What Were They Thinking? The Fed on the Brink of Zero
How farsighted was the leadership at the Federal Reserve as the world economy was heading toward a steep decline more than five years ago? Outside the Fed’s marble halls, the answers to that question are only now becoming known, and the verdict is perhaps surprisingly positive.HT: Economist's View
In December 2008, a few months after the Lehman Brothers collapse threw the world economy into crisis, participants in the Fed’s steering group, the Federal Open Market Committee (FOMC), met to discuss their policy options. It was widely agreed that the conventional policy instrument, the federal funds rate target, would have to be lowered to zero. The big question was “what should we do next?” A recently released transcript of the meeting shows that the FOMC was already considering most of the monetary policy options that are still being debated by economists and pundits today. The transcript frequently mentions a package of 21 memos on monetary policy at the zero bound that were prepared by Fed staff just before the meeting. The Peterson Institute for International Economics has obtained those memos through the Freedom of Information Act and is making them available to the public on its website [pdf] as of today. In the interest of full disclosure, I was a coauthor of three of those background memos.
Together, the transcript and background memos display that FOMC participants understood the severity of the economic outlook they faced and that they and their staff had a good grasp of the pros and cons of the options available. That is not to say that Fed policy over the past few years could not have been improved upon, but simply to recognize that the Fed was not flying blind and indeed was already cognizant of many of the issues that would come to dominate the public debate about monetary policy.
Is 0.25 Zero?
The primary tool the Fed had to achieve its federal funds rate target at that time was the interest rate on bank reserves at the Fed, which was 1 percent in early December 2008. Almost all participants wanted to lower this rate and a few argued for a rate of zero percent. But most wanted a rate slightly above zero and they settled on 0.25 percent, which has remained constant to this day. The primary reason for a rate slightly above zero was concern that banks and money market funds needed to earn a spread between deposit and lending rates in order to pay their operating costs and they would find it difficult to impose negative interest rates on their depositors. In addition, there was some concern about reduced liquidity and disruptions in the bond markets that were already evident at low interest rates. The possible harm from further disruptions in banking and securities markets was judged to outweigh any small macroeconomic benefit from an even lower interest rate.
The FOMC did not discuss the possibility of a negative interest rate on bank reserves, but it is widely agreed that a significantly negative interest is not feasible because banks would convert their reserve balances to paper currency. A lingering puzzle is why the Fed never lowered interest on reserves to zero in subsequent years, when financial strains had diminished and depositors and market participants had gotten used to the low rate environment, but standard macroeconomic models imply that the benefits of such a small decline would have been correspondingly small....MORE
And via the PIIE:
Authorized for public release by the FOMC Secretariat on 03/07/2014
Notes on Issues Related to the Zero Lower Bound on
Nominal Interest Rates
Nominal Interest Rates
December 12, 2008
179 page PDF
