The Federal Reserve and the Monetary Policy Corner

 

"…the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight.  When a depository institution has surplus balances in its reserve account, it lends to other banks in need of larger balances. In simpler terms, a bank with excess cash, which is often referred to as liquidity, will lend to another bank that needs to quickly raise liquidity. (1) The rate that the borrowing institution pays to the lending institution is determined between the two banks; the weighted average rate for all of these types of negotiations is called the effective federal funds rate.(2) The effective federal funds rate is essentially determined by the market but is influenced by the Federal Reserve through open market operations to reach the federal funds rate target."

 

The Federal Open Market Committee or FOMC meets eight times a year to determine the federal funds target rate.  If the FOMC believes the economy is growing too fast and inflation pressures are inconsistent with the dual mandate of the Federal Reserve, the Committee may set a higher federal funds rate target to temper economic activity. In the opposing scenario, the FOMC may set a lower federal funds rate target to spur greater economic activity.  The FOMC influences the Fed Funds Rate through open market operations or through the buying and selling of government bonds in one of two ways:

 

1.)  It can raise the rate by selling government bonds which reduces liquidity because banks have less liquidity to trade with other banks.

 

2.) It can lower the rate by purchasing government bonds which increases liquidity because banks have excess liquidity.  

 

Here is a graphic showing what has happened to the Fed Funds Rate since 1961 noting that the shaded areas on the graph are recessions:

 

You will notice that every time there is a recession, the FOMC acted to push interest rates down by lowering the Fed Funds Rate as shown on this table:

 

In each of the seven recessions from 1969 onward, the FOMC has lowered the Fed Funds Rate by more than 500 basis points (5 percent) with the drop averaging 6.24 percentage points.  In each of the nine recessions from 1958 onward, the FOMC has lowered the Fed Funds Rate by more than 50 percent (excluding the 1980 recession when the drop was only 48.7 percent) with an average drop of 70.4 percent.  Right now the Fed Funds Rate sits at 0.12 percent, just above its all-time low and roughly the level that it has been at since December 2008.  Basically, the Fed Funds Rate cannot drop any further because it is already at the zero lower bound.

 

Let's look at a historical recession time table.  If you look carefully at the table, you'll notice that, over the past six decades, recessions have occurred quite regularly with the gap between the beginning of two concurrent recessions as follows:

 

1957 to 1960 recession – 2 years 8 months

1960 to 1969 recession – 9 years 8 months

1969 to 1973 recession – 3 years 11 months

1973 to 1980 recession – 6 years 2 months

1980 to 1981 recession – 1 year 6 months

1981 to 1990 recession – 9 years

1990 to 2011 recession – 10 years 8 months

2001 to 2007 recession – 6 years 9 months

 

The last recession officially ended in June 2009, putting us very nearly six years closer to the next recession.  Over the last nine recessions, the average length of time between the beginning of one recession and the beginning of the next is 6.1 years.

 

When we put the entire picture into place, we can see that it is quite clear that the Federal Reserve has painted itself into a policy corner.  When the next recession occurs, as it surely will, the Fed cannot use its normal tactic of lowering the Fed Funds Rate.  During previous economic recoveries, monetary policymakers, like the Federal Reserve, have been able to "replenish their ammunition" by allowing interest rates to float upwards.  Since the end of the Great Recession, interest rates have either fallen or remained at or near generationally low levels, meaning that the use of traditional monetary stimulus is completely ruled out.  Unlike previous recoveries, the Fed simply cannot lower the Fed Funds Rate by anything that even approaches the 5 percentage point plus drop seen during the past seven recessions.