34.4 Unconventional Monetary Policy
The Fed’s primary tool for affecting the economy is the federal funds rate, but this is not its only tool. The Fed’s other tools are particularly relevant when it needs to encourage spending even after it has lowered the federal funds rate to zero. Additionally, the Fed has a responsibility to ensure stability in the financial system. During the 2007–2009 financial crisis the Fed explored several new tools to help increase stability in the financial sector. Let’s explore some of these tools.
Monetary Policy Choices When Nominal Interest Rates Are Zero
Things were desperate in 2008.
In order to fight the deepest recession since the Great Depression, the FOMC lowered its target for the federal funds rate essentially to zero in 2008. The zero lower bound meant that the Fed thought it could not push the federal funds rate any lower, so it had to start exploring other instruments that might encourage additional spending. The two main approaches both reflect the same goal—to push longer-term interest rates down. In normal times, the Fed sets a short-term interest rate—recall that the federal funds rate is an interest rate on overnight loans. (That’s pretty short term!) But when this rate has hit the lower bound, and the economy is still below potential, the Fed can still push longer-term rates even lower to encourage people and businesses to take out more long-term loans to fund more spending today.
Forward guidance helps push down longer-term interest rates.
Communication became a more important policy tool once the federal funds rate was at zero. The idea is that the Fed can stimulate the economy even when short-term interest rates are as low as they can go by committing to low rates in the future. This strategy of providing information about the future course of monetary policy in order to influence market expectations of future interest rates is called forward guidance.
The way it works is that the Fed makes up for the fact that rates can’t go lower today by promising that they will stay low in the future. This pushes down longer-term interest rates because the Fed is promising that people can count on low interest rates for longer. This promise pushes down the interest rates on longer-term loans, like home mortgages, five-year car loans, and longer-term business loans, and these lower rates will lead more people to buy houses, cars, and make business investments.
For forward guidance to work, it’s crucial that people believe that the Fed is committed to keeping rates low for a while because it’s those beliefs that push down the interest rate on long-term loans, and spur more spending.
Quantitative easing aims to push interest rates below zero.
Quantitative easing, or QE, is the name given to the Fed’s strategy of purchasing large quantitites of longer-term government bonds and other securities in an effort to put downward pressure on long-term interest rates, including mortgage rates. Over several periods between 2009 and 2014, the Fed purchased trillions of dollars of these assets.
The Fed wasn’t exactly spending trillions of dollars through quantitative easing. Instead, it bought government bonds from savers like you. By buying long-term bonds, the Fed is effectively increasing the supply of long-term loans. This increase in supply pushes down interest rates on other long-term loans, allowing businesses to borrow at lower rates. Quantitative easing also helped increase lending in the housing market, and as a result, people paid historically low rates on mortgages.
The deep recession of 2008 meant high unemployment even with interest rates as low as they could go.
Quantitative easing works a lot like open market operations, except instead of buying short-term government bonds in order to influence short-term interest rates, the Fed buys long-term bonds in order to try to lower long-term interest rates. This reduction in long-term interest rates also helps the Fed convince banks that it’s committed to keeping rates low for a long period.
Lender of Last Resort
Finally, the Fed plays a key role in preventing bank runs and financial panics. A bank run occurs when many people want to withdraw their savings from a bank at the same time, collectively trying to withdraw more cash than the bank has on hand. The bank has enough money on the books to pay everyone, but it’s not all accessible because it has lent some of it to its other customers.
The Fed can help prevent bank failures by acting as a lender of last resort, meaning it is the lender that financial institutions turn to when they need cash right away, but they’re having trouble getting a loan elsewhere. A lender of last resort is what it sounds like—someone who gives you a loan when no one else will. The main way the Fed does this is by lending money to banks at the discount window. Because the discount rate is typically set higher than the federal funds rate, banks typically only borrow from the Fed’s discount window when they’re in trouble.
The lender of last resort can prevent a financial crisis.
During the financial crisis of 2007–2009, the Fed acted aggressively as a lender of last resort, providing loans to financial institutions in an effort to prevent an emerging financial panic from spreading. To understand why, consider the Fed’s failure to act during the Great Depression: The Fed had the capacity to bail out banks, but it opted not to help. If a handful of banks were to go bust, it probably wouldn’t pose much of a problem to a huge economy like that of the United States. But bank runs tend to be contagious because the failure of one bank prompts savers at other banks to worry that their bank might be next; those savers race to withdraw their money, and the trouble spreads. Indeed, more than 5,000 banks failed during the early 1930s, contributing to the severity and length of the Great Depression. In 2008, the Fed was determined to avoid a replay, which is why it provided hundreds of billions of dollars in loans to prevent banks from going bust.
The Fed is a lender of last resort to a broad set of financial institutions.
There was something different about the 2007–2009 financial crisis: It wasn’t just banks that were in trouble. Other financial institutions known as shadow banks were also at risk of failing. Shadow banks often act like banks, but they’re not officially banks, and so they can’t borrow at the discount window. The collapse of a shadow bank called Lehman Brothers prompted widespread fear that others like it would fail. To prevent runs on other shadow banks, the Fed worked to expand its reach as a lender of last resort throughout the financial system including to shadow banks.
The Fed’s role as a lender of last resort is largely about ensuring financial stability, but as this episode demonstrated, it also serves to ensure maximum employment and stable prices by helping to prevent financial crises.
The Fed can lose money when it makes loans to failing financial institutions.
When the Fed acts as a lender of last resort, it takes on some of a financial institution’s risk. After all, if that financial institution can’t repay its loan, then it’s the Fed—and hence taxpayers—who stand to lose money. Some people argued that the Fed should not have used public money to prop up private, for-profit companies. For example, loans from the Fed (together with help from Treasury) helped prevent AIG, an American multinational insurance company, from going bust. These actions benefited AIG’s shareholders, even as they also prevented broader financial chaos, which arguably benefits the taxpayers who were putting their money on the line.
Ultimately, the Fed was fully paid back (with interest) for all the loans it made in its capacity as a lender of last resort during the financial crisis. But while these bailouts worked well—the American taxpayers made money and helped save some financial institutions—there were real risks involved.
Bailouts can lead banks to take bigger risks.
There’s an old joke that says that if you owe the bank $100 that’s your problem, but if you owe your bank $100 million, that’s the bank’s problem. The Fed faces a similar problem when it acts as lender of last resort to the largest and most interconnected financial institutions: If any big financial firm were to fail, it would create widespread economic chaos, which the Fed was set up to prevent. The problem is that these financial institutions understand that—from the Fed’s perspective—they’re too big to fail. That creates incentives for these financial institutions to take on extra risk. After all, if their financial bets don’t pay off, the Fed has little choice but to help them. This suggests that even as the Fed acting as lender of last resort can soften the blow of a financial crisis, it may also make future financial crises more likely.
In response, Congress passed legislation known as Dodd-Frank that requires banks to stand on a sounder financial footing, so that they’re less likely to need to rely on the Fed to act as lender of last resort during the next crisis. This new law also placed restrictions on the Fed’s ability to act as a lender of last resort, in the hope that financial institutions will be a bit more cautious, knowing that the Fed can’t bail them out quite so easily. While the Fed is still able to make loans during times of financial stress, the next financial crisis will undoubtedly look different, and so will the Fed’s response.