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A Look Into the Monetary Policies During the Great Recession and the Great Depression - Part 12


5.5 Monetary Policy During the Great Recession

The monetary policy and the federal government combined together had a big impact on the economic recession and its subsequent recovery.

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During the five years before the Great Recession officially began, there was significant shifts in the monetary and fiscal policy of the Fed. From 2003 to 2005, the Fed kept interest rates low when compared to the previous decades. The monetary policy that was prevalent during the 1980s and 1990s was based on the Taylor rule , according to which the federal funds rate was set at a certain level. This rule states that the fed funds rate should be set at one plus 1.5 times the inflation rate plus 0.5 times the output gap. This rule offers many advantages as it describes how policymaker should respond to changes in the economic environment. Moreover, it helps policymakers to commit to an established inflation objective over the long-term by explaining the rationale of their decisions to the American public. For these reasons, the Taylor rule was seen as the line to which the Fed had adhered to in the 1980s and 1990s.

However, during the early part of 2000s, the Fed deviated from this rule and kept the federal funds rate lower than the levels recommended by Taylor. For example, the federal funds rate was at one percent when the inflation was only two percent, and the economy was working close to normal. According to Taylor's rule, this rate should have been 4.5 percent. These rates were low when compared to the previous decade. In 1997, for example, the federal funds rate was 5.5 percent when the inflation was the same two percent, and the economy was also at similar levels. This was more in tune with Taylor's rule. These examples go to show the shift in policy that the Fed adopted during the beginning part of 2000s.

There was no explicit reason for this change in policy, but past history as well as several theories such as the Lucas critique, point out that such deviations would have adverse impact on the environment. Robert Lucas argues that it is not right to predict any change in economic policy based on past historical data. In other words, he contends that it is not right for the Fed to change its policy because of past historical aggregated data. Instead, deep parameters should be used to analyze the situation before doing any conclusive policy change (Lucas, 1976).

These theories were, unfortunately, right in this case. These rates that were kept artificially low by the Fed led to the housing boom that ensued during early 2000s.

The demand for housing and the ability of people to afford the same depends primarily on the rates offered on long-term mortgages. These rates can be kept down by low short term interest rate because the short term interest rates have an impact on the adjustable rate mortgage (ARM).. When the Fed kept the interest rates low, the ARM rates also fell, and this enticed more people to buy homes. In fact, statistics showed that number of people opting for ARM doubled during the same period. All these factors led to an increase in the demand for houses. When the demand increased, the prices of houses increased manifold. The housing price inflation rose from seven percent to 14 percent between 2003 to 2005.

This boom in the housing market when the rates were low have occurred in the US and other countries in the past. In Europe, for example, the European Central Bank kept the interest rates low for Greece, Ireland and Spain. As a result of these low rates, the housing markets started having a boom. Similarly, the US too had a boom in the housing market due to the low interest rates. Furthermore, these interest rates also increased risk taking, and many people began to take big risks in their professional and personal life. They bought bigger houses than they could afford, and these measures added to the growing problem.

These haphazard monetary policies continued even after the housing market crashed and the recession began. The discrete nature of these policies is best seen by analyzing the reserve balances that commercial banks kept with the Federal Reserve Bank, which in other words, is the amount of liquidity that the Fed provided for the commercial banks within the US economy.  To provide a greater degree of liquidity for banks, the Fed played as the lender of the last resort.

However, the difference is that these liquidity measures were not temporary. Rather, the Fed continued to pump in liquidity almost throughout the period of recession. It began an expansion of liquidity at an unprecedented scale to finance its quantitative easing programs such as the purchase of mortgage-based securities and long-term treasury bonds. In fact, the magnitude at which the Fed brought in liquidity is at massive scales, not seen before!

However, many economists and researchers believe that it was these efforts that prevented the economy from plunging into another depression. The US government and the Fed responded to the financial crisis with a slew of measures and programs that included some of the most aggressive fiscal and monetary policies in US history. The official response to the economic crisis was multifacted, and involved both the US government and the Fed. However, many of these policies continue to be controversial, with one segment of the society calling it misguided and ineffective. This debate is important because the US economy continues to be weak and fragile, so there is always a question of whether these policies are improving or harming the economy. Consequently, the support of the government and the Fed may have to continue or not.

The Fed took many measures to contain the Great Recession, and they are:

  • Lowering of the Fed Funds rate
  • Credit facilities for distressed financial institutions
  • Purchasing of security bonds and MBS
  • TARP
  • Quantitative Easing

These measures were taken both by the Fed and the US federal government as a response to the Great Recession. When many financial institutions were failing,the Fed decided it was time to intervene and worked with the US government to stabilize the situation.

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These measures were started with two basic goals, and they were to stabilize the financial system and to mitigate the recession, with the ultimate aim to restart growth. The first goal was necessitated by the financial crisis that began in 2007, and which later precipitated into an economic panic in 2008. Due to this panic, liquidity vanished from the economy, credit became difficult to obtain, and many major financial institutions began to fail. The second goal was necessitated as a result of the first one. To prevent further downfall, the Fed had to intervene with the right measures.

