MONETARY POLICY OF

USA DURING THE

CRISIS

ÀLEX SOLÀ

SERGI BONILLA

JOAN ANTONI SENTÍS

SARA PINO

MARIA PUIGDELLIVOL
INTRODUCTION

Monetary policy concerns the actions of a central bank or other regulatory authorities
that determine the size and rate of growth of the money supply. In the United States,
the Federal Reserve is in charge of monetary policy, and implements it primarily by
performing operations that influence short term interest rates.

Monetary policy in the USA is determined and implemented by the United States
Federal Reserve System (better known as “the Fed”). Created in 1913 to provide
central banking functions, the Fed is a semi-public institution. The Federal Reserve
Banks are 12 private banking corporations; they are independent in their day-to-day
operations, but legislatively accountable to Congress through the auspices of Fed
board of governors. The Board of Governors is an independent governmental agency
consisting of seven officials and their support staff of over 1800 employees The
Chairman of the Board of Governors of the Federal Reserve System is the head of the
central banking system of the United States, nowadays, the Chairman is Ben Bernanke.
The Fed is independent in the sense that the Board orates without official obligation to
accept the requests or advice of any elected official with regard to actions on the
money supply, and its methods of funding also preserve independence. The Federal
Reserve System is primarily funded by interest collected on their portfolio of securities
from the US Treasury, and the Fed has broad discretion in drafting its own budget, but,
historically, nearly all the interest the Federal Reserve collects is rebated to the
government each year.

The Fed has three main tools to control the supply of money and credit in the economy.
The most important is the open market operations, or the buying and selling of
government bonds. When The Fed wants to increase the supply of money, buys
government securities from banks, other businesses, or individuals, paying for them
with a check (a new source of money that it prints); when the Fed's checks are
deposited in banks, they create new reserves -- a portion of which banks can lend or
invest, thereby increasing the amount of money in circulation. On the other hand, if the
Fed wishes to reduce the money supply, it sells government securities to banks,
collecting reserves from them. Because they have lower reserves, banks must reduce
their lending, and the money supply drops accordingly.

The Fed’s second main tool control the money supply by fixing what reserves deposit-
taking institutions must set aside either as currency in their vaults or as deposits at their
regional Reserve Banks. Raising reserve requirements forces banks to withhold a
larger portion of their funds, thereby reducing the money supply, while lowering
requirements works the opposite way to increase the money supply. Banks often lend
each other money overnight to meet their reserve requirements. The rate on such
loans, known as the "federal funds rate," is a key gauge of how "tight" or "loose"
monetary policy is at a given moment.

The Fed's third tool is the discount rate (the federal founds rate), which is the interest
rate charged to commercial banks and other depository institutions on loans they
receive from their regional Federal Reserve Bank's lending facility, the discount window.
By increasing or lowering the discount rate, the Fed can encourage or discourage
borrowing and thus alter the amount of revenue available to banks for making loans.
Causes of the economical crisis at the EUA

As we all know we are immersed in

a serious recession period. We can
find the most important causes of
the crisis, for example, in the turning
of the housing cycle in the USA and
the risk on the subprime mortgages.
Most of the experts agree that we
could say that the crisis start with
the failure of house prices, which
was followed by an increase in loan
delinquency and a decrease in
liquidity on the market. The financial
institutions suffered losses. They
lost output, jobs and wealth.

As we have said, one of the most important causes were the subprime credit is the
credits that the banks gave to the people, but they are characterized for having an
insecure return. In other words, the banks gave lots of credits without knowing if the
person was able to return them to the banks. So many people demand this credit. So,
by the years, the interest grew so fast that most of the people weren’t able to return
them. It leaded to a decrease on the consumption and, the people that didn’t pay the
mortgage (more frequently credit), the bank expropriate them the house.

Subprime mortgages remained below 10% of all mortgages before 2004, when they
start to increase until 20% and remained there through the 2005-2006 peak of the
United States housing bubble. Subprime mortgage payment delinquency rates
remained in the 10-15% range from 1998 to 2006, then began to increase rapidly,
rising to 25% by early 2008.

As is represented in the following picture, the situation was really critical in some states,
especially which have big cities and a lot of population more population in the country.

