federal reserve

The Fed's monetary policy toolbox

A prolonged period of near-zero interest rates, such as the time of the 2008 financial crisis through the present, severely limits the Fed's ability to conduct monetary policy through interest rate targets, McBride says. As a result, the board turns to other tools in its arsenal.

Providing liquidity

The Fed is often referred to as the lender of last resort. During the 2008 financial crisis, that was certainly true. When the financial market climate seems so uncertain that no other institution will make loans, the Federal Reserve steps in to fill the gap. This is known as providing liquidity because the availability of credit is what keeps financial markets from creaking to a halt like a set of rusty gears.

The Fed can provide liquidity directly through loans to primary dealers, whether overnight or for a month or more. Other Fed loan programs are open to any U.S. bank or holding company, each aimed at a slightly different market segment. This allows the Fed to strategically inject liquidity to a specific market, whether it's the market for commercial paper, money market funds or asset-backed securities.

"Those are things that you'd only roll out at a time when the financial market is headed for collapse," says Mark Zandi, chief economist at Moody's Analytics and author of "Paying the Price: Ending the Great Recession and Beginning a New American Century," a book on the policy response to the financial crisis.

While the Fed doesn't actually print money -- that power is exclusive to the U.S. Treasury -- people often refer to the Fed as "printing money" when it lends to banks because it essentially is pushing additional money into the economy. The Fed uses this tool sparingly because even though it gooses the economy, it also can lead to runaway inflation.

"Long term, the consequence is inflation," McBride says. "It's like eating too many cheeseburgers. Eventually it catches up with you."

Buying and selling securities

Because of the financial crisis, the Federal Reserve developed some new tools for managing monetary policy. Prime among these is making direct purchases of bonds, known as quantitative easing. This technique helps in a number of ways. First, it calms markets because it provides a buyer when other investors are panicked or simply reluctant. Simply by announcing plans to purchase bonds, the Fed has an impact, Zandi says.

Second, buying bonds will increase the demand for these securities and increase their price, which brings down interest rates. So when investors were scared about the future of the financial markets in 2008, the Fed purchased long-term Treasury bonds and brought down long-term interest rates in a targeted way. Those long-term rates are important because they govern mortgages and the rates that impact the housing market, which were at the center of the financial crisis.


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