The article published in this column on May 15, 2019 showed how recent US monetary policy tightening has not been feasible, given new concerns raised over the growth of the US and world economy. This tightening was expected to reverse the ultra-loose/relaxed monetary policy that was implemented since August 2007 towards 2016 to recover from the financial crisis 2007/09 in the US and Europe. This article highlights the nature of the US monetary policy relaxation in 2007-2016 and underlying economic benefits.
Financial Crisis 2007/09
Any financial crisis is characterized by a general damage of public confidence in the financial system or investments such as deposits, debt, equities and derivatives where investors rush to recover their investments in cash to escape possible default or losses. As a result, the economy immediately confronts a crunch of liquidity and credit across financial institutions, markets, business community and consumers while the payment system breaks down. This causes reduction in investments and spending and sudden increase in business bankruptcies across the economy.
Therefore, the economy will confront a severe downturn or recession where production, growth, employment, income and prices fall during several years. Considerable increase in unemployment, reduction in growth (even negative growth) and fall of inflation (even decline in general prices or deflation) are the eventual recessionary outcomes of financial crises.
In general, excessive credit (leverage), too much trust in financial system, too much risk-taking and poor regulation are the core causes of financial crises. However, economic and other factors that cause them are diverse. Therefore, crises occur from time to time, despite the fancy macroprudential/financial stability mechanisms aimed to detect and defuse systemic risks and intellectual monetary policies adopted to keep economic and price stability.
The financial crisis 2007/09 hit the US and Europe since the fourth quarter of 2007. This is the most severe crisis experienced after 1930s. By 2009, the growth declined to negative 2.5% with unemployment rising to 10% and inflation falling (deflation) to negative or near zero (negative 2.1% in July 2009)
(See chart 1)
Monetary Relaxation
Monetary policy relaxation in general involves in phase-wise reduction in interest rates and expansion of liquidity and credit to promote growth and employment. Therefore, monetary policy relaxation is a general prescription implemented to recover economies from financial crises. However, the relaxation required involves in slashing interest rates and printing money immediately to keep the financial system open and operating by providing necessary credit and currency at easy terms supported by a wider set of policy tools inclusive of lender of last resort facilities to bailout illiquid financial institutions and businesses.
Further, this relaxation should be a part of wider state-sponsored resolution package covering fiscal stimulus, government guarantees, business liquidity and capital supports, economic policy reforms, tightening of regulation and supervision and resolution of illiquid/bankrupt financial institutions and business corporates. Even though central banks have brave talks of stability and crisis toolkit in normal times, the governments have to resolve crises due to nation-wide damages and general lethargy of central banks to react promptly.
Unconventional Monetary Relaxation Tools
At the inception of the crisis in August 2007, the US Federal Reserve System (Fed) commenced reducing interest rates and pumping the liquidity to the inter-bank market through normal policy tools. However, as the crisis turned out to be severe, the Fed implemented a set of new (unconventional) monetary tools as normal tools were not sufficient.
- Near Zero interest rates
As usual, immediate monetary relaxation was the interest rate cut to ease credit flows. Prior to the crisis, the Fed had followed a policy of monetary tightening with fed funds rate target increased from 1% in June 2003 to 5.25% in July 2007, i.e., 17 increases with each 0.25%. Some analysts believe that this fast tightening also was a cause for the crisis or burst of the asset/credit bubble. The Fed immediately started cutting interest rates fast commencing from September 2007 (from 5.25%) to near zero level of 0-0.25% in December 2008. Accordingly, the total rate cut in 15 months was historic 5% to ease liquidity and credit flows.
(See chart 2).
- Normal Liquidity Injections
As the crisis caused a severe crunch of credit and liquidity in the banking sector and financial markets, the Fed injected immediate liquidity through normal open market operations (OMO) and discount window to banks. Such liquidity was provided in large volumes to serve as normal lender of last resorts.
- Special Liquidity Injections
As the crisis got aggravated through 2008 with the collapse of Lehman Brothers in September 2008 that caused a new round of economy-wide liquidity crunch, the Fed implemented a number of special liquidity injection programmes targeted to provide immediate liquidity directly to various markets/sectors affected by the crisis with the intension of activating them back. This a major shift from overnight inter-bank liquidity regulation-based policy to sectoral credit/liquidity distribution policy.
Those are the Money Market Investor Funding Facility October 2008-October 2009, Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility September 2008-February 2010, Commercial Paper Funding Facility October 2008-February 2010, Primary Dealer Credit Facility March 2008-February 2010, Term Securities Lending Facility March 2008-February 2010, Term Auction Facility in March 2010, Term Asset-Backed Securities Loan Facility March 2008-June 2010, Maturity Extension Programme and Reinvestment Policy September 2011-December 2012 and Central Bank Swaps (see the website of the Fed for details).
