Name:

Sari Melianti

Course:

Financial Markets and Institutions

Assignment: Define monetary policy and discuss the operation of monetary policy in the
United States post-GFC

1.

Brief Summary of GFC crisis

The Global Financial Crisis (GFC) began in the US because there was excessive and imprudent
lending to borrowers who did not meet normal criteria of creditworthiness, against a backdrop of
expansive monetary policy. (Sengupta 2014) As the chart below shows, sub-prime loans accounted
for 79% of mortgage originations in US from as low as 5% in 1999:

Source: US Census Bureau cited

http://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%9308
These loans were then put together as financial products (securitised) and sold in large amounts to
financial institutions all over the world (helped also by good credit ratings). When the US subprime
housing market collapsed, those assets became worthless. Banks suffered huge losses which led to
the bankruptcy of Lehman Brothers in September 2008 and started the GFC. As it appeared that
many other financial institutions had large exposure to such toxic assets, general mistrust among
banks arose. They stopped lending to each worsening the crisis. (Sengupta 2014)

The Federal Reserve (Fed) took major steps to help the crisis. Their policies included the normal
tools such as lowering short-term interest rate to near zero. In addition, they also purchased
government bonds and mortgage backed securities (known as quantitative easing) issued or
guaranteed by government-sponsored agencies such as Fannie Mae or Freddie Mac.

Monetary Response from the Federal Reserve

2.

Reduce interest rate to record low

Monetary policy refers to the steps executed by a central bank (such as the Fed) to influence the
availability and cost of money and credit to help promote national economic goals. The Fed is in
charge of three tools of monetary policy, namely: Open market operations (OMO), reserve
requirement and discount rate. Specifically, the Federal Open Market Committee (FOMC) is
responsible for open market operations. The OMO refers to the sale and buying of securities in the
open market by the Fed to adjust the supply of reserve balances so as to keep the Federal Funds
Rate -- the interest rate at which depository institutions lend reserve balances to other depository
institutions overnight--around the target established by the FOMC. (Federal Reserve, n.d.,
Monetary Policy)
To tackle the GFC, the Fed reduced the Federal Funds Rate from 5.25% to 0.25% from September
2007 to December 2008.
Economic Situation for introduction:
The Fed actually begun the cycle by first reducing the discount rate (NB not the Fed Funds Rate) by
50 bps in August 2007, in response to the crisis in the financial markets caused by BNP freezing a few
of its funds that were exposed to the US mortgage debt. This was a bad signal from BNP because
people began to think that any bank which had exposure to US mortgage loans would be in trouble.
Hence because no one knew how large the losses were or how much any bank was exposed this,
trust evaporated overnight and so banks stopped lending to each other. (Elliot, 2011). Thus Fed
said it was doing this to promote the restoration of orderly conditions in financial markets.
(Federal Reserve, n.d., Press Release).
As for the actual reducing of Fed Funds Rate from Sep 2007 till Dec 2008, there were various reasons
cited by the Fed for each of the 10 rate cuts. We have summarised the key reasons cited by the Fed
in the table below. However as can be seen, the central bank was keen to restore liquidity to the
market. In addition it wanted to prevent the economy from slowing down.
Date

18 Sep 2007
31 Oct 2007
11 Dec 2007
22 Jan 2008

(Rate Cut in bps)

Fed Funds Rate
After Cut
(50) 4.75%
(25) 4.5%
(25) 4.25%
(75) 3.5%

20 Jan 2008
18 Mar 2008
30 April 2008

(50) 3%
(75) 2.25%
(25) 2%

Feds Reasons

broader financial market conditions have continued to

deteriorate and credit has tightened further

8 Oct 2008
29 Oct 2008

(50) 1.5%
(50) 1%

pace of economic activityslowed decline in

consumer expenditures. Business equipment spending
and industrial production have weakened in recent
months

Source: (Federal Reserve, n.d. Press Release 2007/2008)

Effectiveness of Policy
We shall look at 2 main areas, namely the stock market and economic data.
We look at the stock market as a proxy for the financial markets whose stability the central bank is
worried about and also economic growth, which the central bank is keen to resusticate.
Interestingly as the table below shows, despite all the rate cuts, the stock market kept falling. Of
course the aim here is not whether the market is up or down but rather, we would say the policy has
worked if the market is stable (upside is a bonus). Of course some people may say, the rate cuts
needed some time to work, like medicine, so the rise of the stock market in the later part was due to
the period of rate cut. This is hard to say as the Fed did undertake some quantitative easing during
that period.

