Uncharted Territory
| Author | Koshy Mathai; Simon Willson |
| Position | International Monetary Fund |
| Pages | 32-33 |
Page 32
When aggressive monetary policy combats a crisis
THE current global economic downturn will probably not be as severe as the Great Depression, partly because of the vigorous response from the world's policymakers. Eighty years ago, policymakers were initially not even convinced of the need to ease monetary conditions, and they bear a good part of the blame for the ensuing depression. This chart shows how radically policy thinking has changed since then.
When the crisis began in mid-2007, the U.S. Federal Reserve (Fed) reacted by aggressively cutting its target for the policy interest rate-the fed funds rate, at which banks lend to each other overnight-and introducing special facilities to ensure that all parts of the financial system had access to liquidity. At the same time, too much money in the system would push the fed funds rate below target and possibly stoke inflation, so the Fed sold U.S. Treasury securities to mop up liquidity.
Following the collapse of Lehman Brothers in September 2008, financial and economic conditions worsened dramatically. The Fed cut the policy rate further, introduced yet more facilities, and now allowed its balance sheet to more than double in size over just a few months, pumping up bank reserves and thus the monetary base. Broader monetary aggregates, however, increased only modestly, given banks' cautious behavior.
The expansion of the Fed's balance sheet made it difficult to maintain the fed funds rate near the policy target, and in December 2008 the Fed dropped the target to a range of 0 to 25 basis points. Although there is no more scope for interest rate cuts, the Fed retains the ability to conduct monetary policy through changes in the composition and size of its balance sheet. And this ability is crucial, given the threat of deflation.
The Fed tightened policy in 1930, helping to trigger the Great Depression, and in 1937 it put the brakes on too early, killing off the recovery and sending the economy into recession. In between, it did expand the money supply, but far less aggressively than today's Fed has chosen to do.
The Federal Reserve bought Treasury debt during World War II, when the government had to borrow on a large scale to finance its greatly expanded...
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