It’s Not Your Mother and Father’s Monetary Policy Anymore: The Federal Reserve and Financial Crisis Relief

By Andrew T. Hill and William C. Wood

First published in Social Education #75(2), pp. 76–81

The recent financial crisis brought about dramatic changes in the way that the Federal Reserve, the nation’s central bank, conducts monetary policy. One challenge for high school educators going forward will be to strike a balance between the teaching of traditional monetary policy and the teaching of the monetary policy used during these turbulent times. In this paper, we show how the Federal Reserve implemented monetary policy in “ordinary times” before the financial crisis. We also provide an overview of the monetary policy tools created during the financial crisis and a summary of the Fed’s expansion of its balance sheet. Finally, we provide a set of suggestions on how to approach the teaching of monetary policy in the post-financial crisis world (see sidebar).

Monetary Policy in Ordinary Times

For decades, high school and college textbooks were predictable in their coverage of monetary policy. The textbook version would define money, pointing out that the definition goes well beyond currency to include money in checking accounts. The text would describe the Federal Reserve, its Board of Governors, and the 12 regional Federal Reserve Banks. The text would explain that commercial banks are required to hold funds in reserve against their deposits, and that the Federal Reserve can change the quantity of money to achieve economic goals. For example, if the Federal Reserve reduces the reserves that banks are required to hold, banks have a greater ability to lend, and can expand lending, creating multiple new deposits through the process summarized in the “money multiplier.” Next, students would be shown how the Federal Reserve can encourage lending through changes in the discount rate, or the interest rate it charges member banks for loans. Finally, students would see how the Federal Reserve’s purchases and sales of government securities, called open market operations, can change bank reserves and therefore the quantity of money (see Table 1).

The order in which textbooks present the elements of monetary policy makes sense because reserve requirements, coming first, are the easiest of the Fed’s policy tools to understand. Open market operations are the hardest. And yet the textbook treatment leaves the impression that changes in reserve requirements are a viable monetary policy option for the Federal Reserve in ordinary times. In fact, reserve requirements have not been changed since the 1990s, and were not changed during the crisis that began in 2007. The textbook treatment also tends to leave students believing that discount rate changes are important. In fact, discount rate policy has become passive in ordinary times, in that the discount rate only reflects other Federal Reserve policies — rather than being an independent way of influencing the quantity of money.

As the Federal Reserve Board states on its website, open market operations are the Fed’s “principal tool for implementing monetary policy.”1 For teachers, the implication is that the most important tool of monetary policy is the hardest one for students to learn. The Federal Open Market Committee (FOMC) guides open market operations by specifying targets for an important short-term interest rate, the federal funds rate. It is open market transactions, usually carried out on a daily basis, which affect the amount of money and credit available in the banking system. In turn, these changes in the supply of money and credit affect interest rates, which in turn affect the spending decisions of households and businesses and ultimately the overall performance of the U.S. economy.2

Monetary Policy in Turbulent Times

The financial crisis that began to take hold in 2007 significantly affected the way the Federal Reserve implemented monetary policy. Beginning in September 2007, the FOMC began dropping its target for the federal funds to near zero. In 10 steps, the target was taken from 5.25% to a band of 0 to 0.25% as of December 2008. And, once the federal funds rate target reached almost zero at the end of 2008, traditional open market operations were no longer able to ease monetary policy further to deal with the crisis. Practically speaking, the rate could go no lower. Targeting the federal funds rate, the Fed’s primary tool of monetary policy, had reached its zero bound and was therefore at its limit as a tool of monetary policy during these turbulent times.

The most important idea for students to understand about financial crisis management is the concept of liquidity. Liquidity is the ability to quickly convert something of value into spendable money. For example, a savings account has a great deal of liquidity for an individual bank depositor. The depositor can get cash with a quick visit to the bank — or can convert the savings to checking money with the click of a mouse. A home has much lower liquidity, in that an individual could convert its value to spendable cash only with a long process of selling the real estate.

Just like individuals, banks and other financial institutions sometimes need more liquidity. Think about a bank that has valuable holdings, such as sound and well-secured loans. Because the payments on the loan come in periodically over time, the bank does not have immediate access to the amount of the loan. It can therefore face liquidity troubles if it is confronted by sudden demands. In ordinary times, banks and the Federal Reserve work together to ensure sufficient amounts of liquidity. In a crisis, however, liquidity can dry up. At such a point, the Federal Reserve will almost certainly be called on to restore liquidity.