S&P 500 During Crisis

Interest Rates
Cut from 5.25%
to 0.25%

2000
1800
1600
1400
1200
1000
800
600

12/30/05
03/31/06
06/30/06
09/29/06
12/29/06
03/30/07
06/29/07
09/28/07
12/31/07
03/31/08
06/30/08
09/30/08
12/31/08
03/31/09
06/30/09
09/30/09
12/31/09
03/31/10
06/30/10
09/30/10
12/31/10
03/31/11
06/30/11
09/30/11
12/30/11
03/30/12
06/29/12
09/28/12
12/31/12
03/29/13
06/28/13
09/30/13
12/31/13

400

Source: Bloomberg.

What about economy? Mixed results. Consumer confidence was on downward trend all during the
rate cuts, same story for personal consumption as well. Likewise unemployment didnt improve,
actually worsened. Inflation went down with lower rates. However as in the previous case, some
would argue, the rate cuts produced the benefits months later and this must be seen together with
the quantitative easing that we shall touch on next.

Source: Bloomberg.

3.

Quantitative Easing (QE)

What is QE? Quantitative Easing refers to a situation when the central bank is unable to lower
benchmark rates any further (because interest rate is already close to zero) and so attempts to
stimulate the economy by buying assets (usually government bonds) to inject money into the
system. (Source: BBC Radio. http://www.bbc.com/news/business-15198789).

Closely related to QE is Operation Twist, (OT) a programme undertaken by the Fed in which they
sold short-term securities and bought long-term securities. This was done just after Q2, with the aim
of lowering long-term interest rates.
Economic Situation for Introduction
In the US, the Fed undertook several rounds of QE, which we summarise below
Name
Duration

QE1
Nov 2008 to
Jun 2010
Amount
$600b in
MBS (peak
$2.1 trln)
Feds
to support
reasoning
the
for
mortgage
Introduction and housing
markets and
to foster
improved
conditions in
financial
markets
more
generally
Details
Fed to buy
MBS backed
by Fannie
Mae, Freddie
Mac, and
Ginnie Mae

QE2
Nov 2010 to
end 2Q11
$600b

Operation Twist
Sep 11 to June
12
$400 bln

To promote
a stronger
pace of
economic
recovery and
to help
ensure that
inflation (is
stable)

Fed wanted to
lower long term
interest rates to
help companies
have access to
cheaper
financing.

strains in global financial

markets and also a desire to
support a stronger economic
recovery and to help ensure that
inflation (is stable)

Fed to buy
longer-term
Treasury
securities

Fed sold short

term treasuries
and boughr
long-term
treasuries.

Fed to buy $40b a month in MBS

as well as $45b a month of longerterm treasuries.

Source: (Federal Reserve n.d. Press Release 2008 to 2010)

QE3 & Operation Twist

QE: Sep 2012
OT: July 12 to Dec 12
$40b MBS and
$45b Treasuries

Effectiveness
Again, we shall look at 2 broad areas: effectiveness on financial markets and economic indicators.
To explain further, the reference in QE 1 to conditions in financial markets was about the adverse
conditions in the global financial markets during late 2008 caused by the collapse of Lehman
Brothers. When this global giant collapsed, it was felt that the government would not step in to help
large banks. As such, investors felt that every bank was now risky. This led to bank runs, sharp drop
in prices of bank stocks and withdrawal of funds from the money market. Within a month, there was
a domino effect through the global financial system. (Elliot, 2011).
For QE2, there was the European debt crisis which led to renewed instability in global markets.
(Kenny, n.d.)
As chart illustrates, the rounds of QE1, QE2, OT and QE3 were successful not just bringing stability to
the equity market but also pushing up asset values. Why? Funding for investment was cheap and
there was some confidence that the Fed was determined to do all it could to ease the crisis.

What about long-term rates that the Fed was targeting? As chart below indicates, there were
successful in lowering long-term rates.

Source: http://www.whatisquantitativeeasing.com/quantitative-easing-timeline/

Impact on Economy
However it was no so clear cut for the economy.
It is widely agreed that QE1 did not result in banks increasing their lending. This was because banks
had remained worried about liquidity and exposure to toxic assets. As such they were initially
reluctant to lend. (Source: About US Economy. http://useconomy.about.com/od/Fed/g/QE1.htm)
As a proxy for the economy, we look at the impact of QE on Consumer Confidence. AS it can be seen
below, the first two rounds did not produce sustainable gains. However after OT and QE3,
confidence generally picked up and was able to stay that way for a long while; suggesting again that
the medication needed some time to work.

