History will not show us the future verbatim, however, it can provide insight that will help us make educated decisions that will affect our future. Just as the saying goes, History does not repeat, but it can rhyme. It is for this reason we find ourselves discussing recent Fed monetary history in the past few decades. For one, it grants us a deeper understanding of the Federal Reserve. Also, by placing it within our understanding of the economic and political environments of the time, we have a series of monetary policy experiments that aid in the development of future policy as well.
Global Financial Crisis (GFC)
Before the GFC, the Federal Open Market Committee’s main tool on overall financial conditions was their influence over short-term interest rates by adjusting fed funds. However, it was clear during the GFC this would no longer be enough to provide a safety net for the economy. Some of the changes that were made are rather well known today, such as Quantitative Easing and lowering interest rates. When I say well known, its more so for the masses and retail investors, most professionals would be knowledgeable of the other routes the Fed uses to implement its policy (i.e., special facilities and programs).
In the case of the GFC, the Fed introduces several emergency lending programs that were designed to fill the short-term liquidity needs of financial institutions. In tandem with these emergency programs, the Fed also increased its lending to institutions through its discount window, its usual means of lending. All of this is with the purpose of relieving the institutions of short-term liquidity shortages. In a banking system such as ours, money must flow, when it stops flowing, then there are problems. The reason for this could be amplified by the nature of our financial system based on fiat money. The currency itself might not mean much, but it is its ability to move that keeps the system from collapsing.
Foreign Interactions In Recent Fed Monetary History
I have listened to a lot of people get angry at the fact of U.S. dollars being exported to foreign countries to the degree at which they are. However, this is necessary due to the dollar being the global reserve currency where foreign central banks and governments literally need USD to engage in certain types of commerce. Particular to the Fed’s actions during the GFC, I am alluding to the dollar liquidity swap arrangements where foreign central banks are provided USD so that they have the ability to fund their institutions, a necessary part of a global economy.
Now, I am not talking about some of the programs the U.S. has done in the past that provided funding for morally questionable reasons. Also, it is arguable that the Fed should not bailout foreign banks as well since they could be considered, for lack of a better term, “not our problem”. Delving into these topics and dealing with the nuances of these foreign interactions is not the purpose of this post. I am simply stating some of the actions the Fed has done in response to the GFC. Also, for full disclosure, I lean more towards no banks or institutions being bailed out at all. However, unfortunately, that is not how the monetary system works at this point in time.
Interest rates
As the Fed usually does when the economy goes into a recession, the Fed Funds rate is cut, most of the time significantly. Above is a chart of the effective fed funds rate from macrotrends going back to before 2000. They have data going all the way back to the mid-1950s, but only the mid-1990s forward are applicable to us at the moment. The grey shaded areas are times when we were technically in a recession, and as can be seen, rates are essentially only going down during these time periods.
The period of concern at the moment is the middle (and largest) grey area, which is the GFC. As shown, the effective fed funds rate went from around 5.25% in the end of 2007 all the way down to almost 0% by the end of 2008, and it stayed there until after the beginning of 2015. Without the ability to further decrease interest rates, the Fed had to come up with other devices in order to influence short-term interest rates. This is were the forward guidance of the fed and QE came in.
Forward Guidance In Recent Fed Monetary History
Forward guidance is rather self-explanatory. This is where the Fed tells the market something in order to provoke the ir to react in a certain way. For example, the Fed can come out and say they are thinking about raising interest rates in hopes that the market will believe them and then act accordingly. This is literally the Fed’s way of guiding the market to do something, without actually changing their monetary policy at that time.
Quantitative Easing (QE)
Now, Quantitative Easing is an interesting topic. It seems like a lot of people believe that it is equivalent to money printing. However, this is not really true, due to some nuance. Namely, it depends where the asset comes from to begin with because this determines where the dollars are flowing. If a commercial bank owned the asset (usually a U.S. treasury), then the commercial bank would receive bank reserves denominated in dollars from the Fed. However, if the treasury comes from a non-bank entity, like an individual, then those dollars show up as a dollar denominated bank liability on that individual’s balance sheet. Obviously, the individual is not dealing directly with the Fed, they are selling their treasury to a primary dealer bank and that dealer is flipping it to the Fed.