Beginning in summer 2007, the Federal Reserve initiated a number of temporary liquidity measures aimed at improving credit conditions and economic conditions nationwide. Initially, the Federal Reserve Board of Governors enabled additional borrowing at the discount rate. Specifically, the Board extended the availability of discount window lending beyond the usual overnight basis to up to 30 days with possible renewal. This measure was put in place to provide greater assurances to depository institutions that they could borrow from the regional Reserve Banks.3

What to Teach

The sweeping changes to the framework of monetary policy in recent years present a huge challenge to high school and college instructors. While it is clearly important to teach students about the critical work that the Federal Reserve did through monetary policy to avert a second Great Depression, it’s very easy to get drawn into the details of the Fed’s programs and over teach. There are a number of things that we absolutely must teach our students about monetary policy in order to make them well-informed citizens participating knowledgeably in our economy:

We need to continue to teach students about the Federal Reserve’s conduct of monetary policy, implemented, in ordinary times, day-to-day through open-market operations. We should emphasize how open market operations affect the size of the money supply, the availability of credit, the level of interest rates, and eventually the health of the economy in ordinary times.
In addition to making certain that our students understand the causes of the financial crisis that began in 2007, we need to ensure that we teach them about the importance of liquidity in a time of crisis. This provides the foundation for teaching about the extraordinary measures that the Fed took as lender of last resort to increase liquidity in specific credit markets and the economy as a whole. Students are then prepared to understand how emergency action helped to ensure that sound financial institutions would emerge from the crisis rather than failing and that borrowers and investors would have greater access to credit and their funds than if credit markets had remained seized.
We need to emphasize to our students that providing liquidity in times of crisis can reduce financial damage and increase overall stability. This involves the Fed’s ability to quickly put extensive, effective liquidity measures in place during a financial crisis and remove them effectively when they are no longer needed.
We need to ensure that our students understand how and why the Federal Reserve expanded its balance sheet, making it possible to increase liquidity through lending programs during the height of the crisis and to implement so-called quantitative easing during the lingering period of weak economic growth.
We need to present our students with comparisons to other times in our nation’s history (i.e., the Panic of 1907 or the Great Depression) when, with less understanding of monetary economics, policymakers had few tools to mitigate the effects of a financial crisis or used the wrong policy for the economic conditions.

New Tools of Monetary Policy

As the crisis unfolded, the Federal Reserve implemented new monetary policy tools. Some of these new tools required the Fed to invoke a special provision of the Federal Reserve Act — referred to as Section 13(3) — that gives the Fed the authority to lend to any individual, partnership, or corporation in “unusual and exigent circumstances.”4 Three of the new tools were directed at providing short-term liquidity to banks and other financial institutions. These tools, summarized in Table 1, were implemented in late 2007 and early 2008:

The Term Auction Facility (TAF), announced in late 2007, provided one- and three-month loans to depository institutions. The TAF program worked to improve liquidity in the economy as a whole.5
The Term Securities Lending Facility (TSLF), initiated in March 2008, allowed the Fed’s primary dealers, the banks and securities broker-dealers with which the Open Market Trading Desk at the Federal Reserve Bank of New York trades U.S. government and other select securities, to swap less liquid assets for U.S. Treasury securities owned by the Federal Reserve. This, too, improved liquidity.6
The Primary Dealer Credit Facility (PDCF), also initiated in March 2008, provided overnight loans to the Fed’s primary dealers. Again the goal was improved liquidity in the financial system.7

These initial new tools of monetary policy — the TAF, the TSLF, and the PDCF8 — were closely aligned with the Federal Reserve’s long-established role as lender-of-last-resort.9 They all provided short term credit to sound financial institutions. In February 2009, Federal Reserve Chairman Ben Bernanke explained that

In fulfilling its traditional lending function, the Federal Reserve enhances the stability of our financial system, increases the willingness of financial institutions to extend credit, and helps to ease conditions in interbank lending markets, thereby reducing the overall cost of capital to banks.10

As the financial crisis expanded further in 2008, it became apparent to policymakers at the Federal Reserve that additional liquidity measures were needed to address instability in a number of key credit markets. As Ben Bernanke explained,

…lending to financial institutions does not directly address instability or declining liquidity in critical nonbank markets, such as the commercial paper market or the market for asset-backed securities, which under normal circumstances are major sources of credit for U.S. households and firms.11

“Commercial paper” is used when companies need to borrow large amounts of money for short periods of time. In ordinary times, commercial paper is quite safe and therefore is favored by highly conservative investors, such as money market mutual funds.

