Part 3: Monetary Policy in 2008 and Early 2009

After easing the stance of monetary policy 225 basis points over the first half of 2008, the Federal Open Market Committee (FOMC) lowered the target federal funds rate further in the second half, ultimately bringing it to a range of 0 to 1/4 percent (figure 54).¹² The Federal Reserve also took a number of additional actions to increase liquidity and improve market functioning. Some of these measures resulted in a substantial increase in the size of the Federal Reserve’s balance sheet; further, the FOMC announced at its December meeting that the focus of policy going forward would be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that would sustain the size of the Federal Reserve’s balance sheet at a high level.

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Information available last summer indicated that residential construction remained on a downward trend, the labor market had weakened further, and industrial production had declined. Although aggregate output was reported to have expanded in the second quarter, financial market developments suggested that the economy would likely come under considerable stress in the near future--in particular, tight credit conditions, the ongoing housing contraction, and the rise in energy prices were expected to weigh on economic growth over the subsequent few quarters. Core consumer price inflation remained relatively stable, but headline inflation was elevated as a result of large increases in food and energy prices.

With these considerations in mind, the FOMC kept the target federal funds rate unchanged at 2 percent at its August meeting. The accompanying policy statement indicated that, although downside risks to growth remained, the upside risks to inflation were also of significant concern to the Committee. This risk assessment, which many market participants reportedly interpreted as essentially balanced, was in line with expectations at the time. Accordingly, the expected path for policy was little changed in the wake of the announcement, and the response in broader financial markets was minimal.

By the time of the meeting on September 16, the outlook for inflation had moderated as a result of substantial declines in the prices of oil and other commodities as well as weakening aggregate demand. Various measures of inflation expectations declined between the two meetings, nominal wage increases continued to be moderate, and productivity growth remained solid. In addition, declining employment and softening final sales contributed to a weaker outlook for near-term economic activity. Still, some firms reportedly were continuing to pass through to their customers previous increases in the costs of energy and raw materials, and readings on core and headline inflation remained elevated. In this environment, the Committee was concerned that high inflation might become embedded in expectations and thereby impart considerable momentum to overall inflation. Financial strains had increased over the intermeeting period, although the consequences of the bankruptcy of Lehman Brothers Holdings on September 15 were not yet clear at the time of the meeting. Indeed, the substantial easing of monetary policy over the previous year, combined with ongoing measures to foster market liquidity, was seen as likely to support activity going forward. Thus, members agreed that keeping the federal funds target rate unchanged at 2 percent at the September meeting was appropriate.

Over the following weeks, stresses in financial markets continued to mount. Interest rate spreads in interbank funding markets widened markedly, corporate and municipal bond yields rose, and equity prices dropped sharply. The decline in the net asset value of a major money market mutual fund below $1 per share sparked a flight out of prime money market funds and caused a severe impairment of the functioning of the commercial paper market. In response to the extraordinary stresses in financial markets, the Federal Reserve, together with U.S. government entities and many foreign central banks and governments, implemented a number of unprecedented policy initiatives. Measures taken by the Federal Reserve around this time, discussed in detail in the appendix, included the establishment of the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, Commercial Paper Funding Facility, and Money Market Investor Funding Facility, which were intended to improve the liquidity in short-term debt markets and ease the strains in credit markets more broadly. In addition, to address the sizable demand for dollar funding in foreign jurisdictions, the FOMC authorized increases in its existing liquidity swap lines with foreign central banks and established lines with additional central banks. In domestic markets, the Federal Reserve raised the regular auction amounts of the 28- and 84-day maturity Term Auction Facility (TAF) auctions and announced two forward TAF auctions to provide funding over year-end.

