This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics.
It is widely believed that the Fed is enormously powerful. This belief allowed the Federal Open Market Committee (FOMC), the monetary policymaking part of the Fed, to control the overnight federal funds rate by simply announcing its target for the rate (see Can the FOMC Increase the Funds Rate Without Reducing Reserves?). FOMC announcements also have had a relatively large—if ephemeral—effect on bond and equity prices.
Indeed, many believe the FOMC’s pre-Covid-19 policies reduced the unemployment rate to 3.5% in spite of the fact that most of the decline was due to a historically large, and as yet unexplained, decline in the labor force participation rate (see The Fed’s 3.9% Unemployment Rate?). Some even believe the Fed’s policy actions in the wake of the 2007 financial crisis prevented a second Great Depression. To all of you who believe in the power of the Fed’s interest rate policies,
I ask two questions: If the FOMC’s interest rate policies are so powerful, why did it pursue them increasingly aggressively after each the last three recessions? Why did the Fed increase the amount of credit it supplies the economy four-fold over the last 12 years?
This essay begins by showing that the FOMC has become increasingly aggressive in its pursuit of low interest rates. It ends with some important questions about the FOMC’s policies since 2009.
Using statistical and documentary evidence, I showed (see Greenspan’s Conundrum and the Fed’s Ability to Affect Long-Tern Yields) that the FOMC began using the federal funds rate as its policy instrument in the late 1980s, with the most likely date being May 1988. Figure 1, which shows the overnight federal funds rate from January 1969 to June 2020, gives a visual illustration of what my research found. The first vertical line denotes May 1988; the second denotes June 1999. The recessions are denoted by the shaded areas, where the width denotes the duration of the recession.
Note the marked change in the behavior of the federal funds rate after the FOMC began targeting it. Initially, the FOMC signaled changes in its target. However, over time the FOMC became more open about the fact that it was targeting the rate and hinting at the target.
The FOMC didn’t stipulate a specific target, so there was some uncertainty about the target rate. This uncertainty vanished after the June 1999 FOMC meeting when the Fed began announcing the target. This is reflected in a further decline in the variability of the funds rate after June 1999.
Figure 1 also shows that the FOMC has pursued its federal funds rate policy more aggressively over time. In response to the 1990-91 recession, the FOMC reduced the funds rate target from 8.5% in early July 1990 to 3% in early September 1992. It kept the target at 3% until February 1994 and increased it slowly. It did this in spite of the fact that on December 22, 1991, the National Bureau of Economic Research Business Cycle Dating Committee (NBER) announced the recession had ended in March 1991.
Moreover, the FOMC engaged in this historically aggressive monetary policy in spite of the fact that the 1990-91 recession was relatively mild and short. This is seen in Figure 2, which presents the annual growth rate of real GDP from 1969Q1 to 2020Q1.
The FOMC’s response to the 2001 recession was even more aggressive. The FOMC began cutting its target for the funds rate in early January 2001, slightly in advance of the onset of the 2001 recession in what it called a preemptive move. In spite of these facts that inflation was trending down and the 2001 recession was short and very mild, the FOMC continued to reduce the target; eventually reducing it to 1% in June 2003. It kept it there until June 2004 in spite of the fact that on July 16, 2003, the NBER announced that the recession ended in November 2001. The first rate increase didn’t occur until June 2004 and the target was increased at a very slow pace—25 basis points at each of its next 17 meetings. Five and a half years elapsed between the first cut and the last increase in the FOMC’s federal funds rate target.
The financial crisis is typically dated as beginning on August 9, 2007, when the French bank and financial service company BNP Paribus announced it suspended the redemption of three of its investments funds. The FOMC’s initial response was tepid. It reduced its federal funds rate target one percentage point when the recession began in December 2007. The Fed introduced the Term Auction Facility (TAF) in December 2007, but only auctioned off $50 billion in loans to banks. The FOMC further reduced the target to 2%, in a series of four reductions by April 30, 2008, following the failure of the global investment bank Bear Sterns in mid-March 2008.
