The Federal Reserve is the United States' central bank. It is the most powerful actor in the economy of the United States, and thus the world. It is a powerful institution known as a secret organization whose principal role is to control the economy's money supply. The Federal Reserve has four basic functions. First, it implements monetary policy, the major goal of which is to control the supply of money in the economy. As such, it is in charge of managing inflation and price stability. It accomplishes this by establishing an inflation objective and pursuing maximum employment. The natural rate of unemployment in a given economy is assumed to be between 4.7% and 5.8%. The Federal Reserve aims at achieving this target. It also moderates the rates of interest through the Open Market Operations (OMO) and rates of discounts. Its main aim is to produce a healthy growth in the economy. Secondly, it regulates commercial banks in the marketplace to ensure consumer protection. Thirdly, it maintains economic stability in the financial sector to prevent crises. Lastly, it acts as a bank to other banks and the government of the US. The 2008 economic crisis was of high impact until it was known as the great depression.
The Great Depression started in 2006 in the housing sector and later spread to other parts of the world. In 2007, the turmoil spread from mortgage markets that were secured to the funding market which then froze. The extent to which the mortgage loses had spread was extensive such that participants in the market lost faith in the creditworthiness of each other as well as the market which provided the US banks with liquidity. The rate at which assets could be converted to cash was high. Commercial banks, as well as insurance companies, could not borrow from each other due to loss of confidence. In September 2008, the entire banking sector in the US had collapsed. The general macroeconomic industry had weakened to the point of pulling down the prices of assets (Palley 45).
The 2008 crisis led to strains in the financial market due to losses on mortgage assets. Many financial institutions faced this stress and turbulence. The Federal Reserve responded by providing liquidity and other support programs aimed at improving the financial sector and reduces the harm to the economy. Nonetheless, the economy continued to contract until it acquired the label ‘the Great Depression.' The Federal Reserve in the recovery period of 2009 provided monetary responses to help in curbing the effects of the crisis.
The beginning of 2008 saw the start of debt depression and the fall of asset prices, real estate and prices of commodities in a downward spiral. The crisis spread from the financial sector to the rest of the world. Investors from all over the world were struggling to minimize their leverage, meet their profit margin and reduce taxes, but it was impossible to flee from their risky investments and save money as the financial sector had collapsed. The 2008 crisis itself had led to the breaking down of the international commercial industry which amplified the turmoil and therefore sending a shock to the rest of the world.
The economic depression continued to be an international crisis with its scope characterized by declining incomes, reduction in total output and employment. The primary cause of the turmoil was the inability or incapability of the financial sector of the US to perform the roles it used to in the early 1990s. The purpose of the US Federal Reserve in the 1990s was to control and regulate the circulation of the social capital (Labonte 23).
The instability in the financial sector was brought by problems in the housing sector and neoliberal deregulation aimed at achieving capitalism. It was manifested in the credit market and the money market. The 2008 global crisis has its origin in the US ion that it is in the United States banking that it resurfaced and by September, it was severe, and the only route the world economy could take was downwards. The sector stopped acting as intermediaries between the households who are the savers and the firms who are the investors. The interruption of the intermediating process blocked capital circulation in the world thereby making the US money market responsible for the 2008 crisis.
In September 2008, circulation of capital in the US came to stand still. The United States Federal Reserve responded to the crisis which was termed as an intervention policy. The monetary authorities in the US responded with a quick and considerable reduction in the rate of interest. The overnight target of interest rates by the end of the year 2008 was slightly above 0.0%. This was also known as the zero lower bound which meant that the interest rates could only be positive and any further decrease would be impossible to achieve.
The efforts of the Federal Reserve to us interest rates in the stimulation of the economy were followed by other developments which meant that it would leave the traditional monetary policies. First, the Federal Reserve started reorganizing itself to act s a financial institution. It changed how it provided credit to other financial institutions. It also transformed the terms in which it lent money to the commercial banks.
The management of the Federal Reserve recognized that the rate of interest was already low and therefore the collapse of the financial market could not be mended by just reducing the interest rates. Thus, it opted to become the lender of the last resort to all financial institutions including SACCOs and commercial banks in the US. As such, it took the responsibility of managing credit and liquidity in the sector.
The size of the total balance sheet was held constant for more than twelve months which was a shock. To counter the effects that it sent to the economy of the world, the Federal Reserve used its lending ability to bring about an increase in the reserves of banks. The increase in the reserves aimed at pushing the Federal interest rates to zero which the commercial banks absorbed in the form of excess reserves.
Reserve liabilities are assets of the banks. US banks are supposed by law to hold specific amounts of their holdings in the Federal Reserve to back up their deposits. Excess reserves according to the Board of Governors referred to the change in the total size of assets as well as liabilities in the depository institutions.