The expansion of existing liquidity facilities and the creation of new facilities contributed to a substantial increase in the size of the Federal Reserve’s balance sheet. Two initiatives were introduced to help manage the expansion of the balance sheet and promote control of the federal funds rate. First, on September 17, the Treasury announced a temporary Supplementary Financing Program at the request of the Federal Reserve. Under this program, the Treasury issues short-term bills over and above its regular borrowing program, with the proceeds deposited at the Federal Reserve. Second, using authority granted under the Emergency Economic Stabilization Act, the Federal Reserve announced on October 6 that it would begin paying interest on required and excess reserve balances. The payment of interest on excess reserves was intended to assist in maintaining the federal funds rate close to the target set by the Committee by creating a floor on interbank market rates. Initially, the interest rate paid on required reserve balances was set as a spread below the average targeted federal funds rate established by the FOMC over each reserve maintenance period, and the rate paid on excess balances was set as a spread below the lowest targeted federal funds rate for each reserve maintenance period. Subsequently, with the federal funds rate trading consistently below the target rate, the spreads were eliminated.

In late September and into October, macroeconomic conditions deteriorated in both the United States and Europe, prices of crude oil and other commodities dropped substantially, and some measures of expected inflation declined. In light of these developments and the extraordinary turmoil in financial markets, the Committee members agreed that downside risks to economic growth had increased and that upside risks to inflation had diminished; at an unscheduled meeting in early October, the FOMC cut its target to 1-1/2 percent in an unprecedented coordinated policy action with five other major central banks. This action, along with the accompanying statement, led investors to mark down further the expected path for the federal funds rate.

At its October 28–29 meeting, the FOMC lowered its target for the federal funds rate an additional 50 basis points, to 1 percent. The Committee’s statement noted that economic activity appeared to have slowed markedly, a development due importantly to weakening consumer and business spending and softening demand from many foreign economies. Moreover, the intensification of financial market turmoil was likely to exert additional restraint on spending by further tightening credit conditions for households and businesses. The Committee noted that, in light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, it expected inflation to moderate in coming quarters to levels consistent with price stability. With risks to economic activity to the downside, the Committee indicated that it would monitor economic and financial developments carefully and act as needed to promote sustainable economic growth and price stability.

The decision of the FOMC at its October meeting was broadly in line with market expectations and elicited only a modest reaction in financial markets. However, subsequent economic data releases suggested that economic activity was weaker and inflation lower than had been earlier anticipated. Those readings, along with continued strains in financial markets that weighed on investor sentiment, contributed to a sharp downward revision in the expected path of policy over the following weeks. Reflecting investor concerns about the condition of financial institutions, spreads on credit default swaps for U.S. banks widened sharply, and those for insurance companies remained very elevated.

Available evidence also suggested further tightening in consumer and small business credit conditions; in view of this tightening, the Federal Reserve announced on November 25 plans for the Term Asset-Backed Securities Loan Facility (TALF) to support lending to these borrowers. The Federal Reserve also announced on November 25 that, to help reduce the cost and increase the availability of residential mortgage credit, it would initiate a program to purchase up to $100 billion in direct obligations of housing-related government-sponsored enterprises and up to $500 billion in mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae. The announcement and implementation of the agency purchase program appeared to reduce spreads on agency debt; conditions for high-quality borrowers in the primary residential mortgage market subsequently recovered somewhat.

Although some financial markets exhibited signs of improved functioning ahead of the December meeting, financial conditions generally remained very strained. Credit conditions had continued to tighten for both households and businesses, and ongoing declines in equity and house prices further reduced household wealth. Against this backdrop, indicators of aggregate economic activity continued to worsen. The Committee expected economic activity to contract sharply in the fourth quarter of 2008 and in early 2009; it noted that the uncertainty surrounding the outlook was considerable and that the downside risk to even this dour trajectory for economic activity was a serious concern. Inflation pressures had diminished appreciably as energy and other commodity prices dropped and economic activity slumped. Looking forward, members agreed that inflation pressures appeared set to moderate further in coming quarters, and some saw risks that inflation could drop below rates they viewed as most consistent over time with the Federal Reserve’s dual mandate for maximum employment and price stability.

