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Monetary Policy During the “Great Recession”
By Mel Miller

The U.S. economy is slowly recovering from the most severe economic decline since the Great Depression. The Great Recession, which started in 2007 and “ended” in 2009, was anything but typical as it relates to recessions of the past. Before we discuss one of the primary causes, let’s review the role of the Federal Reserve to reverse a recession.

In 1977, Congress amended the Federal Reserve Act, stating the monetary policy objectives of the Federal Reserve as:

"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates."

This dual mandate has often led to past recessions as the Federal Reserve (the Fed), needing to reestablish stable prices, was forced to raise interest rates. Unfortunately, all too often the Fed, in an attempt to lower inflation, raises short term rates to the point that not only does inflation slow but the economy lapses into a recession.

The trade-off between full employment and inflation creates a conundrum for the Fed Board of Governors. Once the economy slips into a recession, normal reaction of the Fed is to lower short-term interest rates by decreasing the Fed Funds rate to stimulate borrowing on the part of consumers and businesses. But what sounds good in theory is complicated by real world realities. The reality is that there is not a formula which states how long it takes and how low rates must decline before the economy responds.

In hindsight we know that the Fed had been raising the Fed Funds rate from June 30, 2004 until the interim high was reached June 29, 2006. By September 18, 2007, the economy was beginning to falter and the Fed lowered the Fed Funds rate by 50 bps to 4.75%.

As the economy was rapidly deteriorating, the Fed was forced to aggressively lower the rate until reaching the bottom December 16, 2008. The Fed Funds Target Rate floor of zero to 0.25% still did not revive the economy. In fact, after more than five years the Target Rate remains at the floor. The “traditional” tool was not working, as the economy continued its slide.

A new tool called Quantitative Easing (QE) was initiated December 2008 and continues yet today—with no end date commitment. Quantitative Easing is the process of the Fed buying large amounts of existing Treasury and mortgaged bonds in the open market with the sole purpose of driving down long-term interest rates. The ultimate goal is lower borrowing costs for not only short-term borrowers but long-term mortgage borrowers as well.

Hopefully this review of the traditional monetary tool along with the additive tool of Quantitative Easing is helpful to understanding current Fed thinking. In my next blog, I will explain my stated opposition to the new monetary tool: Quantitative Easing.


Posted: April 7, 2014