment, and how can the FOMC effectively communicate its expectations for the economy
and its policy decisions to the public?
Keeping Policy in Step with Evolving Economic Conditions
As discussed, the FOMC’s overall approach to its decision making is described in its statement
on its longer-run goals and its strategy for setting monetary policy to achieve them. In practice,
however, selecting policy tools to implement the FOMC’s policy strategy is not clear cut. The
U.S. and global economies are complex and evolving, and changes in monetary policy take time
to affect economic activity, employment, and inflation.
Moreover, monetary policy is just one of the factors determining the pace of domestic economic
activity, employment, and inflation. Accordingly, in making their assessment of how the economy
is likely to evolve in the near and medium term, policymakers take into account a range of other
influences on the economy. Some can readily be built into economic forecasts. For example,
federal, state, and local tax and spending policies have important and relatively predictable effects
on household and business spending and are typically budgeted in advance. Even so, the range of
uncertainty about the effects of some predictable factors may be wide.
And, of course, some economic developments—such as shifts in consumer and business
confidence, changes in the terms under which banks extend loans, or disruptions to oil or
agricultural supplies—can occur suddenly and with little warning. Finally, the actions of other
central banks and fiscal authorities abroad also play a role through the effects on international
trade and global financial flows and exchange rates.
How the FOMC Determines Its Monetary Policy Stance
FOMC policymakers use a broad range of information to assess trends in the U.S. economy and
to judge the appropriate stance of monetary policy. They analyze the most up-to-date economic
data and review reports and surveys from business and financial market contacts. In addition, they
use various tools for forecasting economic developments and evaluating the effects of monetary
policy decisions. Statistical models can help analyze how changes in economic conditions may
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affect the outlook for economic activity, employment, and inflation, and how the level of the target
federal funds rate might respond to those changes. Simulations of these models, including results
using a variety of policy rules that relate the setting of the target federal funds rate to the objectives
of monetary policy, can provide some indication of how monetary policy is likely to affect the
economy over the longer run.
Because policy actions take time to affect the economy and inflation, policymakers may assess
the effects of their policies by looking at various indicators that are likely to respond more quickly
to changes in the federal funds rate. Over the years, policymakers have at times monitored
indicators such as the monetary aggregates (measures of the stock of money), changes in Treasury
yields and private-sector interest rates and the levels of those rates for securities that mature at
different times in the future, and exchange rates. Importantly, to be valuable to policymakers,
these and other possible policy guides must have a close, predictable relationship with the ultimate
goals of monetary policy, but this has not always been the case.
Forward Guidance Signals the FOMC’s Policy Intentions
In addition to adjusting the target for the federal funds rate, the FOMC also can influence financial
conditions by communicating how it intends to adjust policy in the future. Since March 2009,
when the federal funds rate was effectively at its lower bound, this form of communication, called
“forward guidance,” has been an important signal to the public of the FOMC’s policy intentions.
For example, when the FOMC said in its March 2009 post meeting statement that it intended to
keep the target for the federal funds rate “exceptionally low” for “an extended period,” its goal
was to cause financial market participants to adjust their expectations to assume a longer period
of lower short-term interest rates than they had previously expected and, thus, put downward
pressure on long-term interest rates to provide more support for the economic recovery.
Between 2009 and 2014, the FOMC revised its forward guidance several times, strengthening its
intent to put downward pressure on interest rates when the economy appeared to be operating at
a lower level than desirable and, more recently, revising it to clarify how, when the time was
appropriate, the Committee would make the decision to raise the target federal funds rate.
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3. TACKLING FINANCIAL CRISIS
3.1 The Financial Crisis
In near the end of 2007, the great financial crisis exploded in US, and rapidly affected most of the
global economy. In an interconnected world, a seeming liquidity crisis can very quickly turn into
a solvency crisis for financial institutions, a balance of payment crisis for sovereign countries and
a full-blown crisis of confidence for the entire world
Indeed, this explosion related to the Housing Market Bubbles Pop, which has not been subject to
pricing “bubbles” as the other assets market. Most of people, investing in real estate, have never
thought about price declining of their house as the enormous amount of money they have to pay
to the transaction cost of purchasing, legal fees of owning and maintaining costs for house blurred
their analytical and assessing vision. However, theoretically, the price of housing, like the price
of any good or service in a free market, is driven by supply and demand. When demand increases
and/or supply decreases, prices go up. So, if there is a sudden or prolonged increase in demand,
prices are sure to rise.