The Fed has been doing a lot of this since the GFC. Specifically, they were doing it with longer-term securities in order to put downward pressure on longer term interest rates in the hope of making broader financial conditions more favorable.
By placing downward pressure on longer-term interest rates, the Fed was incentivizing businesses and individuals to take longer term risk, hopefully through growing a business and actually producing. It seems to me that the shorter-term interest rates are more applicable to large financial institutions and that it is the realm of more financialized assets and products. However, longer-term interest rates are more applicable to individuals and businesses as their risk profiles are different. You’re just not going to have an average individual directly playing with overnight repurchase agreements.
If you aren’t sure about what repurchase agreements are, I’ll link a few of my previous posts explaining how they work and what exactly they are at the bottom of this page.
Normalizing Monetary Policy
One thing to remember, all of the actions of the Fed were done with the purpose of easing financial conditions in an attempt to soften the blow of the GFC. So, in late 2015, 7 years after fed funds was zero bound, the FOMC decided it was finally time to normalize monetary policy. This “normalization” entailed raising interest rates to the level at which they were before the recession as well as reducing the size and composition of their balance sheet to what they were at that time.
That first-rate hike brought the fed funds rate from 0%-0.25%, and the hiking lasted all the way to the end of 2018 by ending with 2.25%-2.5%. This period of time can also bee seen in the chart above as the period that looks like a step-function closer to the right side.
In terms of the fed’s balance sheet, its reduction in size began in late 2017 and had declined to under 20% of nominal GDP by 2019 [1]. Notice that the Fed did not start reducing the size of their balance sheet until about 2 years after they began raising fed funds. Also, the fed reducing the size of their balance sheet is just another way to say Quantitative Tightening (QT). This is when the Fed is getting rid of the treasuries and other assets, they bought during the QE programs. However, just because the securities are leaving the Fed’s balance sheet does not mean they are being sold. Remember, treasuries, corporate debt, and the other financial sausages the Fed buys are fixed income securities, meaning when they mature, they essentially just roll off of the Fed’s balance sheet. So, rather than sell the securities, the Fed can just allow them to mature, and not replace them.
The Predicament Because Of Recent Fed Monetary History
Now, remember back to the GFC. What were the tools that the Fed had at its disposal to “fight” a recession? Lowering the fed funds rate, QE, and multiple “emergency” lending programs. Well, even after this period of “normalization” of monetary policy, rates were still historically low. Meaning that if another recession happened, the fed would not be able to lower interest rates to the same degree in order to fight it. Essentially, the fed no longer had the elbow room to be able to maneuver and fight a recession in the typical fashion. Therefore, when the events of March 2020 came along with a pandemic, the Fed had to resort to the alternative means of easing monetary policy to a much greater degree than before. This included massive QE and the “temporary” emergency programs.
This also included the Fed becoming much more active in the repo market (standing repo facility), programs to coordinate with the treasury, and setting the reserve requirement to zero.
For more on these, I will defer to previous posts in which I go much more in depth on each case.
For more on Interest On Reserve Balances (IORB)
For more on the Fed’s ample reserves regime
Above is a chart of the amount of total assets on the Fed’s balance sheet, just to show its growth. The amount of assets measured in this chart held by the fed literally doubled since 2020.
Final Words
All of the topics described in this post could probably have multiple posts themselves. Recent Fed monetary history can be considered a rather general topic. The purpose of this post is mostly just to make you aware of the major events regarding the federal reserve in the past couple decades. Now, a lot has happened, and each one of these can go significantly more in depth, which as always, will be subject to future posts. The world of money and the monetary system is changing rapidly before our very eyes, at least to those who are paying attention. And by studying recent Fed monetary history, we will have a better understand of how we arrived to our current situation, and therefore, make more educated decisions that will affect where we are going.
To your wealth and future,
James Forsythe
[1] https://www.federalreserve.gov/aboutthefed/files/the-fed-explained.pdf
[2] Board of Governors of the Federal Reserve System (US), Assets: Total Assets: Total Assets (Less Eliminations from Consolidation): Wednesday Level [WALCL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WALCL, May 28, 2022.
