Federal Reserve's Effective Management of the Great Recession - Admission/Application Essay Example

Yes. The Federal Reserve was effective/ successful in its management of the Great Recession. This research will analyze the Federal Reserve’s actions in response to the great financial recession of 2008. The study will show the action that Federal Reserve took during and after the recession to counter its effects. The arguments will show that it was successful in mitigating the impact of the recession. It will also evaluate the policies that Federal Reserve used to fix the recession to explain why it was effective in the same. The research arguments will be derived from published articles, credible websites and datasets all for authenticity. Introduction According to Pettinger, the great economic recession occurred in the year 2008 and 2013. He goes on to say the recession began, as a result of the 2007/08 global credit crunch which was characterized by a long period of little economic growth and escalation in the levels of unemployment. The great recession did not only affect the US alone but also affected the countries from the Eurozone that are believed to have experienced a double dip recession. He goes on to say that the primary cause of the great economic downturn was the credit bubble of 2001-2007 which led to the credit crunch of 2007-2008. The credit crunch was characterized by bad debts in the US housing market which had an enormous negative effect on the economies of the US and Europe. Below are the causes of credit crunch: The period 2000-2007 was characterized by high economic growth, low inflation, and reduced unemployment. Banks started targeting low inflation and ensuring stability, but all was not well with the economy. Housing bubble; this occurred due to rising in banks’ lending power and high confidence. This resulted to people buying houses at high prices as compared to their income. Bad loans; banks gave out loans without checking the customers repay ability due to their increased aggressiveness and willing to take risks in lending mainly mortgages in the US banks. Bad loans repacked and resold; European and Europe financial institution bought mortgages from the US (CDOs) hence exposing them to loss. Housing bubble burst; this occurred when the prices of the houses on mortgage started to fall this led to many mortgage default cases hence causing the banks to lose out due to defaulting. Bank losses led resulted in banks being unable to borrow money from other financial institution. It also became hard for them to get credit liquidity. To counter these, several countries like the US, UK and Ireland had to bail their major financial institution from turmoil that in turn reduced consumer and investors’ confidence leading to low spending and investments. Generally speaking, Credit Crunch and recession in 2008 resulted in a drop in real GDP due to small investments and consumer spending. The fall in houses prices also led to low spending since people could not refinance the mortgage using the houses as collateral. Recession also affected global trade as it reduced the exports. High prices of oil in 2008 also led to cost-push inflation. This is because although there was a recession in Europe and the US. Oil was still in high demand and China and India. Consequently, oil prices did not lower (Pettinger 2013). Federal Reserve Policies Designed To Fix the Economy and Explain Why [And How] They Were Effective According to Thorton, the financial crisis began Rising in august 9, 2007 when BNP Paribas, France Largest bank stopped redeeming three investments funds. The Federal Reserve (Fed) reacted to this by announcing a discount window by reducing the interest rate by 50 basis points. The federal Open Market Committee (FOMC) decreased national rates from 5.25% to 2% in a seven move steps from September 18th, 2007 and April, 30th 2008 aimed at reducing the lending rate. Next, it introduced the Term Auction Facility (TAF) on 11th December. This was followed by another one on December 12 after Lehman Bros. filed for bankruptcy, by raising credit in the market through increasing lending facilities. In mid-March, 2009 FOMC started quantitative easing 1 (QE1), by purchasing up to $1.75 trillion in mortgage-backed securities, agency debt, and longer-term treasuries. Next was QE2; this was used in buying up further $600 billion in longer-term Treasuries, and operational Twist, further bought another $400 billion in longer term (1). He goes on to give the give an analysis of how the Fed should have handled the recessions and its effects. He offers an evaluative discussion of how the policies used by Fed should have been more productive as well as giving the plan. Although they were applied, they were not as fruitful as was expected. The research starts by discussing “conventional” versus “ unconventional” monetary policy followed by Fed’s Pre-Lehman monetary policy and later the discussion of post-Lehman monetary policy (Thorton 2). Conventional Versus Unconventional Monetary Policy Thorton (2012) says that Fed expands or