Everything that we have talked about in this section helps to explain why central bankers must be skilled and knowledgeable individuals with a good grasp of both economics and the workings of financial markets. Still, we have essentially been describing the job of a technocrat. Central bankers really earn their salaries in abnormal rather than normal times.
Starting in 2007 and stretching well into 2008, the United States and other countries began to experience financial crises that were similar in some ways to those experienced in the Great Depression. [***The financial crisis of 2008 is discussed in Chapter 4 "The Interconnected Economy" andChapter 15 "The Global Financial Crisis".***] The crisis seemed to begin innocently enough, with a decrease in housing prices that left some people unable or unwilling to cover their mortgage payments. But because of the way financial markets work, it became very hard for lenders to work out which of their assets were “nonperforming”—that is, unlikely to be repaid. As a result, financial markets froze up.
Part of the Fed’s response was an aggressive use of the tools that we have described in this chapter. For example, the Fed reduced the federal funds rate down to 0.25 percent. At that point, the Fed had just about reached the limit of what was possible with monetary stimulus. The problem is that nominal interest rates cannot go below zero because cash has a nominal interest rate of zero. If you keep a dollar bill from this year to next year, it is worth $1 next year. Therefore it would always be better just to keep cash rather than invest in an asset with a negative nominal return. The Fed had hit what is known as the zero lower bound.
Even though it was at the zero lower bound, the Fed still had other options. In normal circumstances, it operates in the economy by buying and selling short-term government debt, one of the many assets in the economy. But these were highly abnormal circumstances, and it is possible for the Fed to buy and sell other assets as well. This is what the Fed did. During the crisis, the Fed started purchasing many other assets, such as commercial paper. In other words, instead of just lending to banks, the Fed started lending directly to firms in the economy. Central banks in some other countries, such as the United Kingdom, pursued similar policies. [***Explaining what happened in 2008 involves understanding the actions of the Fed, but it requires many of our other tools as well. For that reason, we take up this crisis in more detail in Chapter 15 "The Global Financial Crisis".***]
KEY TAKEAWAY
Despite the large reduction in aggregate economy activity and deflation during the Great Depression, the Fed did not pursue a very aggressive policy. The effectiveness of the Fed was hampered by the unwillingness of households to deposit funds in banks and the unwillingness of banks to make loans.
The conduct of monetary policy is made difficult by uncertainty over the current state of the economy and the inexact nature of the effects of interest rates on real GDP and prices.
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Checking Your Understanding
In what ways was the Fed not very aggressive during the Great Depression?
How could the goals of the Fed be in conflict?
Does the Fed know the current state of the economy when it makes decisions?
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