The Effectiveness of the Federal Funds Rate as the U.S. Monetary Policy Tool Before, During and After the Great Recession

Abstract

1. Introduction The Business Cycle Dating Committee of the National Bureau of Economic Research determined that a recession occurred in the U.S. between December 2007 and June 2009. Given the historic severity of the length, depth and breadth of the decline and subsequent recovery--the worst economic performance since the Great Depression of the 1930s--economists have dubbed this period the Great Recession (GR). Once the severity of this downturn became clear in 2008 U.S. policy makers were quick to use both fiscal and monetary policies to inject confidence and liquidity into the rapidly declining financial system and economy. The Fed's use later that year of not only substantial reductions in the Fed funds target rate but also quantitative easing via the purchase of $1.7 trillion in assets was strong evidence of an expansionary monetary policy of unprecedented magnitude. The $787 billion stimulus package passed in the early days of the Barak Obama administration is but one example of a very expansionary fiscal policy. While fiscal policy tried to prop up the financial institutions and the economy directly by giving them immediate rescue funding, monetary policy was geared more toward providing lower interest rates and almost unlimited liquidity for financial institutions such as commercial banks, mortgage companies and investment banks. The primary tool used to provide liquidity was known as the large-scale asset purchase (LSAP) program, also called quantitative easing (QE). Rather than a single event, QE was instituted in four phases. The first action, known as QE1, began in December 2008 (2). Unlike normal Fed policy that limits asset purchases to Treasury bills, QE1 involved the targeted purchase of agency mortgage-backed securities (MBSs) and long-term Treasury securities as well. During QE1 the Fed accumulated over $1.7 trillion in mortgages and Treasuries. The next phase, QE2, occurred well after the official trough of the Great Recession of June 2009, lasting between November 2010 and June 2011. During this period, the Fed purchased an additional $600 billion in Treasury securities. The third phase involved a change in the average duration of the Fed's asset holdings known as Operation Twist, beginning in September 2011 and ending in December 2012. The Fed' actions extended the average bond maturity of its asset holdings from short term to long term yet did not in itself add any new monetary base to the economy. Since short-term rates as represented by the target range had hit the zero lower (ZLB) bound nearly three years earlier and could no longer lower rates in general, the Fed had to achieve lower intermediate and long rates by directly injecting liquidity into the markets for those securities. The fourth program, ongoing as of this writing, was QE3 which began in September 2012. (3) Initially, a monthly purchase of $40 billion in mortgage-backed securities was planned but the amount gradually increased to $85 billion. (4) In the early days of the financial turmoil, beginning with mortgage market troubles in August 2007, the Fed responded with a reduction in the FF by 50 basis points in September, 25 basis points in October, and another 25 in December 2007 as seen in Table 1. The first reductions in the FF during the GR were in January 2008 when the Fed, in two moves, lowered the target by a total of 125 basis points. March and April of 2008 combined for another reduction in the FF by 100 basis points, to a 2.00% target. The reason for the actions was not, however, the GR since no one at the time knew the recession had begun. The Federal Open Market Committee's 2008 statements through April of that year speak of a weakened outlook for economic output, but the statements in April, June and August report expanding economic activity. (5) Clearly the drops in the FF that occurred through April 2008 were aimed solely at the financial weakness rather than output. It was not until a 100 basis point drop in the FF over two meetings in October 2008 that the FOMC explicitly recognized a marked slowing of economic activity. …