The response of the Federal Reserve to the effects of the crisis was materialistic and not structural. The central bank of the US had to change how it economically interacted with commercial banks and other financial institutions. It also turned how it connected itself with capital that was interest bearing giving it a new image and unity that was political. It embodied itself with the new procedures of operation. The seventeen-month period for reviews made the US central bank the only institution with the powers to respond to the crisis. The response of the United States Treasury and other federal organizations were weak and therefore incompetent to deal with the turmoil. To fill the gap, the central bank took the responsibility of managing every aspect of finance in the economy thereby subordinating the role of the treasury and its leadership in the marketplace. In responding to the crisis, it is certain that the monetary policy that the US central bank used was different as well as new. The US embarked on reforming the international financial sector to bring a change in its unity with other commercial banks. There was the establishment of a new regulatory regime for managing the crisis (Bernanke, et al.,678).
Before the economic crisis, Open Market Operations (OMO) was the principal policy tool in the US Treasury market. Banks were the only institutions which maintained reserve accounts at the FED. They were also allowed to get loans from the US central bank discounts. The Federal Reserve held securities belonging to the US Treasury on the left-hand side of the balance sheet. Some of the securities included portfolio loans and foreign exchange reserves. The FED used the OMOs in regulating the interest rates while holding the assumption that monetary policy will impact the economy through commercial banks and other financial institutions. After the happening of the crisis, the FED had to behave differently. It advanced its credit against collateral security to the banks as well as itself. In September 2007, the FED flooded the US financial sector with the zero interest rate which had no risk to the liquidity ratio.
In dealing with the crisis, the FED in 2007 established new lending facilities which were Term Auction Facility (TAF) and Swap Lines. The TAF allowed the FED to lend commercial banks funds for one month which was against the conventional overnight lending. It did so through auctions that was regularly scheduled. The foreign exchange swap lines allowed the US FED to lend dollars to other central banks which could then give them to other troubled commercial banks. As such, the two strategies became the principal ways through which the US central bank created credit.
The FED had to change its portfolio regarding the Treasury securities to allow the new lending strategy to work efficiently. In the process of increasing credit creation through the TAF and swap lines, it had to decrease the holding of US Treasury securities at a similar rate. Thus, the total size of the FED loans and securities were kept at the bar with the liabilities to commercial depository banks at constant. The FED established a program for lending dealers with treasury securities against collaterals which aimed at careful sterilization of impacts that this actions might have to the central bank of the US through OMO.
The FED changed itself from being a participant in the treasury and became a direct lender. Therefore, it replaced Treasuries in the US with little or no liquid and loans that are creditworthy especially on the left hand side of the balance sheet. It extended the FED credit terms from overnight to one full month. It also absorbed vast quantities of noncredit worthy assets thereby increasing liquid credit in the private sector. The FED took the responsibility of reviving the US financial market. It also accepted less creditworthy securities as collateral and in the process, it reduced its saving holdings. It was not a policy on interest rates (Martin 567).
Another policy which the FED used in reviving the economy was the increase in the stock of state money which was also known as an emergency measure. It was driven by the confused events on the ground which rapidly changed the liquidity situation in the US Treasury. As such, it created a Troubled Assets Relief Program (TARP) which weakened the real economy in the US and other parts of the world. Such an act was not neutral in its operations since it increased the supply of money in the economy.
In conclusion, the total impacts of the new developments on the size of the FED reserve assets and exposure to risk are overwhelming. On the last quarter of 2007, 96% of the FED loans and securities existed as Treasuries under repurchase agreements. Credit and liquidity risks were minimized. At the end of 2008, 9%, 28%, 26% and 15% of the FED credit was discount borrowing, TAF borrowing, swap line drawings and ABCP respectively. Therefore, at the end of 2008, 77% of assets were loans from the private sector. 3% of the assets were mortgage securities and derivatives which no one was willing to hold. Credit and liquidity risks of the FED therefore at the end of 2008 were considerable. It became a policy that the FED is a lender to troubled and undercapitalized financial institutions. It also took ownership of the waste that the sector had produced.
After the crisis, we are facing a new routine based on servicing of mortgages. Nowadays, mortgage servicing involves regulations that are complex and many internal control systems. The new normal is characterized by the hiring of more employees and enhancement of technology which we are experiencing today.
Bibliographies
Martin, Antoine, et al. "Federal Reserve tools for managing rates and reserves." (2013).
Kotz, David M. "The financial and economic crisis of 2008: A systemic crisis of neoliberal capitalism." Review of Radical Political Economics 41.3 (2009): 305-317.
Palley, Thomas I. "Asset‐based reserve requirements: reasserting domestic monetary control in an era of financial innovation and instability." Review of Political Economy 16.1 (2004): 43-58.
Bernanke, Ben S., and Alan S. Blinder. "The federal funds rate and the channels of monetary transmission." The American Economic Review (1992): 901-921.
Cecchetti, Stephen G. Crisis and responses: the Federal Reserve and the financial crisis of 2007-2008. No. w14134. National Bureau of Economic Research, 2008.
Labonte, Marc, and Gail E. Makinen. "Monetary policy and the Federal Reserve: current policy and conditions." Congressional Research Service, Library of Congress, 2008.