With the goal of reducing key instabilities, late in 2008 the Federal Reserve announced four additional liquidity measures, again summarized in Table 1. These measures involved providing liquidity directly to borrowers and investors:

The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), announced in September 2008, aimed at assisting money market mutual funds. As the crisis deepened, investors in these funds became increasingly concerned about the quality of the assets held by the funds they were invested in. As investors sought to take their money out, the funds were forced to sell securities at fire sale prices in order to meet their investors’ redemptions (withdrawals).The specific securities targeted by the AMLF were high quality “asset backed commercial paper,” a form of short-term lending that ordinarily is quite safe but had become problematic in the nation’s severely strained money markets.
The Commercial Paper Funding Facility (CPFF), announced in October 2008, provided additional financing for particular types of commercial paper. In particular, it financed the purchase of highly rated unsecured and asset-backed commercial paper from eligible issuers through the Fed’s primary dealers.
The Money Market Investor Funding Facility (MMIFF), also announced in October 2008, supported a private-sector program to provide liquidity to money market mutual fund investors by financing the purchase of the funds’ assets, thereby helping to facilitate smoother redemptions (withdrawals). Both the MMIFF and AMLF assisted people with money in money market mutual funds to withdraw their money.
The Term Asset-Backed Securities Loan Facility (TALF), announced in November 2008, was aimed at a method of financing called “securitization.” In securitization, individual loans are bundled together and securities based on those bundles are sold to investors. To help ease disruptions in the securitization of loans to consumers and businesses, the TALF program provided funding to U.S. companies (including banks and investment funds) with eligible collateral to borrow funds for the purchase of high-quality asset-backed securities. By late 2008, uncertainty had caused the securitization process to “seize up” — in effect to stop functioning. With the assistance provided by the TALF program, consumers and businesses saw greater access to credit and lower interest rates on the loans they took out than they would have experienced had the TALF program not been initiated and credit markets remained seized.12

Managing Depository Institutions’ Reserves

In 2008 and 2010, the Federal Reserve put in place two additional tools of monetary policy, again summarized in Table 1. The first involves paying interest on reserves held by banks and other financial institutions. Traditionally, no interest was paid on the reserves these institutions held. The financial disadvantage operated like a tax. In 2008, this implicit tax was eliminated.13 More importantly for the conduct of monetary policy, paying interest on reserves provides the Federal Reserve with an additional tool for controlling the aggregate size of reserves in the banking system. By increasing the interest rate paid on reserves, the Fed can entice depository institutions to put more of their reserves in their accounts at the Federal Reserve Banks and reduce the amount of excess reserves those depository institutions have available to make loans. Conversely, reducing the interest rate paid on reserves would entice depository institutions to reduce their balances at the Federal Reserve Banks and likely increase the amount they lend to consumers and businesses.14

In 2010, the Federal Reserve put in place another method for managing reserves, the Term Deposit Facility (TDF). The TDF works in reverse of the Term Auction Facility. In the TDF, the Fed is offering term deposits on an auction basis. When a depository institution purchases a term deposit from the Federal Reserve, the funds are removed from its reserve account at a Federal Reserve Bank, thereby reducing the amount of bank reserves for the specified term of the deposit. Both paying interest on reserves and the TDF provide the Fed with strong tools for reducing aggregate bank reserves and will be very useful when it comes time to tighten monetary policy and reduce the size of the Fed’s balance sheet.

The Role of the Fed’s Balance Sheet

Any financial institution’s balance sheet shows what it owns (its assets) and what it owes (its liabilities). The Federal Reserve’s balance sheet provides an important summary of its overall position.

From fall 2008 onwards, the Federal Reserve has significantly expanded the size of its balance sheet from around $900 billion in summer 2008 to over $2.3 trillion in fall 2010. The majority of that expansion occurred during the height of the crisis from September through December 2008. This substantial expansion of the Fed’s balance sheet has been a key factor in its ability to provide large amounts of additional liquidity to the U.S. economy during the crisis. Initially, the expansion of the balance sheet allowed for the significant expansion of the Fed’s lending facilities. In 2009 and 2010, as the lending facilities shrank in size and eventually closed, the Fed carried out large purchases of U.S. Treasury and agency securities and U.S.-backed mortgage-backed securities. These purchases, often called “quantitative easing,” increased the amount of reserves in the banking system and worked to keep interest rates low to spur economic growth.

In Table 2, we show four snapshots of the Fed’s balance sheet at different periods of time. We have simplified the balance sheet in order to ease the discussion.15 In Panel 1 of Table 2 is the Fed’s simplified balance sheet on July 9, 2008. At that point, the Fed’s balance sheet was about $900 billion with its lending programs totaling just over 18% of total assets. In order to fund those programs, the Fed had sold a portion of its portfolio of U.S. Treasury securities, which at one time had totaled over $700 billion.