QE and Consumer Confidence

90

OT and QE3

QE2

QE1

85
80
75
70
65
60

46.

Mar-

Dec-13

Sep-13

Mar-

Jun-13

Dec-12

Sep-12

Jun-12

Mar-

Dec-11

Sep-11

Mar-

Jun-11

Dec-10

Sep-10

Jun-10

Mar-

Dec-09

Jun-09

Sep-09

Mar-

Dec-08

Sep-08

Jun-08

Dec-07

Sep-07

50

Mar-

55

Conclusion

The big debate is really about whether the Fed should have undertaken quantitative easing in the
way it did.
6.1
Policy makers seem to think Yes. For example, a neutral policy maker (not from the US)
felt that the clean view was popular before the GFC. That is, monetary policy should not respond
to asset or credit bubble. However he says this has changed. The lean view has become stronger
since the GFC for two reasons. First, governments were shocked at how large and dangerous asset
bubbles could become. Second, the output and employment losses and other social
(unemployment) and economic costs (drop in output) associated with GFC was worse than policy
makers expected. (Grant 2014)
According to the IMF, the quantitative easing policies undertaken by the central banks of the major
developed countries since the beginning of the late-2000s financial crisis have contributed to the
reduction in systemic risks following the bankruptcy of Lehman Brothers. The IMF states that the
policies also contributed to the improvements in market confidence and the bottoming out of the

recession in the G7 economies in the second half of 2009.[19]

(http://en.wikipedia.org/wiki/Quantitative_easing#cite_note-imf-19)

6.2
Some academics disagree, arguing that the extent and timing of the quantitative easing was
not necessary. Daniel Thornton (2012) says that QE was unnecessary because financial markets had
already stabilised by then. He notes that risk spreads (gap between AAA rated corporations and 10year Treasuries) had gone back to levels before Lehman crisis. Also the recession, ended 3 months
after QE 1. (Daniel 2012 page 13-15)
6.3
Journalists are not sure. The Economist for example felt that the jury is still out. While it did
raise economic activity, it fears that it has encouraged reckless behaviour and worries especially
what would happen when the Fed starts to sell back assets it has bought. (Economist Jan 2014
http://www.economist.com/blogs/economist-explains/2014/01/economist-explains-7)

References:
Thornton, D.L. (2012). The Federal Reserves Response to the Financial Crisis: What it did and what
it should have done. Federal Reserve Bank of St Louis Working Paper 2012-050A.
Sengupta, J. (2014). The Global Financial System: A post-GFC Report Card. ORF Issue Brief#66.
Thornton, D.L. (2012). The Federal Reserves Response to the Financial Crisis: What it did and what
it should have done. Federal Reserve Bank of St Louis Working Paper 2012-050A. October 2012
Grant Spencer: Coordination of monetary policy and macro-prudential policy. Speech by Mr Grant
Spencer, Deputy Governor and Head of Financial Stability of the Reserve Bank of New Zealand,
at the Credit Suisse Asian Investment Conference, Hong Kong, 27 March 2014.
US Federal Reserve

Mishkin, F.S and Easkins, S.G. (2012). Financial Markets and Institutions. England: Pearson Education
Limited. C
Because there is no date and no author, your text citation would include the title (or short title)
"n.d." for no date, and paragraph number (e.g., "Heuristic," n.d., para. 1). The entry in the reference
list might look something like this:
Heuristic. (n.d.). In Merriam-Websters online dictionary (11th ed.). Retrieved from http://www.mw.com/dictionary/heuristic

For Reference: Federal Reserve (n.d). In US Federal Reserves website. Retrieved from http://
www.federalreserve.gov/faqs/money_12849.htm

For text: (Federal Reserve, n.d, para1.)

Elliot, L. (2011, August 7th). Global financial crisis: five key stages 2007-2011. The Guardian.
Retrieved from URL: http://www.theguardian.com/business/2011/aug/07/global-financial-crisis-keystages

Kenny, T. (n.d.) About Quantitative Easing, About.Com. Bonds. Retrieved from URL:
http://bonds.about.com/od/advancedbonds/a/What-Is-Quantitative-Easing.htm