Subprime mortgages with really important pay problems on March 2009 (%)
Since 2004 the USA government had been given permissions to the banks to have
more debt. Lots of financial institutions were with a big quantity of debt between 2004
and 2007 and they invest the benefits in mortgages. They tough that the people would
pay the increase on prices, and they didn’t expect problem to pay any debt (in some
way, as we will see after, because of the monetary policy of USA). When the prices of
the houses start to decrease, all the investments that the banks and people had done
were no profitable. Some borrowers stopped to pay the mortgages and the financial
institutions suffered losses.

In this graph we can appreciate the five more important investment banks. Between
2004 and 2007 the banks were increasing their investments a lot. It is also interesting
to know that the subprime mortgages’ percentage increased 10% (between 2001 and
2003) to 19% (between 2004 and 2006).

With all of this information, wasn’t difficult to avoid the failure of some banks and
companies. Lehman Brothers was the first one, in September of 2008 with a debt of
613.000 millions of dollars. Then fell down the American International Group (AIG),
which was the maximum insurance company of the EUA.

With these two failures, the unemployment increases considerably, because Lehman
Brother had a total of 25.935 employees around the world.

In front of this situation, the Government took a series of actions to avoid the disaster.
One of this was to inject a big quantity of public capital. However, this wasn’t enough
because of there was a lack of effort and motivation by the directives and the
shareholders of the bank. The cause was that Mr. Richard Furd, director of Lehman
Brothers’ bank, despite having led the bank into bankruptcy, earned a remuneration of
22 millions of dollars. People were outraged and Lehman Brothers couldn’t be saved.

AIG was a bit more “lucky”, this entity couldn’t be saved by itself as Lehman Brothers,
so the Government injected money, specifically, a quantity of €60.049. At this moment,
the insurer entity was going to belong to the State, a public entity. So, the AIG
Company didn’t fall thanks of the State intervention, but Lehman fell down because
nobody bought it.

We can find other causes, some of them still being studied. For example the corporate
culture is based in financial speculation with very high salaries for the executives. This
represents a high unequal distribution of income between different countries. Another
cause was the irrationality of the people acting without having realistic expectations.

Government responsibility and answers

Most of the experts said that despite the lack of regulations and the other market
conditions, the crisis could have been avoid with a monetary policy that didn’t provide
banks to increase their debt (because of the fed lower founds rates) and to invent some
strange financial products so as to give the clients some positive profitability (because
of the high inflation that Fed maintained during the 2000s).

From 2001 to 2007 and as a consequence of the 2001’s recession and 11 of

September terrorist attacks, USA government and the Fed took a very expansionary
outline policies in order to avoid the pessimism in the population, and the de

The federal Found rate decreased from 6.5% to 1% in 2 years due to deflationary fears
and mitigates the recession of 2001 and to also avoid the negative effects of 2001’s
terrorist attacks on USA .This low market interest rates start feeding debt. 2004 the
federal found rate increase, it was extremely low so it was the logical consequence, but
this only made go up the mortgage price. At the end of 2007, household debt as% of
disposable income reached 127% (77% in 1990). But in

This debt was caused by the current deficit. Bernanke explained that between 1996
and 2004, the USA current account deficit increased by $650 billion, from 1.5% to 5.8%
of GDP. In order to finance these big deficit, USA needed to borrow large sums from
abroad, much of it from countries running trade surpluses, mainly the emerging
economies in Asia and oil-exporting nations.

Capital imports of USA from 2001 to 2009

 All of this combined with a relaxation in bank regulation, made a bubble that increase
until the 2008, when crash and appear the financial crisis.

Once the crisis exploits, hat did the fed do? Viewed the financial situation, the EUA
Government injected liquidity in the financial sector. So, it conducted an expansionary
policy. That promoted a lowering of the interests. The Government tried to reach to the
productive economy. It causes inversions in production and distribution. So they had a
positive consequence: new jobs and new incomes. Thus, the Federal Reserve faced
the danger of a sharp contraction in credit and bank lending in a way that threatened a
deep recession or worse. The Federal Reserve did it taking three important movements
to control the effects of the crisis:

1) They gave liquidity to some financial institutions in short-term. The Fed talked with 14
foreign central banks, to lend money. With that, the Fed’s received foreign currency for
exchanging money. This liquidity gives security to the invertors. Instead of the high
liquidity, all the financial institutions were frightened to give credits.

