Monetary Policy and the Fed
Read this chapter to understand in more detail the monetary policy tools, process, and impacts on the U.S. economy. Review specific monetary policies and their effects from our recent history.
Monetary Policy in the United States
Case in Point: A Brief History of the Greenspan Fed
Figure 11.3
With
the passage of time and the fact that the fallout on the economy turned
out to be relatively minor, it is hard in retrospect to realize how
scary a situation Alan Greenspan and the Fed faced just two months after
his appointment as Chairman of the Federal Reserve Board. On October
12, 1987, the stock market had its worst day ever. The Dow Jones
Industrial Average plunged 508 points, wiping out more than $500 billion
in a few hours of feverish trading on Wall Street. That drop
represented a loss in value of over 22%. In comparison, the largest
daily drop in 2008 of 778 points on September 29, 2008, represented a
loss in value of about 7%.
When the Fed faced another huge plunge
in stock prices in 1929 - also in October - members of the Board of
Governors met and decided that no action was necessary. Determined not
to repeat the terrible mistake of 1929, one that helped to usher in the
Great Depression, Alan Greenspan immediately reassured the country,
saying that the Fed would provide adequate liquidity, by buying federal
securities, to assure that economic activity would not fall. As it
turned out, the damage to the economy was minor and the stock market
quickly regained value.
In the fall of 1990, the economy began to
slip into recession. The Fed responded with expansionary monetary
policy - cutting reserve requirements, lowering the discount rate, and
buying Treasury bonds.
Interest rates fell quite quickly in
response to the Fed's actions, but, as is often the case, changes to the
components of aggregate demand were slower in coming. Consumption and
investment began to rise in 1991, but their growth was weak, and
unemployment continued to rise because growth in output was too slow to
keep up with growth in the labor force. It was not until the fall of
1992 that the economy started to pick up steam. This episode
demonstrates an important difficulty with stabilization policy: attempts
to manipulate aggregate demand achieve shifts in the curve, but with a
lag.
Throughout the rest of the 1990s, with some tightening when
the economy seemed to be moving into an inflationary gap and some
loosening when the economy seemed to be possibly moving toward a
recessionary gap - especially in 1998 and 1999 when parts of Asia
experienced financial turmoil and recession and European growth had
slowed down - the Fed helped steer what is now referred to as the
Goldilocks (not too hot, not too cold, just right) economy.
The
U.S. economy again experienced a mild recession in 2001 under Greenspan.
At that time, the Fed systematically conducted expansionary policy.
Similar to its response to the 1987 stock market crash, the Fed has been
credited with maintaining liquidity following the dot-com stock market
crash in early 2001 and the attacks on the World Trade Center and the
Pentagon in September 2001.
When Greenspan retired in January
2006, many hailed him as the greatest central banker ever. As the
economy faltered in 2008 and as the financial crisis unfolded throughout
the year, however, the question of how the policies of Greenspan's Fed
played into the current difficulties took center stage. Testifying
before Congress in October 2008, he said that the country faces a
"once-in-a-century credit tsunami," and he admitted, "I made a mistake
in presuming that the self-interests of organizations, specifically
banks and others, were such as that they were best capable of protecting
their own shareholders and their equity in their firms". The criticisms
he has faced are twofold: that the very low interest rates used to
fight the 2001 recession and maintained for too long fueled the real
estate bubble and that he did not promote appropriate regulations to
deal with the new financial instruments that were created in the early
2000s. While supporting some additional regulations when he testified
before Congress, he also warned that overreacting could be dangerous:
"We have to recognize that this is almost surely a once-in-a-century
phenomenon, and, in that regard, to realize the types of regulation that
would prevent this from happening in the future are so onerous as to
basically suppress the growth rate in the economy and . . . the
standards of living of the American people".