The policy to keep away from the recession in 2001 was a wrong decision. According to this, the
federal funds rate was lowered 11 times from 6.5% in 5/2001 to 1.75% in 12/2001. This action
which created the flood of liquidity in the economy made money cheaper. As result, it was easy
to become an attractive pitfall, which caused damage to the restless bankers and borrowers. This
environment of easy credit and the upward spiral of home prices made investments in higher
yielding subprime mortgages look like a new rush for gold. In 6/ 2003, interest rates continued
downing 1%, the lowest rate in 45 years. The whole financial market resembled this rate.
But, every good item has a bad side, and several of these factors started to emerge alongside one
another. The trouble started when the interest rates started rising and home ownership reached a
saturation point.6/ 2004, onward, the Fed raised rates so much that by 6/2006, the Federal funds
rate had reached 5.25%.
Decline Begins
There were early signs of distress: by 2004, U.S. homeownership had peaked at 70%; no one was
interested in buying houses. Then, during the last quarter of 2005, home prices started to fall,
which led to a 40% decline in the U.S. Home Construction Index during 2006. This caused 2007
to start with bad news from multiple sources. Every month, one subprime lender or another was
filing for bankruptcy. During February and March 2007, more than 25 subprime lenders filed for
bankruptcy, which was enough to start the tide. In April, well-known New Century Financial also
filed for bankruptcy.
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Investments and the Public
Problems in the subprime market began hitting the news, raising more people's curiosity. Horror
stories started to leak out. According to 2007 news reports, financial firms and hedge funds owned
more than $1 trillion in securities backed by these now-failing subprime mortgages - enough to
start a global financial tsunami if more subprime borrowers started defaulting. By June, Bear
Stearns stopped redemptions in two of its hedge funds and Merrill Lynch seized $800 million in
assets from two Bear Stearns hedge funds. But even this large move was only a small affair in
comparison to what was to happen in the months ahead.
August 2007: The Landslide Begins
The financial market could not solve the subprime crisis on its own and the problems spread
beyond the United States borders. The interbank market froze completely, largely due to
prevailing fear of the unknown amidst banks. By that time, central banks and governments around
the world had started coming together to prevent further financial catastrophe. It became apparent
in August 2007 that the financial market could not solve the subprime crisis on its own and the
problems spread beyond the United State's borders.
In the national financial crisis, from 2007 to 2009, the Fed announced many plans/ strategies to
try to push long-term interest rates down. This was achieved mainly by three unconventional
strategies implemented by Fed such as:
1. Zero Lower Bound
2. Quantitative Easing
3. Forward Guidance
3.2 Zero Lower Bound
The bursting of the housing bubble led to the onset of a financial crisis that affected both
depository institutions and other segments of the financial sector involved with housing finance.
As the delinquency rates on home mortgages rose to record numbers, financial firms exposed to
the mortgage market suffered capital losses and lost access to liquidity. The contagious nature of
this development was soon obvious as other types of loans and credit became adversely affected.
This, in turn, spilled over into the broader economy, as the lack of credit soon had a negative effect
on both production and aggregate demand. In December 2007, the economy entered a recession.
As the housing slump’s spillover effects to the financial system, as well as its international scope,
became apparent, the Fed responded by reducing the federal funds target and the discount rate.
Beginning on September 18, 2007, and ending on December 16, 2008, the federal funds target
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was reduced from 5.25% to a range between 0% and 0.25%, where it remained until December
2015. Economists call this the zero lower bound to signify that once the federal funds rate is
lowered to zero, conventional open market operations cannot be used to provide further stimulus.
The decision to maintain a target interest rate near zero is unprecedented. First, short-term interest
rates have never before been reduced to zero in the history of the Federal Reserve. Second, the
Fed has waited much longer than usual to begin tightening monetary policy in this recovery. For
example, in the previous two expansions, the Fed began raising rates less than three years after
the preceding recession ended.
With liquidity problems persisting as the federal funds rate was reduced, it appeared that the
traditional transmission mechanism linking monetary policy to activity in the broader economy
was not working. Monetary authorities became concerned that the liquidity provided to the
banking system was not reaching other parts of the financial system. Using only traditional
monetary policy tools, additional monetary stimulus cannot be provided once the federal funds
rate has reached its zero bound. To circumvent this problem, the Fed decided to use nontraditional
methods to provide additional monetary policy stimulus.