2) Another solution was to inject liquidity provision to borrowers and invertors in the credit
market. The Federal Reserve and the Treasury gave student, cars and credit card
loans. Also in Small Business Administration. Seeing how people were retiring their
money from the banks, the injection of liquidity avoids the possibility of selling assets.
The results of this can be lower rates and more possibilities to consume and small
business’ credits. Rising the liquidity of the market and motivating the activity of the
market, the private lending is being helped. If the establishment for asset-backed
bonds becomes successful it would lead to higher volumes or additional classes of
securities depending on circumstances.

3) The last one was to purchases security long-term loans in some companies, most of
them related with the Government (because they were, in most cases, safer than
privates ones). Also, with the mortgages rates dropped, they thought people were more
motivated to buy houses.

To sum up: loans to financial institutions, injecting liquidity directly to the credit markets
and buying stock in the long-term. All of that, involving loans or bonds motivated the
Fed to decrease the interest rates.
Global view of Monetary crisis at USA

Until now we have talked about the policy of the Fed in the moment that crisis becomes
real. We also want to take into account the different policies that took place during the
crisis in the USA in order to control it and avoid all the avoidable damages. To address
the crisis, the central bank and the Federal Reserve in partnership with central banks
around the world have taken several steps.
Ben Bernanke, Federal Reserve Chairman, stated in early 2008:
"Broadly, the Federal Reserve's response has followed two tracks: efforts to support
market liquidity and functioning and the pursuit of our macroeconomic objectives
through monetary policy."

Summarizing all the policies, the Fed has lowered the target for the Federal funds rate
from 5.25% to 2%, and the discount rate from 5.75% to 2.25%. This happened
between 18 September 2007 and 30 April 2008 in six steps. In December 2008, the
Fed further lowered the federal funds rate target to a range of 0-0.25% (25 basis
points).
Lowering the target federal funds rate is typically done in recessions or periods where
there is a low growth. Thanks to this measure, the economy is stimulated and it
cushions the fall. The Fed reduces the Funds Rate because this way it makes money
cheaper, which implies an influx of credit into the economy through all types of loans.

The Fed has executed too, along with other central banks, open market operations to
ensure that these banks are able to have and maintain liquidity. These are effectively
short-term loans to member banks collateralized by government bonds. Another
measure is that Central banks have also lowered the interest rates (the discount rate)
through which they charge member banks for short-term loans.

The problem of liquidity made the Fed invent some tools in order to control it, these are
some of the most important ones:

 Extend the ending of the transactions used in the conduct of open market
operations.

 Include (implicitly) other asset classes in conducting market operations.

 The Fed lent money to non-bank institutions and to private sector institutions that
buy debt in the money market short term.

 Establish or restore foreign exchange swap lines with other central banks (Europe,
Switzerland, England, and Japan).

The Fed also created a wide variety of lending facilities to lend directly to banks and
non-bank institutions, against specific types of guarantees of varying credit quality;
lending facilities such as: Term Auction Facility (TAF) and Term Asset-Backed
Securities Loan Facility (TALF).

There is a wide range of these lending facilities; those ones are mechanisms that the
Central Bank uses when is lending funds to primary dealers. They are also usually
used in order to increase the liquidity over longer periods.

As Ben Bernanke says, the meaning of the expansion of the Fed balance sheet is that
the Fed is creating money, necessary. He states our economy is very weak and the
inflation in very low. We will unwind those measures, programs, the raising of the
interest rates, reduction of the money supply, and we will make sure that we have a
recovery not related to the inflation anymore.

Measures taken

The economy in the first half of 2007 performed well, as the economic activity
continued to increase and the unemployment stayed stable. The FOMC meetings
agreed that this situation would continue during 2007 and 2008, with the only problems
of controlling inflation. Also in the financial markets, the situation is stable, with the
exception of the subprime-mortgage sector, which is suffering a significant deterioration.
However, it’s not affecting the economy and shouldn’t do it.
The economy started decelerating sharply in the fourth quarter of 2007, and despite the
Fed and FOMC’s analysis, it started in the financial markets, and the housing activity
also started to contract. The situation is getting worse also because of inflation,
especially as the price of oil and food are increasing.
In December, the committee had to take measures in order to fix the problems in
financial markets, and made arrangements with the ECB to address the pressures in
the short term dollar funding markets.

