Fed's Response to 2008-09 Recession Research Paper

Pages: 9 (3043 words)  ·  Bibliography Sources: 7  ·  File: .docx  ·  Level: College Junior  ·  Topic: Economics

Federal Reserve

Role of Federal Reserve

The mission of the Federal Reserve is to provide the United States with a safer, more flexible and more stable monetary and financial system (Federal Reserve, 2009). The Fed describes its duties as falling into four general areas: conducting monetary policy, regulating banking institutions, maintaining the stability of the financial system and providing financial services to depository institutions (Federal Reserve, 2009). With respect to the role of the Fed in the economy, arguably the middle two are the most important.

For the purposes of evaluating the Federal Reserve, the current economy essentially began in 2008, when the financial system started to demonstrate signs of collapse. At that time, the prevailing conditions included multiple major financial institution failures, hundreds of banks on the brink of failure, and rapidly deteriorating economic conditions. Typically, the Fed would respond to such conditions in a number of different ways, given its mission. With respect to some of the elements of its mission, in particular stabilizing the economy, the Fed would be expected to work in concert with Congress, which would implement fiscal policy, while the Fed addressed monetary policy and the stability of the financial system.Buy full Download Microsoft Word File paper
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Research Paper on Fed's Response to 2008-09 Recession Assignment

In the short run, the Fed made a number of moves specifically aimed at addressing the stability of the system, which in the fall of 2008 was starting to become unstable. The Fed "responded forcefully to the crisis since its emergence in the summer of 2007," according to the Federal Reserve's 2008 Annual Report. Between that time and the end of 2008, the Fed responded with monetary policy, specifically lowering the federal funds rate by 325 basis points, essentially to its functional minimum. This move was intended to spur economic growth, by lowering the cost of money. The fed funds rate is one of three primary mechanisms of monetary policy. The Fed funds rate is the rate at which the Fed lends to banks. The concept behind this is that when the Fed lowers the cost of money, banks will be more willing to lend, and companies more willing to borrow. This is because lower money costs equate to lower hurdle rates on projects, theoretically making projects more viable. If more projects are viable, more will be undertaken, which should spur economic growth.

In practice, lowering the Fed funds rate did not have the desired effect. The economy entered into a tailspin, and low rates did nothing to prevent that. The Fed essentially lowered its rates too quickly, and lowering the rates was never going to be sufficient. The reality is that conventional economic policy was not going to address the issues that were causing the crisis. The economic slowdown was caused more by the crisis in the financial system, and ultimately the decline in demand. Without demand, new projects were unlikely to be viable even with rock bottom interest rates, so the rates themselves were insufficient to address the economic decline. Rates have a zero bound -- they cannot be lower than zero, but if rock bottom rates are not enough to spur demand, then the economic cannot recover (Investopedia, 2015). One major problem is that the economy of the U.S. was not offering meaningful growth, so investment capital either sat unused (unlent by banks) or was shifted overseas where stronger growth prospects existed. The conventional economic logic behind this monetary policy approach was derived in an era were capital flowed nowhere near as fluidly across borders.

The reality is that rate cuts create the underlying conditions for increased economic activity; they do not literally equate to increased economic activity. So cutting the rates did set the stage for economic recovery, but ultimately they were not enough by themselves to address the economic crisis. It is worth noting that the Fed still had to cut rates that low -- the policy did not fail to spur economic growth because it was faulty in concept or execution. It failed only because the depth of the crisis was larger than the Fed anticipated, and other measures needed to be undertaken in addition to cutting rates. The Fed did its part, but banks were slow to lend out capital even at the low rates, and there was little motivation for companies to invest in an American economy that offered dismal growth prospects.

For its part, the Fed has worked hard to address the issue. It has consistently sent signals to the market with respect to what could be expected regarding interest rates in the future. This has allowed the market to maintain some degree of confidence that interest rates are not going to change without a significant uptick in the economy, and in particular to the inflation rate. While the economy has recovered somewhat, it has not been a particularly strong recovery and interest rates have remained generally low.

The other thing the Fed has done is conducted its quantitative easing, which is a fancy term for expansionary monetary policy that functions in the long-run. Normally, when the Fed conducts open-market transactions to influence the money supply, it does this via short-term Treasury instruments. Thus, if the Fed wants to increase the money supply, it would buy back short-term Treasuries, thus lowering short-term rates. As increasing short-term money supply had not to that point spurred economic growth, the Fed engaged in successive rounds of quantitative easing, which was buying back longer-term Fed securities. This not only increased the money supply, but it also lowered long-term rates. This reduces the spread between short-term rates and long-term rates, making short-term investment relatively more attractive. The easing was done in several rounds. Over that period, the GDP increased and unemployment diminished, so it is fairly reasonable to conclude that the overall effect was successful -- the Fed spurred some recovery in the economy. However, the inflation rate has remained fairly stable, which is line with the Fed's mandate, and indicates that the Fed's policies are working, at least in the short run.

In the long run, there remain reasons to be concerned. Arguably, the crisis was originally caused by structural issue s- issues that to some extent remains unresolved. Several years of expansionary monetary policy has certainly been good for the stock market, and real estate is also beginning to recover, though there is reason to be concerned that perhaps another asset bubble is forming, given that the stock market since 2009 has more than doubled while the size of the U.S. economy -- or the global economy for that matter -- has not. This indicates that asset values are misaligned, providing support for the idea that the quantitative easing has been excessive in nature, and runs the risk of long-run economic destabilization. At some point, there needs to be evidence that the economy can grow without relying on rock bottom interest rates.

In recent years, the economy has been stable, and this is without much in the way of meaningful fiscal policy. The Bureau of Economic Analysis measures the U.S. GDP. In the latest quarter, the annualized GDP increase was 2.3%, up from 0.6% in the prior quarter. For the most part, GDP growth since the recession in 2009 has been muted. Only three quarters have seen strong growth of over 4% - rates that were not unusual in the years leading up to the recession. Many quarters have seen sub-1% GDP increases (BEA, 2015). This is stable, and almost always there is growth, but at fairly low rates. In that sense, the Fed is doing just enough to encourage economic growth, but has by no means been able ot spur sustained strong economic growth, which is why the Fed has continued with expansionary monetary policy for so many years in a row. I believe that the Fed is doing what it can, but that it does not have the capability to address the underlying structural issues that are preventing faster GDP growth.

Economic Indicators

Given the Fed's mandate, the major economic indicators are the gross domestic product, the inflation rate (core CPI) and the unemployment rate. All of these are directly related to the Fed's lawful mandate, and thus all need to be evaluated by the Fed to help it determine its monetary policy program. Core CPI is the inflation rate not including volatile commodities such as food and fuel. Because core CPI is less volatile than CPI, it is more reliable as a measure by which monetary policy -- which tends to work more on the medium-term than the short-term, can be set.

There are other economic indicators as well. First, each of these indicators can be broken down to provide better insight. The gross domestic product varies from one state to the next, and there are a number of different elements to the GDP that merit consideration. The durable goods report is a major indicator used for its reflections on the housing market, consumer confidence and formerly manufacturing. The consumer confidence survey is also used as a gauge for where consumer spending might be… [END OF PREVIEW] . . . READ MORE

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