First, the Federal Reserve introduced a number of emergency credit facilities to provide increased
liquidity directly to financial firms and markets. The first facility was introduced in December
2007, and several were added after the worsening of the crisis in September 2008. These facilities
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were designed to fill perceived gaps between open market operations and the discount window,
and most of them were designed to provide short-term loans backed by collateral that exceeded
the value of the loan. A number of the recipients were nonbanks that are outside the regulatory
umbrella of the Federal Reserve; this marked the first time that the Fed had lent to nonbanks since
the Great Depression. The Fed authorized these actions under Section 13(3) of the Federal Reserve
Act, a seldom-used emergency provision that allows it to extend credit to non-bank financial
institutions and to nonfinancial firms as well.
The Fed provided assistance through liquidity facilities, which included both the traditional
discount window and the newly created emergency facilities mentioned above, and through direct
support to prevent the failure of two specific institutions, American International Group (AIG)
and Bear Stearns. The amount of assistance provided was an order of magnitude larger than
normal Fed lending. Total assistance from the Federal Reserve at the beginning of August 2007
was approximately $234 million provided through liquidity facilities, with no direct support given.
In mid-December 2008, this number reached a high of $1.6 trillion, with a near-high of $108
billion given in direct support. From that point on, it fell steadily. Assistance provided through
liquidity facilities fell below $100 billion in February 2010, when many facilities were allowed to
expire, and support to specific institutions fell below $100 billion in January 2011. The last loan
from the crisis was repaid on October 29, 2014. Central bank liquidity swaps (temporary currency
exchanges between the Fed and central foreign banks) are the only facility created during the crisis
still active, but they have not been used on a large scale since 2012. All assistance through expired
facilities has been fully repaid with interest. In 2010, the Dodd-Frank Act changed Section 13(3)
to rule out direct support to specific institutions in the future.
With the federal funds rate at its zero bound since December 2008 and direct lending falling as
financial conditions began to normalize in 2009, the Fed faced the decision of whether to try to
provide additional monetary stimulus through unconventional measures. It did so through two
unconventional tools—large-scale asset purchases (quantitative easing) and forward guidance.
3.3 Quantitative Easing
With short-term rates constrained by the zero bound, the Fed hoped to reduce long-term rates
through large-scale asset purchases, which were popularly referred to as quantitative easing (QE).
Between 2009 and 2014, the Fed undertook three rounds of QE, buying U.S. Treasury securities,
agency debt, and agency mortgage-backed securities (MBS). These securities now comprise most
of the assets on the Fed’s balance sheet.
This increase in the Fed’s assets must be matched by a corresponding increase in the liabilities on
its balance sheet. The Fed’s liabilities mostly take the form of currency, bank reserves, and cash
deposited by the U.S. Treasury at the Fed. QE has mainly resulted in an increase in bank reserves,
from about $46 billion in August 2008 to $820 billion at the end of 2008. Since October 2009,
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bank reserves have exceeded $1 trillion, and they have been between $2.5 trillion and $2.8 trillion
since 2014. The increase in bank reserves can be seen as the inevitable outcome of the increase in
assets held by the Fed because the bank reserves, in effect, financed the Fed’s asset purchases and
loan programs. Reserves increase because when the Fed makes loans or purchases assets, it credits
the proceeds to the recipients’ reserve accounts at the Fed.
The intended purpose of QE was to put downward pressure on long-term interest rates. Purchasing
long-term Treasury securities and MBS should directly reduce the rates on those securities, all
else equal. The hope is that a reduction in those rates feeds through to private borrowing rates
throughout the economy, stimulating spending on interest-sensitive consumer durables, housing,
and business investment in plant and equipment. Determining whether QE has reduced rates more
broadly and stimulated interest sensitive spending requires controlling of other factors, such as
the weak economy, which tends to reduce both rates and interest-sensitive spending.
The increase in the Fed’s balance sheet has the potential to be inflationary because bank reserves
are a component of the portion of the money supply controlled by the Fed (called the monetary
base), which has grown at an unprecedented pace during QE. In practice, overall measures of the
money supply have not grown as quickly as the monetary base, and inflation has remained below
the Fed’s goal of 2% for most of the time since 2008. The growth in the monetary base has not
translated into higher inflation because bank reserves have mostly remained deposited at the Fed
and have not led to increased lending or asset purchases by banks.