After easing the stance of monetary policy 100 basis points over the second half of
2007, the Federal Open Market Committee (FOMC) lowered the target federal funds
rate 225 basis points further in the first half of 2008. The Federal Reserve also took a
number of additional actions to increase liquidity and to improve the functioning of
financial markets (some of those are which we have explained before).

As we can see in the graph, target federal funds rate grew gradually since 2004, and
reached 5% in 2006. After remaining stable, it started a sharp decrease in the half of
2007. At begging of 2008, it was fixed at 2%, and remained at this level for a few
months.

In the different FED and FOMC meetings that took place during 2007 and the
beginning of 2008, two measures were being done in order to expand liquidity:

First of all, there was a reduction in the target for the federal funds rate (blue line). At
the beginning of 2007, it was set at 5% (as it was since the beginning of 2006), and by
the January of 2008 it had been gradually lowed to 2%. The other measure was to
successively increase the reciprocal currency agreements with the European Central
Bank (to $50 billion) and Swiss National Bank (to $12 billion). They didn’t just increase
them, but also extend them through 2009.
After remaining stable at 2%, the funds rate decreased sharply again at half 2008, and
it stayed between 0 and 0.25 basis points. This is the level at which they have been
since, and this makes monetary useless or impossible to be done.

In the second half of 2008, the Fed decreased the target federal funds rate to 0%. This
measure was taken in order to increase the economic recovery and to maintain some
stability in prices. The FOMC has maintained between 0 and ¼ percent since then.
In this part, we reach the point that we know as the “liquidity trap”. As the FOMC had
reduced the fund rate to 0 (or even not zero, but very close) monetary policies where
no longer effective or possible. This is because the interest couldn’t go down. The Fed
had tried to diminish funds rate gradually, and as slowly as possible, trying to have a
longer effect on time. However, as financial markets were under high pressures and
the economy was not growing, they finally had to diminish the rate very near to 0.
It was In November 2008 when the Fed announced a $600 billion program to purchase
the MBS (mortgage-backed security) of the GSE (government-sponsored enterprises),
to help lower mortgage rates.
MBS is an asset-backed security that represents a claim on the cash flows from
mortgage loans through a process known as securitization.

We still had a sharp contraction in the economic activity, and the main problems of the
Federal Reserve were trying to increase liquidity and the situation in most of the
financial markets. The pressure on financial markets was very high since the crisis
started, and the Fed was always worried about this, which made it difficult to decide
which the decreases in the expected rate were the appropriate ones.

By the beginning of 2009, economy was still deteriorating. GDP still was falling sharply
in the first quarter of 2009, but we had an improvement in the overall output, and
consumers spending stopped decreasing.

The Federal Reserve maintained its target for the federal funds rate at a range
between 0 and 1/4 per cent. Also, and continuing with the policy of buying assets and
Treasury securities, the Fed purchased additional agency mortgage-backed securities
(MBS). During the first half of the 2009, the Federal Reserve also continued to provide
funding to financial institutions and markets. This is part of the policy developed by the
Fed to increase liquidity. After declining for a year and a half, economic activity in the
US started to slowly grow in the second half of 2009, supported by an improvement in
financial conditions, stimulus from monetary and fiscal policies, and a recovery in
foreign economies.

It was in March 2009 when the FOMC (Federal Open Market Committee) made the
decision to increase the size of the Federal Reserve’s balance sheet even more by
purchasing up to an additional $750 billion of agency (GSE, government-sponsored
enterprises) mortgage-backed securities, bringing its total purchases of these securities
up to $1.25 trillion this year, and to increase its purchases of agency debt this year by
up to $100 billion to a total of up to $200 billion.
Moreover, the Committee decided to purchase up to $300 billion of longer-term
Treasury securities in order to improve the conditions in private credit markets. This
took place during the 2009.

In August 11-12, the FOMC observed that the economy was stabilizing after having
decreased during 2008 and the first half of 2009. However, the economy was likely to
recover only slowly during the second half of 2009, and the Fed announced that it
would extend its measures at least until the beginning of 2010, in order to maintain this
small recuperation. This stabilization was mainly due to a small turn up in the housing
activity, and to the recuperation that was starting in the financial markets.