As shown in Panel 2, by middle October 2008, the height of the crisis, the Fed’s lending programs totaled about 40% of its assets. The Fed’s total balance sheet had grown from $900 billion in July 2008 to over $1.7 trillion in October 2008. The growth in the balance sheet was facilitated by an increase in U.S. Treasury deposits to $523 billion and an expansion of depository institutions’ reserves at the Fed to over $270 billion.

By December 2008, as shown in Panel 3, the Fed’s balance sheet had expanded to over $2 trillion and lending represented nearly 46% of total assets. While Treasury’s deposits had shrunk slightly, reserve deposits had grown to nearly $780 billion. This growth in reserve deposits allowed for the expansion of the lending programs on the asset side of the balance sheet.

Fast forwarding nearly two years to September 2010, as shown in Panel 4, the Fed’s balance sheet was over $2.3 trillion. While the Fed’s overall lending had shrunk to less than 1% of assets, the Fed’s extensive purchases of U.S. Treasury securities, agency securities, and mortgage-backed securities replaced the lending programs on the asset side of the balance sheet. Depository institutions no longer needed assistance from the Fed’s lending programs and the Fed had carried out extensive quantitative easing through its securities purchases.16 In turn, depository institutions’ reserve deposits at the Reserve Banks increased to over $980 billion. The Fed continued to provide a very large amount of liquidity to the economy through its expanded balance sheet.17

Andrew T. Hill is the economic education advisor at the Federal Reserve Bank of Philadelphia and adjunct professor of economics at Temple University. He can be reached at andrew.hill@phil.frb.org .
William C. Wood is professor of economics and the director of the center for economic education at James Madison University. He can be reached at woodwc@jmu.edu .

The views expressed here are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.

Notes

¹Board of Governors of the Federal Reserve System, “Open Market Operations .”
²For more information on the roles, responsibilities,and work of the FOMC see Federal Reserve Bank of Philadelphia, “A Day in the Life of the FOMC.”
³Board of Governors of the Federal Reserve System, Press Release, August 17, 2007 .
⁴For more information on the “unusual and exigent circumstances” provisions of the Federal Reserve Act see David Fettig, “The History of a Powerful Paragraph,” Federal Reserve Bank of Minneapolis The Region (June 2008): 33-34.
⁵For more information on the Term Auction Facility see Olivier Armantier, Sandra Krieger, and James McAndrews, “The Federal Reserve’s Term Auction Facility,” Federal Reserve Bank of New York Current Issues in Economics and Finance 14, no. 5 (2008).
⁶For more information on the Term Securities Lending Facility see Michael J. Fleming, Warren B. Hrung,and Frank M. Keane, “The Term Securities Lending Facility: Origin, Design, and Effects,” Federal Reserve Bank of New York Current Issues in Economics and Finance 15, no. 2 (2009).
⁷For more information on the Primary Dealer Credit Facility see Tobias Adrian, Christopher R. Burke,and James J. McAndrews, “The Federal Reserve’s Primary Dealer Credit Facility,” Federal Reserve Bank of New York Current Issues in Economics and Finance 15, no. 4 (2009).
⁸Beginning in late 2007, the Federal Reserve also sought to provide dollar-denominated liquidity to global financial markets through a set of reciprocal currency agreements established with a number of central banks around the world.
⁹For a more extensive discussion of central banks’ roles as lenders of last resort, see Stephen G. Cecchetti and Piti Disyatat, “Central Bank Tools and Liquidity Shortages,” Federal Reserve Bank of New York Economic Policy Review 16, no. 1 (2010): 29-42.
¹⁰Ben Bernanke, “Federal Reserve Policies to Ease Credit and Their Implications for the Fed’s Balance Sheet,” February 18, 2009.
¹¹Ibid.
¹²For additional information about the Term Asset-Backed Securities Loan Facility see Brian P. Sack,“Reflections on the TALF and the Federal Reserve’Role as Liquidity Provider,” June 9, 2010.
¹³The Financial Services Regulatory Relief Act, passed by Congress in 2006, originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008.
¹⁴For more information on monetary policy with interest on reserves see Charles T. Carlstrom and Timothy S. Fuerst, “Monetary Policy in a World with Interest on Reserves,” Federal Reserve Bank of Cleveland Economic Commentary no. 2010–4 (2010).
¹⁵For more information about the Fed’s balance sheet see Federal Reserve Board of Governors, “Credit and Liquidity Programs and the Balance Sheet.”
¹⁶The Federal Reserve announced a second round of U.S. Treasury securities purchases in late 2010.
¹⁷For extensive discussions of the Fed’s balance sheet and depository institutions’ excess reserves see Todd Keister and James J. McAndrews, “Why Are Banks Holding So Many Excess Reserves?” Federal Reserve Bank of New York Current Issues in Economics and Finance 15, no. 8 (2009).