3.4 Forward Guidance
Another tool the Fed introduced to achieve additional monetary stimulus at the zero bound was a
pledge to keep the federal funds rate low for an extended period of time, which has been called
forward guidance or forward commitment. The Fed believes this would stimulate economic
activity because businesses, for example, will be more likely to take on long-term investment
commitments if they are confident rates will be low over the life of a loan. Over time, this forward
guidance became more detailed and explicit. In August 2011, the Fed set a date for how long it
expected to maintain “exceptionally low levels for the federal funds rate.” In December 2012, the
2007-2008 FINANCIAL
CRISIS
QE-1
(Nov. 25, 2008)
END OF QE-1
(March 31, 2010)
QE-2
(Nov. 3, 2010)
END OF QE-2
(June 30, 2011)
21. 20
Fed replaced the date threshold with an economic threshold: it pledged to maintain an
“exceptionally low” federal funds target at least as long as unemployment is above 6.5% and
inflation is low.
It is difficult to pinpoint how effective the forward guidance tool has been, in part because its
efficacy depends on how credible market participants find the commitment. Because economic
conditions may unexpectedly change, this commitment is only a contingent one, causing the Fed’s
commitment to change when conditions change. This occurred in 2013-2014, when the
unemployment rate fell unexpectedly rapidly without a commensurate improvement in broader
labor market or economic conditions. Had the Fed followed its existing forward guidance, the fall
in the unemployment rate would have led to a tightening of policy sooner than intended. Instead,
as the unemployment rate neared 6.5% in March 2014, the Fed replaced the specific
unemployment threshold in its forward guidance with a vaguer statement—“The Committee
currently anticipates that, even after employment and inflation are near mandate-consistent levels,
economic conditions may, for some time, warrant keeping the target federal funds rate below
levels the Committee views as normal in the longer run.” Less specific statements provide less
clarity to market participants about the path of future rates, but future policy is less likely to need
to deviate from them.
The Fed’s forward guidance has signaled a more aggressively stimulative policy stance than the
Fed has taken in the past. Typically, the Fed keeps interest rates below normal when the economy
is operating below full employment, at normal levels when the economy is near full employment,
and above normal when the economy is overheating. Because of lags between changes in interest
rates and their economic effects, the Fed often will preemptively change its monetary policy stance
before the economy reaches the state that the Fed is anticipating. By contrast, in this case, the Fed
has pledged to keep interest rates below normal even after the economy is approaching full
employment. Normally, such a stance would risk resulting in high inflation. In this case, the Fed
views low inflation as a greater risk than high inflation.
3.5 The “Exit Strategy”: Normalization of Monetary Policy after QE
On October 29, 2014, the Fed announced that it would stop making large-scale asset purchases at
the end of the month. Now that QE is completed, attention has turned to the Fed’s “exit strategy”
from QE and zero interest rates. The Fed laid out its plans to normalize monetary policy in a
statement in September 2014. It plans to continue implementing monetary policy by targeting the
federal funds rate. The basic challenge to doing so is that the Fed cannot effectively alter the
federal funds rate by altering reserve levels (as it did before the crisis) because QE has flooded
the market with excess bank reserves. In other words, in the presence of more than $2 trillion in
bank reserves, the market-clearing federal funds rate is close to zero even if the Fed would like it
to be higher.
22. 21
The most straightforward way to return to normal monetary policy would be to remove those
excess reserves by shrinking the balance sheet through asset sales. In its normalization statement,
the Fed ruled out MBS sales and indicated that it does not intend to sell Treasury securities in the
near term. Instead, it eventually plans gradual reductions in the balance sheet by ceasing to roll
over securities as they mature. However, the Fed continued rolling over maturing securities after
it began raising the federal funds rate. The Fed intends to ultimately reduce the balance sheet until
it holds “no more securities than necessary to implement monetary policy efficiently,” which Fed
stated might not occur until the end of the decade. At that point, it plans to hold primarily Treasury
securities.
As a result of QE, the Fed has become a major holder of Treasuries and MBS. At the end of the
third quarter of 2016, the Fed held 21% of outstanding agency- or GSE-backed securities and 18%
of marketable Treasury securities. Thus, rapid asset sales could cause volatility in those markets,
but modest and gradual sales likely would not pose that risk.
Instead of selling securities, the Fed has increased market interest rates by raising the rate it pays
banks on reserves held at the Fed and using large-scale reverse repos to alter repo rates. The Fed
has raised the federal funds rate by manipulating these two rates that are close substitutes.
Reverse repos are another tool for draining liquidity from the system and influencing short-term
market rates. They drain liquidity from the financial system because cash is transferred from
market participants to the Fed. As a result, interest rates in the repo market, one of the largest
short-term lending markets, rise. The Fed has long conducted open market operations through the
repo market, but since 2013 it has engaged in a much larger volume of reverse repos with a broader
range of nonbank counterparties, including the government-sponsored enterprises and certain
money market funds. The Fed’s normalization statement indicated that reverse repos will be
limited in size-although it has lifted the cap at times-and phased out after normalization is
completed.
