6 years ago to the month, the United States entered its longest and deepest post-war recession. 18 months later, in June of 2009, economic growth finally resumed. Ever since, barring a few quarters of “bounceback growth” in late 2009 and blips in 2011 and Q3 2013, the recovery has been extraordinarily sluggish by historical standards. What does this have to do with the Federal Reserve’s (recent) 100th birthday? Lots, actually. But first, let me go all the way back to the beginning.
100 years ago to the month, the United States entered its longest and deepest experiment in centralized banking. Congress had passed The Federal Reserve Act of 1913 to set up the Federal Reserve System, a quasi-private quasi-governmental central banking system, in response to the many financial panics that had plagued the US since its founding (especially the severe 1907 financial crisis). It originally started out with three specific mandates: full employment, price stability, and moderate interest rates, each of which would receive particular emphasis during different periods of time.
The Fed got off to a fairly rocky start. It failed to adequately mitigate the severe early 1920s post-WW1 recession, and exacerbated the Great Depression by attempting to fight non-existent inflation. After the horrendous 1930s, beginning in the 1940s the Federal Reserve placed heavy emphasis on the “full employment” mandate. This coincided with the post-war “Keynesian consensus”, in which fiscal policy was also leveraged to support the full-employment mandate. Growth was generally robust during this time, though during the 50s growth was slower and was repeatedly interrupted by short recessions. During the 1960s, activist monetary and fiscal policies reached their nadir, with the Fed coming under increasing political pressure to maintain full employment at all costs. This continuous monetary expansion helped set the stage for the stagflation of the 1970s, where too much money was chasing too few goods. Further compounding the situation was President Nixon’s removal of the dollar from the gold-standard, putting further downward pressure on the dollar. By 1980, inflation was running in the double-digits even as unemployment now remained above the “full-employment” level of 5-6% (challenging the Phillips Curve inflation/unemployment tradeoff theory).
It was with the appointment of Paul Volcker as Fed Chairman in 1979 that the Fed’s emphasis on price stability (rather than full employment) can be observed. Volker enacted an extremely tight monetary policy (selling government bonds to remove money from the economy, depress bond prices, push up bond yields and thus push up interest rates) that led to the double-dip recessions of 1980 and 1981-82′ (the latter being particularly severe). After the prime rate hit 21% in 1980, it and inflation fell rapidly, as did interest rates. Growth rebounded strongly. From then on until the 2008 financial crisis, the Fed maintained a steadfast commitment to lower inflation (sometimes at the price of full employment). Rates of inflation and interest steadily declined until 2008 (with intermittent spikes now and then).
Either as a cause or effect of the Fed’s actions, savings rates also trended down beginning in the 1980s, following the pattern of interest rates (which makes sense, as depositors have less incentive to save with lower interest rates). Lower interest rates spurred consumer spending, beginning a quarter-century long consumption boom. Balance of payments and the federal budget recorded significant deficits for the first time. Almost all forms of debt – governmental, commercial, and household debt – began to rise as a percentage of GDP and personal income.
This unsustainable situation, as noted, would last until the late 2000s. Just a few years earlier, after the dot-com bubble burst at the turn of the millennium, the Federal Reserve pursued what was (up until then) one of its most aggressive monetary expansions ever. The Federal Funds target rate was repeatedly reduced until it reached around 1% until the mid-aughts. This monetary expansion (characterized, as all monetary expansions are by massive bond buying = higher bond prices = lower bond yields = lower interest rates to hopefully spur investment, borrowing, and spending), however, coincided with the rise of surplus financial capital in other parts of the world. A surplus of capital almost everywhere looked in vein for investment vehicles to profit from, and safe government bonds, with such low prevailing yields, would not suffice. As a result, they turned to riskier assets such as mortgage-backed securities (MBS). These instruments, backed by the value of actual mortgages, would yield investors dividends essentially in the form of monthly mortgage payments – a much higher rate of return than treasury bonds yielded at the time. The demand provided by the investors of MBS’ increased the demand and funds available for mortgages, which pushed up lending and housing prices. Of course, we now know that many of these mortgages were sub-prime and extremely risky.
When the Fed finally began to raise interest rates in the mid-aughts, several things occurred as a result. Higher interest rates caused a wave of mortgage defaults and foreclosures, especially among risky borrowers. This reduced the value of MBS’ and weakened investor demand for them, putting downward pressure on the net worth and financial positions of multiple investment banks. This weakening of investment banks weakened demand for mortgages from mortgage lenders, who thus lent less. This started the infamous “credit crunch”, which not only lowered mortgage lending and demand for housing (further lowering housing prices) but put pressure on all forms of borrowing. Higher interest rates also made bonds look more attractive than risky assets, causing further pullback from investors. Although far more complex than this explanation, this is the essence of the financial crisis that sparked the Great Recession.
The Fed responded to the crisis quickly, purchasing billions worth of “troubled” or “toxic” assets in a bid to stabilize the financial system and money supply. The Fed funds target rate was lowered to almost zero, and the conventional monetary policy of purchasing short-term bonds was commenced. However, even with these policies, inflation remained (and still remains) precariously low. Thus, various “unconventional” monetary policies have also been pursued, notably “quantitative easing” (QE), in which large quantities of long-term financial & commercial assets (including long-term government bonds) are purchased with newly created money to both lower long-term interest rates and raise the quantity of money in the money supply. As of this writing, the Fed is still purchasing about $85 billion in bonds per month as part of its QE strategy.
So, about the financial crisis and our agonizingly slow economic recovery: can the Fed ultimately be to blame? You could argue that low interest rates pursued by the Fed ultimately pushed investors into too-risky of assets. Of course, the Fed wasn’t the only downward pressure on interest rates since 1980 – the emergence of several developing nations has given rise to a global “savings glut” that has pushed down interest rates worldwide. The Fed may have kept the Fed Funds rate down too long during the mid-aughts – but then again, who can really blame them, considering they were desperately trying to make sure the US didn’t enter a deflationary spiral after the dot-com bubble burst? As for its role in our slow economic recovery, that is also unclear. Normally after recessions, an expansionary monetary policy (and the low interest rates that come with it) spur consumer & business borrowing, spending, and investment, increasing short-term economic growth. However, this time is different, as households and businesses are still trying to deleverage from their debt overhang (a process that requires less consumer spending and increased savings for a time). Considering that debt deleveraging (so that debt as a percentage of GDP and household income is down to more normal levels) is essential for long-term economic growth and recovery, the downward push exerted by the Fed on interest rates could actually be retarding the process as it makes it more difficult to accumulate savings to pay off debt. At the same time, an easing of the Fed’s ultra-loose monetary policy right now may not be a good option, either, as it may cut off all sources of growth. Whatever the Fed’s role in the crisis and its aftermath, it is clear that the crisis has provoked a strong discussion in consideration of which part of the Fed’s mandate (if any) should be emphasized from now on.
To sum up, the Fed has had a tumultuous century. Though it has had its monetary successes (inflation taming?), its failures weigh heavily. Ironically, the very cause of its creation – financial crisis – also marks the end of its first centennial. Though there has been progress, one can’t help but feel that we’re back to square one.