Chapter 26: Monetary Policy and the Fed

Start Up: The Fed’s Extraordinary Challenges in 2008

“The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.” So went the statement issued by the Federal Open Market Committee on December 16, 2008, that went on to say that the new target range for the federal funds rate would be between 0% and 0.25%. For the first time in its history, the Fed was targeting a rate below 1%. It was also acknowledging the difficulty of hitting a specific rate target when the target is so low. And, finally, it was experimenting with extraordinary measures based on a section of the Federal Reserve Act that allows it to take such measures when conditions in financial markets are deemed “unusual and exigent.”

The Fed was responding to the broad-based weakness of the U.S. economy, the strains in financial markets, and the tightness of credit. Unlike some other moments in U.S. economic history, it did not have to worry about inflation, at least not in the short term. On the same day, consumer prices were reported to have fallen by 1.7% for the month of November. Indeed, commentators were beginning to fret over the possibility of deflation and how the Fed could continue to support the economy when it had already used all of its federal funds rate ammunition.

Anticipating this concern, the Fed’s statement went on to discuss other ways it was planning to support the economy over the months to come. These included buying mortgage-backed securities to support the mortgage and housing markets, buying long-term Treasury bills, and creating other new credit facilities to make credit more easily available to households and small businesses. These options recalled a speech that Ben Bernanke had made six years earlier, when he was a member of the Federal Reserve Board of Governors but still nearly four years away from being named its chair, titled “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” In the 2002 speech he laid out how these tools, along with tax cuts, were the equivalent of what Nobel prize winning economist Milton Friedman meant by a “helicopter drop” of money. The speech earned Bernanke the nickname of Helicopter Ben.

The Fed’s decisions of mid-December put it in uncharted territory. Japan had tried a similar strategy, though somewhat less comprehensively and more belatedly, in the 1990s when faced with a situation similar to that of the United States in 2008 with only limited success. In his 2002 speech, Bernanke suggested that Japanese authorities had not gone far enough. Only history will tell us whether the Fed will be more successful and how well these new strategies will work.

This chapter examines in greater detail monetary policy and the roles of central banks in carrying out that policy. Our primary focus will be on the U.S. Federal Reserve System. The basic tools used by central banks in many countries are similar, but their institutional structure and their roles in their respective countries can differ.

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