During the first half of 2010 the Federal Open Market Committee (FOMC) still
maintained a target range for the federal funds rate of 0 to 1/4 per cent.
Federal Reserve also continued its program of large-scale asset purchases, completing
purchases of $300 billion in Treasury securities and making considerable progress
toward completing its announced purchases of $1.25 trillion of agency mortgage-
backed securities (MBS) and about $175 billion of agency debt.
Also, as they noticed the beginning of the recuperation in some financial markets, by
the end of June the Federal Reserve had closed all of the special liquidity facilities that
it had created to support markets during the crisis.
 Conclusion

So, after all, is the monetary policy responsible of the crisis? In part, after 2001 the fed
has been following a “wrong” line. As we have said before, the expansionary policy
applied before the crisis provide banks to increase their debt (because of the fed lower
founds rates) and to invent some strange financial products so as to give the clients
some positive profitability (because of the high inflation that Fed maintained during the
2000s).

In spite of the fact that it is true, we also need to say that the Fed has taken efficient
measures in a really shot period of time. They low the Federal founds rate and took
some unusual measures in order to control a very complicated and interconnected
financial liquidity problem. Apart of that the Fed took the typical measures that
economy books said that have to be taken in a recession time using his three main
tools: the federal found rate, the open market operations and fixing what reserves
deposit-taking institutions must set aside either as currency in their vaults or as
deposits at their regional Reserve Banks. This measures didn’t finish with the crisis, but
at least they had reduced the effects of its and had helped to support the economy so
as to in a near future, being a bit hopeless, could end with this recession period.

What will the Fed do in the future? There is no a clear answer, as Ben Bernanke said, it
will depend on what happens on the global economy and on the financial markets.

Part of this measures became

evident if we look the actual situation
of USA, which isn’t as bad as which
some European countries (as
Portugal, Greece or Spain) are
suffering, in fact, as we can see in
this graph where is represented the
evolution of bond market (on the
right), We can see that bond markets
are running again-even those with
more risky debt. The unemployment
rate in USA is lower than which the
European countries have too. Despite of that, the unemployment is really high for a
country like USA (which typically has very low rates) is still a serious problem.

Unemployment rate in USA in March 2010

BIBLIOGRAFIA:

For our project we have used, mainly, different websites to get information about the
monetary policy of the US, and also to know the evolution of the economic situation. It
is impossible to put each web site that we have consulted, but the following ones are
the most importants

 http://www.federalreserve.gov/monetarypolicy/mpr_default.htm
In this website we found the different reports that the Federal Reserve makes every
semester. There is information about the economic situation and the different
measures that they have introduced.
 http://econ.tu.ac.th/class/archan/RANGSUN/EC%20460/EC%20460%20Readin
gs/Global%20Issues/Sub-Prime%20Financial%20Crisis/Sub-
Prime%20Financial%20Crisis-
%20Topics/Country%20Studies/USA/The%20Fed%20in%20Early%20Stages%
20of%20Financial%20Crisis.pdf
In this pdf document there is an explanation of the current crisis, which they call
“the sub-prime financial crisis”. Also, we can find here some of the measures
taken by the Fed. Mainly, it talks from 2007 and so on.
 http://en.wikipedia.org/wiki/2007_subprime_mortgage_financial_crisis#Federal_
Reserve_and_central_banks
In this article we find explanations about the current crisis, and also the different
actions that centrals banks have done so as to diminish the effects of this crisis.
 http://books.google.es/books?id=Sk289ndGre4C&printsec=frontcover&dq=The
+evolution+of+monetary+policy+and+banking+in+the+US+by+Donald+D.+Hest
er&hl=ca&ei=Eg12TZ32FoXwsgaCm9z1BA&sa=X&oi=book_result&ct=result&r
esnum=1&ved=0CCwQ6AEwAA#v=onepage&q&f=false
The evolution of monetary policy and banking in the US by Donald D. Hester. In
this recent book we find and explanation and a temporary analysis of the
monetary policy done in the US, and also in the banking sector.

Others:

 http://www.econlib.org/index.html
 http://economics.about.com/