contracts its balance sheet through lending and investing funds. Consequently, these activities increase or reduce the money in circulation and also money that is available for lending purposes. Banking systems and reserve requirements are all connected to the supply of money and hence are affected by changes in the money supply. It, therefore, follows that a rise in the money supply results to an increase in interest rates to decline because of the liquidity effect (2). Apparently, Fed controlled the federal funds rate by adjusting the supply reserves by use of market operations. If the monetary base increases, the federal rates fall and if the federal rate falls the base and federal funds rises. Fed controls the Federal Reserve’s rate by through operations of FOMC, which usually sets its funds rate and the federal funds rate adjusts to the new target level immediately. The confidence that people have on the Fed operations ensures that this mechanism works because they believe it has the power and willingness to achieve and maintain the new target level. The Federal Reserve act gives Fed the mandate to regulate the supply of credit by allowing it to make loans available or by purchasing assets. This is considered as conventional monetary policy (Thornton 3). Federal Reserve act 13(c) gives Fed the mandate to offer loans and provide financial assistance to anyone provided there are an “unusual and exigent” circumstances since they do not regularly occur. Fed acted unconventionally whereby FOMC deliberately attempted to reduce the longer term interests by committing to keeping the rate at zero for an extended period. It also used operation Twist whereby FOMC tried to reduce long-term rates by buying securities and selling a similar amount of short-term securities hence leaving the total supply of credit the same (Thornton 4). Pre-Lehman Monetary Policy Thorton goes ahead to say that major policy actions before Lehman i.e. the 325-basis-point reduction federal reserve rate between September 18th, 2007 and April 30th, 2008 and the Fed’s lending mainly through TAF. These policies were appropriate but did not succeed because the interest rate channel of monetary policy is considered as weak. This is because the expected return on capital is marked down so low that it is problematic to investors without any interest rate. These policies failed, and that is why the Federal reserves adopted other policies (4-5). Sterilized Lending Thorton says that, during the recession, there were uncertainties caused by financial institution holding large quantities of mortgage-backed securities (MBS). Most of the organizations having the MBS were not aware of their existence that was problematic when it came to accessing the creditworthiness of borrowers. Consequently, financial institutions were forced to time and resources to get to know better the MBS portfolios. Fed tried to lend money to depository institutions through TAF. This method of sterilized lending is unconventional. Fed chairman Bernanke argued that their approach was focusing on the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the assets side. He says the Fed focuses on the balance between the assets and the liabilities saying that the recent study supported the principle. This approach was however considered a failure by any as it did not however counter the effects of the recession (Thorton, 6-7). Post-Lehman Monetary Policy Fed stopped sterilized lending after Lehman announced its bankruptcy. This was appropriate since it led to increased spread of risk that consequently reduced long-term private security ranges. This resulted in the adoption of the forward guidance which advocated low levels of federal funds rates. This had a positive impact in mitigating the effects of recession (Thornton 11-12). Quantitative Easing This policy was aimed at buying in large quantity of longer term assets and maintaining a enormous portfolio of government and private debt. Its purpose was to lower longer-term yields and consequently increased the efficacy of monetary policy. Fed purchased up to $100 billion in agency debt and up to $500 billion in MBS. This resulted in improved financial markets conditions without reducing longer-term rates. It is worth noting that recession recovery started three months after the adoption of this policy that means that it was successful (Thornton 12-14). Conclusion According to what the research has shown, we can conclude that the Federal Reserve (Fed) was effective in its quest to quell the effects of the recession. The use of financial policies through conventional and unconventional policies, use of the federal reserve balance sheet tools, as well as quantitative easing, are some of the financial policies that allowed Fed to mitigate the effects of the recession. Works Cited Pettinger, T. The great recession 2008-13. Economic Help. 2013. Web. 2 Nov. 2014 Thorton, D.L. The Federal Reserve’s Response to the Financial Crisis: What It Did and What It Should Have Done. Research Division Federal Reserve Bank of St. Louis ,Working Paper Series. 2012 Read More