With these two goals, the Fed established many credit facilities to improve the liquidity condition within the economy. In 2008, it lowered the Fed funds rate aggressively to near zero percent. Other than these credit facilities and lowered interest rates, the Fed also took massive steps towards quantitative easing in 2009, and even in the early part of 2010 by purchasing Treasury bonds. For the same reason, it bought the mortgage backed securities (MBS) of Freddie Mac and Fannie Mae with an idea to reduce the long-term interest rates. In September 2012, the Fed began a third round of buying Treasury securities and MBS, though this time the Fed gave no timeline of how long this buying will continue. By December 2013, this buying tapered off and in January 2014, the Fed announced that it would purchase about $30 billion of MBS and $35 billion of Treasuries per month as a way to continue to stimulate the economy (Labonte, 2014).

While the Fed worked on one side to provide high levels of liquidity within the market, it also worked on the other side to boost investor confidence. It worked with FDIC by increasing deposit insurance limits and by guaranteeing bank debt to make investors feel confident about their deposits with banks. This move was taken to prevent investors from withdrawing money from the bank, similar to the situation that took place during the Great Depression. Due to this increased insurance and guarantees, investors did not panic, and this gave financial institutions some breathing time to recover from their problems.

Another unique aspect of the measures taken by the Fed was that it worked in tandem with the US Congress. In many ways, the Fed and the US Congress worked together in unison to mitigate the Great Recession, and to prevent it from becoming another depression. The US Congress began with the establishment of the Troubled Asset Relief Program (TARP) in October 2008. A part of this program was used by the US Treasury to increase the level of liquidity within banks. In the spring of 2009, the Federal Reserve and the US Treasury ordered 19 of the largest financial institutions in the US to conduct a stress test to determine if they had the necessary capital and liquidity in the event of an adverse situation. Based on these results, banks were given additional funds if they failed the stress test or if the test showed that they had dangerously low levels of liquidity to meet any adverse financial situation. Furthermore, this stress test was made public to boost the confidence that people had in financial institutions.

This program was also surrounded by much controversy since it was introduced, because of the amount of money involved and its objectives. The program had a funding of a whopping $700 billion, and this massive amount spurred controversy about its intended use, and its very need, in the first place. The government defended this plan saying that it was essential to put the economy back in shape. One area that created controversy is the goal of bailing out financial institutions. The argument against this action was that it was the greed of the financial sector that created this recession. The creation of complex mortgage-based products, they believed, precipitated the crisis. Therefore, bailing out these very institutions that caused the crisis felt unacceptable to some sections of the society. Even today, many economists, legislators and the public at large believe that TARP was a costly failure that could have been avoided, because they contend that it had little impact on the economy. However, numbers prove otherwise. While the big banks have repaid their loans, the progam is expected to lose roughly anywhere between $32 billion and $70 billion (Task, 2012).

“TARP has been a substantial success, helping to restore stability to the financial system and to end the free fall in housing and auto markets. Its ultimate cost to tax payers will be only a small fraction of the headline $700 billion figure: A number well below the $100 billion mark seems more likely, with the bank bailout component probably turning a profit” (Blinder and Zandi, 2011, p.2).

Therefore, the TARP program was successful is maintaining stability in the economy, despite the controversy that surrounded it.

Along with these monetary measures, some fiscal stimulus measures were also implemented. The US government provided tax rebates to consumers to help increase the amount of cash they had on hand. This move was intended to increase the available disposable cash that in turn, would boost the demand for goods and services. As a result, the government believed that companies would not be forced to reduce their operations, and the unemployment levels will halt. With this idea in mind, tax rebate checks were mailed to middle and low-income families in the spring of 2008. Moreover, the American Recovery and Reinvestment Act (ARRA) was passed in 2009, and other smaller packages were passed in 2009 and 2010. All these measures amounted to almost $1 trillion, or seven percent of the US GDP.

At the time of introduction, the ARRA was heavily criticized by some groups because of its high price tag. They argued that such heavy fiscal deficit will affect the future generations of Americans, some of who would probably had not even lived during this crisis. They contended that this heavy fiscal deficit would have to be equalized with high taxation rates that would be borne by the future generation of Americans. Other criticisms of this Act have been the slow recovery of the economy, and the fact that it had no effect on the unemployment rate. In fact, statistics did show that the unemployment went up after the Act was passed, and it was much higher than the rates predicted by the government in January 2009.

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Critics who argue against the ARRA contend that the program did not bring down the unemployment rate below eight percent. However, even before the ARRA was introduced, the unemployment rates were well above eight percent, and many private companies including such giant as Moody's had completely misjudged the severity of the downturn. Due to these factors, it can be argued that the ARRA was successful in curbing the recession and helping the economy on the road to recovery, even though it did not bring the unemployment rate below the projected eight percent.

Besides these major programs that were aimed at restoring the financial sector, other relatively minor ones were also undertaken. As a part of these measures, the Fed and the US government embarked on a mission of saving other industries besides the financial sector that were affected during this economic downturn. During the Great Recession, the housing and auto industries of the US suffered a massive setback too. The housing market suffered a bubble because of the financial crisis, as it started a vicious circle comprising of falling prices and foreclosures. To break this cycle, the Fed introduced an array of actions that were aimed at reducing the mortgage rates, increasing conforming loan limits, and more importantly, expanding the role of the Federal Housing Agency (FHA) in lending and offering guarantee to loans. Along with these measures, a series of credits were offered to homeowners to prevent them from foreclosing their homes.

Now that the measures taken by the Fed are discussed, the next section will quantify the economic impact of these measures.

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