Monetary Policy During the Recession of 2007-2009
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Fed Chairman Ben Bernanke is a student of the Great Depression; many commentators (notably Milton Friedman and Anna Schwartz in A Monetary History of the United States, 1867-1960) believe that the Depression was longer than it would have been had the Fed adopted a more aggressive policy. As the real estate bubble began to unwind there were problems in the credit market and the collapse of Wall Street institutions such as Bear Stearns and Lehman Brothers that led the Fed to act aggressively to not repeat the mistakes of the 1930s.
The time line of the current crisis in financial markets can be dated from the first problems at the Bear Stearns hedge fund in June and July 2007; economic growth slowed and the recession officially started in December 2007. In March 2008 Bear Stearns collapsed and then Lehman followed in September 2008.
There are several ways to think about the Fed’s actions. The primary tool that the Fed used early during the current crisis was to cut the Federal Funds rate. The Fed had raised rates to 5.25% in June 2006 and rates remained at that level until the first rate cut (to 4.75%) in September 2007 (see here for the history of Federal Funds rate changes). The Fed continued to cut rates six more times until rates were at 2% in April 2008. The Fed then paused until the Lehman crisis and then cut rates twice in October 2008 and once again in December 2008 when rates reached the current target range between 0% to 0.25%.
Initially the Fed relied on rate cuts to heal the damage in the financial markets; but by late 2008 it became clear that financial markets were not responding rapidly to the rate cuts and so the Fed took further measures. On December 16 the Fed announced:
The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.
Under normal circumstances the Fed conducts open market operations by buying and selling short-term Treasury instruments (for a bit more detail, see here), but in December 2008 they widened the range of securities to include agency and mortgage-backed bonds (bonds issued by institutions such as Fannie Mae and Freddie Mac—see here for a brief explanation—that buy mortgages from banks, put them together in a package and then resell the package to investors). The Fed’s goal in buying this paper was to improve conditions in the mortgage market. The mechanism is as follows: Fannie and Freddie buy mortgages from banks and resell them to investors; the higher the price that investors are willing to pay, the lower the rate that a person taking out a mortgage will have to pay. If buyers are reluctant to buy Fannie and Freddie paper than people who want to get mortgages will pay higher rates; but if the Fed aggressively buys this paper, then mortgage rates will come down. So the Fed was trying to lower mortgage rates through its actions.
On March 18, the Fed provided more specific information about its actions:
To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.
The mechanism by which purchasing longer-term Treasuries might improve conditions in private credit markets is that the Fed will increase the price and lower the yield on Treasury bonds. If investors are deciding whether to buy corporate bonds or Treasury bonds, the Fed’s action will make the corporate bonds look somewhat more attractive to the lower-yielding Treasuries, making it easier for those corporations to borrow in the future.
The reason that the Fed does not undertake such actions during normal times is that there is a greater risk associated with holdings of mortgage bonds (whose return depends on whether mortgages are paid off) than with Treasury paper (that the US government has always paid off). The Fed clearly made a judgment that in this specific case (the sharp downturn in the economy and the problems in credit markets) that the risk was worth taking.
Whether this action will set a precedent for future Fed chairmen is an open question; one can easily imagine that there would be intense pressure on a future Fed chairman to purchase securities in markets that are in difficulty, with the result that monetary policy becomes more focused in coming years on specific sectors. The Fed has successfully defended itself from outside pressure since it regained its independence in 1951 (see here for a bit more) but when the economy is weak there is always pressure on the Fed.
To summarize, when it became clear to the Fed that the economy was slowing sharply and that credit markets were in trouble, the Fed took extraordinary action: they cut rates to virtually zero and then announced that they would buy (in addition to the usual short-term Treasuries) longer-term Treasuries and agency mortgage debt. With luck, this will shorten the economic crisis by restoring credit markets. But such a large expansion of the Fed’s balance sheet presents an inflationary threat that will be described in another essay.