Lehman Bros. bankruptcy announcement on September 15, 2008—the largest bankruptcy in U.S. history—forced the Fed to make massive loans to banks and other financial institutions. The massive increase in excess reserves that the Fed’s lending produced caused the federal funds rate to decline significantly below the FOMC’s target. The FOMC attempted to regain control of the federal funds rate by paying banks 50 basis points on their excess reserves (IOER) on October 6, 2008. The FOMC then reduced its target to 1.5% on October 8, 2008, but the funds rate fell below that level and declined further even though the IOER was increased to 1.0%. The FOMC eventually acquiesced to the market. It reduced the target to between zero and 25 basis points on December 16, 2008, (see Can the FOMC Increase the Funds Rate Target Without Reducing Reserves?).
In an apparent realization that its zero interest rate policy was ineffective, the FOMC engaged in three additional policies in an attempt to reduce interest rates: a large-scale-asset-purchase program, known as quantitative easing (QE), forward guidance, and the maturity extension program, known as “Operation Twist.” QE was an attempt to push long-term interest rates down by purchasing a large amount of long-term Treasuries, mortgage-backed securities (MBS) and agency debt. Forward guidance was an attempt to reduce long-term interest rates by signaling, in various ways, that the FOMC would keep the federal funds rate at zero for a longer period than the market expected (for more information and evidence of its effectiveness see Verbal Guidance and the Efficacy of Forward Guidance and How Effective Is Central Bank Forward Guidance?). Operation Twist was an attempt to reduce long-term rates by purchasing long-term securities and simultaneously selling short-term securities. If effective, long-term Treasury rates would decline and short-term Treasury rates would increase, i.e., the Fed would “twist” the yield curve.
The Fed has undertaken two types of actions in response to the pandemic: Humanitarian lending to main street businesses that have been hurt by the pandemic and would have trouble acquiring loans, and policy actions aimed at reducing longer-term lending rates to stimulate spending (aka, aggregate demand). To date, the former have been small; the latter have been massive.
The FOMC reduced its federal funds rate target to zero quickly and engaged in QE and forward guidance policies. The Fed’s securities holdings exploded from $3.8 trillion on February 26 to $6.9 trillion on July 8: $4.2 Trillion in longer-term Treasuries and $1.9 trillion in MBS.
The Fed also acquired the debt of corporations and state and local governments through specialized bond purchasing programs.
The FOMC is discussing a new strategy called yield curve control, whereby the FOMC will set a ceiling for the rate on a long-term Treasury security, such as the 10-year Treasury. This is yet another attempt to reduce longer-term interest rates and stimulate aggregate demand (See More Monetary Policy Insanity: Price Fixing!).
Former Fed chairman, Ben Bernanke, has recently (see The new tools of monetary policy) suggested that the Fed should consider using new “tools” that some major foreign central banks have used: purchasing private securities, negative interest rates, and yield curve control.
If the Fed’s QE, forward guidance and Operation Twist policies were successful in reducing longer-term rates, why does the Fed need to make loans to the private sector, set a cap on a long-term Treasury rate, or make interest rates negative so lenders pay borrowers to take the money lenders want to lend? (To understand how nominal interest rates can be negative see Nominal Interest Rates: Less Than Zero?).
Before the financial crisis, U.S. financial markets were the envy of the world. We had the largest and most sophisticated financial markets. Given the Fed deems it necessary to become involved in virtually every segment of our financial markets, I’m led to believe that our financial markets are now crippled, backward and inefficient.
The markets must be unable to satisfy the economy’s need for credit. Otherwise, why would the Fed find it necessary to subsidize mortgage lending by purchasing $1.9 trillion in MBS? Why would the Fed find it necessary to purchase $4.2 trillion of longer-term Treasury debt to assist the government in financing its borrowing?
Why would the Fed make loans to corporations and state and local governments? Why would the FOMC do the things it has done and contemplate doing things that Bernanke and others have suggested it should do?
The Fed is currently supplying the economy with credit equal to 24% of GDP, compared with just 6% before the Lehman Bros bankruptcy announcement in September 2008. This percentage is destined to get much larger as the FOMC persists in its effort to make its interest rate policy work.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.