The Term Securities Lending Facility was an innovative tool through which the Fed offered/exchanged Treasury securities (high liquid and credit-worthy) for various eligible private securities (which are illiquid and low credit-worthy in the market) at haircuts/discounts. This helped holders of private securities/markets to improve their liquidity and to activate markets of both private securities and Treasury securities.
The Maturity Extension programme known as “Operation Twist” involved in selling and redeeming short-term Treasuries and using the proceeds to buy long-term Treasuries in order to lower long-term interest rates in the economy. This is a form of OMO used to shift the yield curve down at the long end for easing long-term financial conditions to encourage long-term investments for the recovery of the economy.
Central Bank Swaps were the exchange of currencies among central banks in advanced market economies such as Bank of England, European Central Bank and Bank of Japan to provide liquidity in all reserve currencies to ease international financial markets and trade.
Quantitative Easing (QE)/Large-Scale Asset Purchase Programmes
The QE is referred to purchases of securities to inject further liquidity when the interest rates are near zero/liquidity trap. Such low interest rates can be maintained and effective only if the central bank provides liquidity in demanded volumes. The Fed announced several stages of QE as listed below.
December 2008 to August 2010 - purchased US$175 bn in direct obligations of Fannie Mae, Freddie Mac and the Federal Home Loan Banks.
* January 2009 to August 2010- purchased US$1.25 trillion in Mortgaged Backed Securities (MBS) guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae.
* March 2009 to October 2009- purchased US$300 bn of longer-term Treasury securities.
* November 2010 to June 2011- Purchased further US$600 bn of longer-term Treasury securities.
* September 2012 to December 2014 - purchased additional MBS at a pace of US$40 bn per month.
* From January 2013 to December 2014 - purchased longer-term Treasury securities at a pace of US$45 bn per month.
* Grant of lender of last resorts/emergency loans to systemically important non-bank business entities under section 13(3) of the Fed Act (action taken first time after 1930s).
As a result of such monetary easing, the balance sheet/assets of the Fed increased by four times from US$ 922 bn in 2007 to US$ 4,498 bn as at end of 2014. Accordingly, the US money supply rose from US$7,468bn in 2007 to US$ 11,696bn (57% growth) in 2014. (See chart 3)
Monetary Relaxation in Advanced Economies
Bank of England (BOE) and European Central Bank (ECB) also followed a similar monetary relaxation package as the crisis spread across the Europe in same magnitude.
Bank of Japan also cut interest rates to negative level and printed a huge amount of money through asset purchases with the aim of keeping the yield of 10-year Treasuries around zero. Central banks in Canada, Australia, Sweden and Switzerland also followed monetary relaxation as the economic slack spread across these countries.
Economic Recovery
- Forward Guidance
All these central banks communicated a forward guidance to markets on goals of the monetary policy relaxation as inflation of 2%. As all advanced market economies suffered recessionary conditions with inflation falling close or below zero, all central banks focused policy relaxation to raise spending through easy credit for a target of inflation of 2%. In this process, all assessed data on trends of employment, economic growth and financial conditions to evaluate whether the inflation was on track.
Accordingly, central banks assured the public that they would continue monetary relaxation until inflation improves to 2% along with strong recovery of growth and employment. In addition, the Fed communicated a second goal as unemployment falling to 6%. Such forward guidance was intended to assure the market with the continuity of accommodative policy.
However, it took nearly a decade of ultra-relaxed policy in extraordinary magnitude to recover economies back to targeted growth path. The financial system has resumed to stable conditions with restored-public trust as a result of relaxed monetary and fiscal policies supported by new regulations. The US economy recovered to strong levels with inflation around 2%, unemployment falling below 5% and growth rising to 3%-4%.
- Policy Reversal
Therefore, the Fed embarked on monetary tightening from 2016 (raising interest rates and tapering the Fed balance sheet) to forestall inflationary pressures that could arise from the prevailing excessive liquidity. However, other central banks did not commence policy reversal as their economies did not improve to strong and sustainable levels. The new developments such as US trade disputes and slowdown in global growth also have contributed to delay the policy reversal.
Therefore, the US economy started confronting slower growth due to liquidity shortages, market volatilities and deceleration in asset prices and the Fed has now paused the policy tightening.
As such, valuable lessons can be learned from the US to address financial instabilities that hit from time to time.
(The next article will cover public concerns on monetary policies)
The writer is a former Deputy Governor of the Central Bank and chairman and member of 6 Public Boards with nearly 35 years of public service. He authored 6 economics and financial/banking books and more than 60 published articles. His latest Book “INNOVATING CENTRAL BANKS” covers a detailed part on the monetary policy and financial crises.
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