Knowing the Federal Reserve’s monetary policy: Then and now

The Fed’s monetary policy during financial crisis

Until the beginning of the 2008, the Fed had only controlled the economy by means of the conventional tools, that is, targeting the Federal funds rate. The Fed lowered the interest rate throughout the period of 2000s in order to revive the labor market. However, the corporations and investors overwhelmingly counted on the cheap borrowings, which pushed the economy on to the brink of its most intense financial crisis.

The Federal funds rate can’t go any lower

The Federal Reserve took extraordinary actions in response to the financial crisis to help stabilize the U.S. economy and financial system. These actions included reducing the level of short-term interest rates to near zero. “And it couldn’t go any lower than that,” said Pianalto.

Turning to the unconventional mode: Quantitative easing

To reduce long-term interest rates to support the U.S. economy, the Federal Reserve also used unconventional tools. Pianalto said, “The most well-known of these tools is what we call large-scale asset purchases, or what you may know as quantitative easing, or QE.” The purpose of the asset purchase program was to put downward pressure on longer-term interest rates. The Fed has purchased large quantities of longer-term Treasury securities and longer-term securities issued or guaranteed by government-sponsored agencies such as Fannie Mae or Freddie Mac.

“This is in contrast to the way we lower the target federal funds rate, which we do by buying very short-term securities,” said Pianalto. The purchase of longer-term securities pushes down the interest rates that consumers and businesses borrow at. Mortgage interest rates are a good example of the kind of interest rates that get pushed down by the asset purchase program. Low interest rates help households and businesses finance new spending and help support the prices of many other assets, such as stocks and housing market.

After five years of a near-zero interest rate

By law, the Federal Reserve conducts monetary policy to achieve maximum employment, stable prices, and moderate long-term interest rates. However, after nearly five years of near-zero interest rates as depicted in the chart above, Sandra said, “The economy is recovering, but progress toward maximum employment has been slow and the unemployment rate remains elevated. At the same time, inflation has been running below the FOMC’s longer-run objective of 2%, but longer-term inflation expectations have remained stable.”

Pianatlo further expressed her views on the Fed’s dual mandate saying, “To put it simply, even though we are making some progress, we are still falling short of achieving our objectives for maximum employment and 2 % inflation.” Read about it in the next part of the series.