The Federal Reserve’s Role in Full Employment: Part Two—Fed Policy from the Great Recession to Present


This is the second part of a four part series on the Federal Reserve and its role in Fixing the Jobs. Part One can be found here.

The Federal Reserve is the institution with the most power to steer the economy and has been the dominant institution responding to the Great Recession. To understand current Fed policy one must be understand what policies led to the current state of the economy.

During the onset of the Great Recession the reaction of the Federal Reserve was initially slow and counter productive to handling the collapse of America’s financial market. Signs of instability in the financial markets began in February 2007 when Freddie Mac announced that it would not buy the most risky subprime mortgages. The crisis accelerated through 2007 with subprime lenders collapsing and Countrywide Financial reporting difficulty. By December 2007 the recession begins and on February 13, 2008 the first economic stimulus is signed into law by President Bush. At this point the Fed had lowered the target interest rate from 5.25% to 3% and the economy became the top issue for the 2008 presidential election. The next month Bear Stearns collapsed and JP Morgan acquired Bear Stearns in an action facilitated by the New York Federal Reserve Bank in order to prevent a “chaotic unwinding” of financial instruments throughout the market.

Financial crises generally result in more severe recessions and require more action by the Fed. Given that we were on the edge of a financial cataclysm, financial instability and the possibility of a severe recession did not worry the Fed nearly as much as it should have. The recently released minutes from the FOMC meetings, including the September 16, 2008 FOMC meeting, demonstrate the misguided priorities. This meeting happened nine months into the recession, and Lehman Brothers had collapsed just a few days before. The insurance giant AIG was on the verge of collapse. During the meeting the FOMC decided to not cut interest rates and—astonishingly—expressed more concerns about inflation than the possibility of a severe recession. A word count from the transcript illustrates their focus on inflation with the FOMC members mentioning inflation 129 times and recession just five times. Indeed, on the edge of the worst economic catastrophe since the Great Depression, laughter was noted more than four times as often as recession concerns (22 times). Their actions would prove so misguided up to that point that the Federal Reserve had to bailout AIG on that very same day. Weeks later, realizing their mistake, the Federal Reserve cut interest rates with other central banks around the world and by the end of 2008 the target rate had reached zero. But the damage was already done—the Fed has missed their opportunity to head off an epic financial and economic collapse.

Reaching the zero bound limit removed the policy tool the Federal Reserve had the most practice with and comfort in using. Eventually, the Fed would begin stimulating the economy through quantitative easing (QE). The Economist best explains QE:

“To carry out QE central banks create money by buying securities, such as government bonds, from banks, with electronic cash that did not exist before. The new money swells the size of bank reserves in the economy by the quantity of assets purchased—hence “quantitative” easing. Like lowering interest rates, QE is supposed to stimulate the economy by encouraging banks to make more loans. The idea is that banks take the new money and buy assets to replace the ones they have sold to the central bank. That raises stock prices and lowers interest rates, which in turn boosts investment. Today, interest rates on everything from government bonds to mortgages to corporate debt are probably lower than they would have been without QE. If QE convinces markets that the central bank is serious about fighting deflation or high unemployment, then it can also boost economic activity by raising confidence.” (Emphasis ours.)

The Fed implemented the first of three rounds of QE in November 2008. The first round of QE lasted fifteen months and increased the Fed’s balance sheet by $1.65 trillion. Eight months later, in November 2010, QE2 was announced. It was a $75 billion per month purchasing program that expanded the balance sheet by another $600 billion ending in June 2011. The recovery was still weak with economic growth slowing during 2011. In response, and because of fear that QE was providing inflationary pressure due to an expanding Fed balance sheet, the Fed implemented Operation Twist to the amount of $667 billion. Operation Twist, a form of QE, had the Fed purchasing long-term bonds with maturity ranging from 6 to 30 years while selling bonds with a maturity of less than 3 years. The Fed implemented the program to lower long-term yields which lowered interest rates to promote lending. Though effective, these previous attempts of QE were not enough to launch a strong recovery so the Fed launched QE3, the most ambitious policy to date. It was made open ended and purchased $85 billion in securities per month at its height. As the official unemployment rate dropped below 7 percent in December 2013 the FOMC, over fears of future inflation caused by QE, announced that the Fed would begin tapering QE3 with a $10 billion reduction per month.

As of June 2014 QE3 has been lowered to $35 billion in purchases per month, and is widely expected to be fully tapered by October 2014 unless the economic indicators substantially weaken. Since 2011 and Operation Twist the Fed also indicated that the Fed target rate would stay at zero at least until 2015. The general position of Fed officials is as follows: “11 of 16 see Fed Funds at or under 1.25% through the end of 2015. Over half still expect that Fed Funds will be at or under 2.5% through the end of 2016. Three of the FOMC members do not expect rate hikes to begin until 2016.”

The problem with all these actions returns to the final sentence of The Economist’s description of QE: “If QE convinces markets that the central bank is serious about fighting deflation or high unemployment, then it can also boost economic activity by raising confidence.” In 2008, the Fed allowed phantom concerns about inflation to blind them to an extraordinary extent. And since that time, their repeated fears about inflation have eroded market confidence in the priority of high unemployment for the Fed. In the end, the Fed has generated exactly the type of recovery they have been seeking: tepid. By repeatedly prioritizing inflation over jobs, the Fed has abandoned far too many American workers, and severely damaged their credibility as guarantors of full employment. And Congress and the President have been far too complicit in this abdication of their duty and their legal mandate.

Photo Via: IMF Flikr: US Treasury Secretary Tim Geithner (R) talks with Federal Reserve chairman Ben Bernanke (L) before the start of the G20 finance ministers and central bank governors meeting at the IMF/World Bank Spring meetings in Washington on April 15, 2011. The IMF/World Bank Meetings are being held in Washington, DC this week which will host Finance Ministers and Bank Governors from 187 countries. IMF Photograph/Stephen Jaffe

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