How the Fed Works: After the Great Recession

During the Great Recession, several factors about the economy changed, and the Fed needed new instruments and policies to continue to be effective. Specifically, falling interest rates and acute problems in some specific parts of the American economy meant that some of the earlier primary tools, like open market operations, well, they were not going to be very effective.

As a result, the Fed used quantitative easing, acquired the ability to pay interest on reserves, and began conducting repurchase and reverse repurchase agreements. Those are big terms, new concepts -- we're going to go through them one by one -- but, overall, those were ways of influencing the economy during and after the Great Recession.

First, to stimulate the economy following the crash of 2008, the Fed conducted a kind of quantitative easing. That term can be used in somewhat different ways, but often it means that the Fed swaps money for assets other than T-bills. Recall now that T-bills are the shortest term and most liquitive government securities. By choosing additional types of assets to purchase, and not just T-bills -- well, that allows the Fed to effect different interest rates, longer-term interest rates, and to target particular parts of the economy.

For instance, the Fed may target mortgage securities or other assets with longer maturities than T-bills. And again, that helps the Fed lower longer-term interest rates rather than just shorter-term rates. In addition, by purchasing, say, mortgage securities, the Fed can help to ensure that lower interest rates also translate into lower mortgage interest rates, and that will help out home buyers and, one hopes, spur the purchase and creation of new homes.

Quantitative easing also increases the bank's supply of reserves, and thus liquidity. Since 2008, excess reserves in banks have increased from about $2 billion to $2.7 trillion. Changing the supply of reserves and the Federal Funds rate, as the Fed did through open market operations -- well, that no longer was going to be so effective in boosting loans. Keep in mind, in this new environment, banks had so many reserves -- they had enough reserves for all their lending requirements. Furthermore, with banks holding so many excess reserves, the Federal Funds market just wasn't so big or so important anymore, and again the Fed had to look for other tools.

Additionally, and this is quite important, interest rates -- they'd been falling for a long time, and in recent years, they've been especially low. At times the short rate has been at or very close to zero in a lot of parts of the world. Exactly why this has been occurring is a subject of debate, but the end result is that interest rates in the American economy, for a considerable number of years, were very close to zero, at least for short-term, low-risk investments. That means that a swap of zero-interest cash for near zero-interest T-bills -- well, that might not really have significant macroeconomic effects.

So instead of focusing solely on asset swaps, the Fed also tries to change the demand for reserves. But to do this, the Fed had to acquire a new tool -- the ability to pay interest on bank reserves held at the Fed. Suppose, for instance, that the Fed wants to pursue a relatively contractionary policy, as was the case in late 2015. This can help you see how paying interest on reserves might make monetary policy more effective. Well, the Fed now takes its new tool, that rate of interest on reserves, and it raises that rate of interest. That increases the bank demand for reserves, and it also places upward pressure on other short-term interest rates. Since banks can now earn a higher interest rate on reserves held at the Fed, they're less willing to lend at market interest rates, and you see that this new instrument can have some effects on the macroeconomy. So even a fairly low rate of interest paid on reserves -- that can encourage banks to hold a lot more reserves at the Fed, since it can be hard for banks to find superior returns elsewhere at a comparable level of risk.

Finally, the Fed expanded its influence through repurchase and reverse repurchase agreements. Now, this requires a bit of explanation. A repurchase agreement is an overnight loan or swap of central bank dollar reserves for T-bills. A basic repurchase agreement involves the central bank sending some reserves to the bank, and taking back, in turn, some Treasury bills. A reverse repurchase agreement means that the Fed takes on reserves and sends the other parties T-bills. In each case, this is like controlling the money supply in some way. So, for instance, a reverse repurchase agreement -- that drains banks and other financial intermediaries of liquid cash, giving them a higher rate of return on T-bill holdings and discouraging their investment elsewhere.

By the way, if you recall the discussion of open market operations from our previous video -- well, repurchase and reverse repurchase agreements -- they're somewhat similar, except think of these as ongoing renewable rental deals rather than just a purchase. Also, keep in mind that the Fed has been conducting repos and reverse repos with financial institutions other than just narrowly defined banks, and that's to make sure its tools have sufficient impact throughout the broader economy.

In sum, the Fed implemented some novel instruments when responding to the 2008 crash. They used quantitative easing; they paid interest on reserves, and they conducted repurchase and reverse repurchase agreements. And those are only a few of the things they did. In any case, monetary policy continues to evolve as economic conditions change.