With the federal funds rate already trading at very low levels as a result of the large volume of excess reserves associated with the Federal Reserve’s liquidity operations, participants agreed that the Committee would soon need to use other tools to impart additional monetary stimulus to the economy. The Federal Reserve had already adopted a series of programs that were providing liquidity support to a range of institutions and markets, and a continued focus on the quantity and the composition of Federal Reserve assets appeared to be necessary and desirable. Participants agreed that maintenance of a low level of short-term interest rates for some time and reliance on the use of balance sheet policies and communications about monetary policy could be effective and appropriate, in light of the sharp deterioration in the economic outlook and the appreciable easing of inflationary pressures.

Accordingly, the Committee announced a target range for the federal funds rate of 0 to 1/4 percent and indicated that weak economic conditions were likely to warrant exceptionally low levels of the federal funds rate for some time. The statement also noted that the size of the Federal Reserve’s balance sheet would be maintained at a high level through open market operations and other measures to support financial markets and stimulate the economy. In addition, the statement indicated that the Committee stood ready to expand purchases of agency debt and agency MBS and that it was evaluating the potential benefits of purchasing longer-term Treasury securities. The FOMC members emphasized that their expectation about the path of the federal funds rate was conditioned on their view of the likely path of economic activity. The interest rates on required reserve balances and excess reserve balances were both set at 25 basis points. These monetary policy decisions apparently were more aggressive than investors had been expecting. Market participants were somewhat surprised both by the size of the reduction in the target federal funds rate and by the statements that policy rates would likely remain low for some time and that the FOMC might engage in additional nontraditional policy actions such as the purchase of longer-term Treasury securities.

Incoming data over the following weeks indicated a continued sharp contraction in economic activity. The housing market remained on a steep downward trend, consumer spending continued its significant decline, the slowdown in business equipment investment intensified, and foreign demand weakened. Conditions in the labor market continued to deteriorate rapidly, and the drop in industrial production accelerated. Headline consumer prices fell in November and December, which reflected declines in consumer energy prices; core consumer prices were about flat in those months. Credit conditions generally remained tight, with financial markets fragile and some parts of the banking sector under substantial stress. However, modest signs of improvement were evident in some financial markets--particularly those that were receiving support from Federal Reserve liquidity facilities and other government actions.

At the meeting in January 2009, participants anticipated that a gradual recovery in U.S. economic activity would begin in the second half of the year in response to monetary easing, another dose of fiscal stimulus, relatively low energy prices, and continued efforts by the government to stabilize the financial sector and increase the availability of credit. As of late January, however, with financial conditions strained and the near-term economic outlook weak, most participants agreed that the Committee should continue to focus on supporting the functioning of financial markets and stimulating the economy through purchases of agency debt and MBS and other measures--including the implementation of the TALF--that will keep the size of the Federal Reserve’s balance sheet at a high level for some time. Committee members agreed that keeping the target range for the federal funds rate at 0 to 1/4 percent would be appropriate. They also agreed to continue using liquidity and asset-purchase programs to support the functioning of financial markets and to stimulate the economy.

In its January statement, the FOMC reemphasized that the Federal Reserve will use all available tools to promote the resumption of sustainable economic growth and to preserve price stability. The Committee also stated that, in addition to the purchases of agency debt and MBS already under way, it was prepared to purchase longer-term Treasury securities if evolving circumstances indicated that such transactions would be particularly effective in improving conditions in private credit markets. The Committee will continue to monitor carefully the size and composition of the Federal Reserve’s balance sheet in light of evolving financial market developments. It will also continue to assess whether expansions of, or modifications to, lending facilities would serve to further support credit markets and economic activity and help preserve price stability.

Footnotes

12. Members of the FOMC in 2008 consisted of members of the Board of Governors of the Federal Reserve System plus the presidents of the Federal Reserve Banks of Cleveland, Dallas, Minneapolis, New York, and Philadelphia; in 2009, FOMC members consist of members of the Board of Governors plus the presidents of the Federal Reserve Banks of Atlanta, Chicago, New York, Richmond, and San Francisco. Participants at FOMC meetings consist of members of the Board of Governors and all Reserve Bank presidents.  Return to text