Great Recession

Monetary Policy Many observers have critiques the U.S. Federal Reserve for its monetary policy leading up to the Great Recession. There were many causal factors to the Great Recession. These range from deregulation of the banking industry with the passage of the Gramm-Leach-Bliley Act of 1999, to financial institutions engaging in desperate yield-seeking in the years after the 9/11 terrorist attacks slowed the economy, to predatory lending, all resulting a surge of debt, much of it of lower quality than many realized, or at least were willing to admit (The Economist, 2013).

One causal factor that has also been attributed was the flood of cheap credit on the global financial markets, courtesy of American monetary policy "Monetary Policy in Ordinary Times" The Federal Reserve Bank conducts monetary policy in the U.S., as the central bank. It has argued that in the years leading up to the financial crisis, it conducted normal monetary policy for ordinary times, phrasing to distinguish from the extraordinary measures it was forced to undertake in the recession to combat the liquidity trap with minimal fiscal policy assistance.

Hill and Wood (2014) outline what the Fed means when it says monetary policy in ordinary times. Monetary policy reflects any policy that the central bank undertakes to influence the money supply. The Federal Reserve relies on three primary instruments of monetary policy -- reserve requirements, the discount rate, and open market transactions. Reserve requirements are the amount of deposits that banks need to hold. The Fed can change this rate, and the banks need to either tighten lending or they can loosen it.

Open market transactions reflect purchases or sales of short-term Treasury securities, as a means of either pulling money out of the economy or injecting money into it. The discount rate is literally the cost of money to financial institutions. When this increases, they pass that increase along to their customers, which should reduce borrowing. In ordinary times, Hill and Wood (2014) note, the Fed is reticent to use reserve requirements as an instrument because of the burden this places on banks.

Further, the discount rate is "passive in ordinary times, in that the discount rate only reflects other Federal Reserve policies." Thus, the primary monetary policy instrument in ordinary times is open market transactions. The Federal Reserve Open Market Committee (FOMC) guides the market through the use of open market transactions, which will be used to price money to a target interest rate, the Fed funds rate. These OMCs are carried out on a daily basis and affect the amount of money in the banking system (Hill & Wood, 2014).

Expansionary policy, used to spur economic growth, would be to buy Treasury securities, which injects money into the system. Contractionary policy, typically used to fight inflation, involves selling Treasury securities, taking money out of the financial system. Ordinary Times The terrorist attacks on 9/11 were the catalyst for an economic downturn. The economy contracted briefly -- not enough to be a recession -- but there was considerable uncertainty in the markets, and economic performance was suboptimal in the ensuring quarters (BEA, 2014).

At the beginning of September, 2001, economic conditions were basically normal, and the Fed funds rate was 3.5%. This rate was reduced rapidly, in three stages, to 2.0% by early November of that year. More cuts ensued, down to a low of 1.0%, before the Fed funds rate began to increase in June of 2004 (NY Fed, 2014). By this time, the economy had recovered strongly. Thus, the Federal Reserve was using expansionary monetary policy at a point in time when the economy was healthy, and the GDP was growing.

This expansionary monetary policy during this 2002-2004 period has been attributed as a causal factor in the economic crisis, because it flooded the economy with low cost money. Credit was cheap at those rates, banks were lending, but there was no yield out there, because of the low rates. There were many manifestations of what went wrong at this point. First, the housing market was heating up because mortgage rates were low.

New borrowers entered the market, and the low rates provided an opportunity for predatory lenders to seek out low-income earners for mortgages. Second, major financial institutions were flush with cash, and were seeking yield. They found it in all sorts of investments -- European real estate was a popular one, and another was in collateralized mortgage securities. These were bundled products containing a range of mortgages, in complex structures. They were marketed as having AAA credit ratings, but the reality is that they did not.

A simple explanation is that any they were diversified against default risk on any individual mortgage, but were not built to withstand systemic risk associated with the entire mortgage market. This despite the fact that the entire mortgage market is subject to interest rate risk, and rates were abnormally low. Free from Glass Steagall regulations, U.S. banks indulged in what looked like AAA products but carried interest rates much higher than that rating would imply.

Nobody asked any questions -- they were playing with found money because the Fed had been flooding the market for two years to spur economic growth to offset the damage caused by the terrorists and perhaps to generate taxes to help pay for a couple of otherwise unfunded wars. What Goes Down Must Come Up Ordinary monetary policy is rather mundane -- when the market is doing well, there is the risk of inflation.

When inflation starts to rise, the central bank steps in, increases the interest rates in order to reduce the inflation. As the flood money cause housing prices to spike, and created a glut of consumer credit as well, the U.S. economy began to heat up across the board. But the real asset bubble that was dangerous was in the housing market, where cheap credit facilitated not only predatory lending but rampant speculation.

The problem is that inflation was beginning to creep up, and the Federal Reserve, this being normal conditions, was going to raise rates. Many observers have criticized the Fed for raising rates too fast. The Fed funds rate increased from 2.0% at the beginning of December, 2004 to 4.0% a year later, and up to 5.25% by mid-2006. This spike in rates had a number of effects. First, it shifted consumer preference towards more savings and away from spending, because the cost of money was significantly higher (Lothian, 2009).

Second, it set the stage for the bursting of the real estate bubble. While the policy was intended to cool the bubble, nobody seemed to realize how this would play out. Predatory lenders were selling step-up mortgages, with a low introductory rates that would float, and thus at this point would rise quickly in 18 months. When these mortgages came due for renewal, many were unable to afford these houses at higher rates. Worse yet, because the real estate bubble burst, they were underwater and couldn't sell either.

This caused a systemic shock in the housing market. Any institution holding real estate assets, and this including collateralized debt obligations, found itself with securities whose value was uncertain, but quite likely dropping. Thus, the crisis in the financial markets. Conclusion The Federal Reserve is by no means "to blame" for the Great Recession, but its somewhat unorthodox approach to monetary policy during the 1990s, where it held onto stimulatory.