The Federal Reserve: Monetary Policy

As the nation delves deeper into a crippling recession, America looks to The Federal

Reserve to provide relief. With only a few, very powerful, options available to them, the Board of

Governors must discern which type of monetary policy to enact, and specifically which aspects

to focus on in order to combat the causes of financial distress. Clearly in this situation it is

obvious that expansionary monetary policy is necessary, but how can the country's central bank

fix the uncooperative financial systems and coerce them into lending to alleviate the tight credit

squeeze placed on many citizens. Their answer so far has been to effectively reduce the federal

funds rate to zero while at the same time implementing a number of programs designed to

support the liquidity of financial institutions and foster improved conditions in financial markets.

The federal funds rate is essentially what influences the ability of banks and other types

of lenders to make loans. The lower the rate, the easier it is to borrow money and therefore the

easier it is to lend money. By reducing the target federal funds rate to between 0 and 25 basis

points The Federal Reserve was expecting banks to continue lending to people, even though

many were defaulting on loans used for big-ticket items such as houses and cars. This was a

potentially risky move, provoking concerns that it could lead to inflation. Although some

inflation did occur, it was not a direct result of the change in policy and has already declined

dramatically. There has been moderate success in the area of lending rates expressed primarily

through lower short-term rates . Unfortunately it has not been enough to promote sustained

lending and overall the financial situation has tightened.

In an attempt to approach to crisis from more than one angle the Fed has deployed a

number of additional policy tools aimed at reducing financial strains by providing liquidity to the
private sector. One of the first things the Federal Reserve did was attempt to influence longer-

term interest rates by communicating to the public that the federal funds rate would be low for an

extended length of time. By doing this they intended to put downward pressure on longer-term

rates and stimulate short-term demand. Another tool took advantage of the pivotal role the

Federal Reserve has as a lender to financial institutions, specifically by providing short-term

liquidity to those that proved stability. By providing access to short-term credit through facilities

for auctioning credit and allowing more parties to borrow directly from the Fed, more funds

would be available to those able to make loans and optimistically more loans would be made.

Another way in which the Federal Reserve hopes to help is by purchasing longer-term securities

including up to $100 billion in government-sponsored enterprise debt and up to $500 billion in

government-sponsored enterprise mortgage-backed securities. By purchasing this "bad" debt the

Federal Reserve expects to alleviate some of the strain currently being put on lending

institutions. With this baggage unloaded their assets to liabilities ratio will improve dramatically

and they will make more loans.

There are many ways in which this elaborate and well-thought out plan can fail, but even

more ways in which it can succeed. First of all just because the federal funds rate is low does not

mean anyone will immediately begin borrowing. The banks have lost an unprecedentedly large

amount of money on defaulted loans and even though the Federal Reserve plans on buying some

of it from them, there is no way of knowing how much they have lost. In addition, with

unemployment at near-record levels most average American's are withdrawing funds to pay for

bills and other necessities. This leads to a decrease in the amount of deposits at banks which in

turn leads to a further decrease in their ability to loan. On the bright side, as the recession moves

through the bottom of the trough and begins the early stages of expansion, the monetary policy
enacted by the Federal Reserve will accelerate the recovery significantly. As the banks recover

from their massive undercapitalization through selling off their bad debt and borrowing at a very

low cost, the financial market will stabilize and funds will slowly begin to unfreeze. At this point

the monetary policy will have served its purpose and the Federal Reserve can go about deciding

how best to prevent the inevitable phase of inflation.