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4. CURRENT POLICY STANCE
In December 2008, in the midst of the financial crisis and the “Great Recession,” the Fed lowered
the federal funds rate to a range of 0% to 0.25%. This was the first time rates were ever lowered
to what is referred to as the zero lower bound. They remained there until the Fed began raising
rates on December 16, 2015, the first step in a series to incrementally tighten monetary policy.
When the Fed raises rates, it usually increases them by 0.25 or 0.5 percentage points at a time.
Although monetary policy is now less stimulative than it had been at the zero lower bound, the
Fed is still adding stimulus to the economy as long as rates are below what economists call the
“neutral rate” (or the long-run equilibrium rate). The Fed’s forward guidance on its expectations
for future rates is that the Fed intends to keep “accommodative” policy in place for some time—
it currently “expects that economic conditions will evolve in a manner that will warrant only
gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time,
below levels that are expected to prevail in the longer run.” The Fed describes this path as “data
dependent,” meaning it would be altered if actual employment or inflation deviate from its
forecast.
As the economic recovery consistently proved weaker than expected, the Fed repeatedly pushed
back the timeframe for raising interest rates. As a result, the economic expansion was in its seventh
year and the unemployment rate was already near the Fed’s estimate of full employment when it
began raising rates. This was a departure from past practice—in the previous two economic
expansions, the Fed began raising rates within three years of the preceding recession ending.
The Fed’s unprecedentedly stimulative policy stance has been controversial. Because the recent
recession was unusually severe, economists disagree about both how much slack remains in the
economy today and how quickly the Fed should remove monetary stimulus.
Choosing a policy path that is consistent with the Fed’s dual mandate depends on an accurate
assessment of how close the economy is to full employment and how quickly inflation will return
to the Fed’s goal of 2%. The economy has made more progress toward achieving the maximum
employment part of the mandate than the price stability part. The unemployment rate—which has
not been above 5.0% since 2015—fell to within the Fed’s estimated range of full employment in
2016. Other labor market measures indicate that an employment gap remains, although they have
also been improving steadily. The Fed’s preferred measure of inflation has been slightly below its
2% goal since 2013 (or 2012, with no upward trend, if food and energy prices are omitted).
Economic growth has been persistently low by historical standards during the economic
expansion. If this weakness is cyclical (i.e., held back by weak spending), then monetary stimulus
could help boost growth. Alternatively, if the weakness is structural (i.e., the economy is not
capable of growing faster), monetary stimulus would be more likely to result in economic
overheating.
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The Fed’s intended policy path poses upward and downward risks. If the Fed raises rates too
slowly, the economy could overheat, resulting in high inflation and posing risk to financial
instability. As an example of how overly stimulative monetary policy can lead to the latter, critics
contend that low interest rates during the economic recovery starting in 2001 contributed to the
housing bubble. Critics see these risks as outweighing any marginal benefit associated with
monetary stimulus when the economy is already so close to full employment. Alternatively, if the
Fed raises rates too quickly, it could prematurely cut off the economic recovery.
As December 2015 marked the first time that the Fed raised rates since 2008, it also marked the
first time in recent years that U.S. short-term interest rates were rising relative to other countries.
Economy theory predicts that this relative difference in rates will attract capital flows into the
United States, thereby pushing up the exchange rate value of the dollar. In fact, the value of the
dollar has been rising in real terms since mid-2014. A stronger dollar reduces aggregate demand
(total spending) by reducing demand for exports and import-competing goods, all else equal.
Another legacy of the financial crisis is the Fed’s large balance sheet. Because the Fed could not
provide any further stimulus through conventional policy at the zero lower bound, it turned to
unconventional policy to provide further stimulus to the economy. The Fed attempted to stimulate
the economy through three rounds of large-scale asset purchases of U.S. Treasury securities,
agency debt, and agency mortgage-backed securities (MBS) beginning in 2009, popularly referred
to as quantitative easing (QE). The third round was completed in October 2014, at which point
the Fed’s balance sheet was $4.5 trillion—five times its pre-crisis size. The end of QE was the
first step to normalize monetary policy. Instead of normalizing monetary policy by selling its
assets to reduce its balance sheet, the Fed has raised rates while maintaining the balance sheet at
its current size for the time being. This has been made possible through increases in the interest
rate the Fed pays banks on the reserves deposited at the Fed and reverse repurchase agreements
(reverse repos).
