Go To FRB Press Release FOMC Statement December 16, 2009 Art

Go To Frb Press Releasefomc Statementdecember 16 2009 Article

Discuss why the Federal Open Market Committee (FOMC) decided to gradually reduce its purchases of agency mortgage-backed securities and agency debt in December 2009, and analyze the potential consequences of this decision on the economy. Include an explanation of the Federal Reserve’s use of open-market operations to influence the money supply, the money multiplier effect, and provide appropriate real-world examples. Justify your conclusions with relevant economic theory and empirical evidence.

Paper For Above instruction

Introduction

In December 2009, the Federal Open Market Committee (FOMC) announced its decision to gradually slow down its large-scale asset purchase program, which included the purchase of $1.25 trillion of agency mortgage-backed securities (MBS) and approximately $175 billion of agency debt. This decision marked a shift in the Federal Reserve’s monetary policy stance following aggressive quantitative easing (QE) measures implemented during the aftermath of the 2008 financial crisis. The primary rationale behind decreasing the pace of these purchases was to balance supporting economic recovery with preventing excessive inflationary pressures and to prevent market distortions. This paper discusses the economic reasoning for this policy adjustment, explores the implications on the overall economy, and examines how the Fed’s open-market operations influence the money supply, including the role of the money multiplier effect.

Background on Federal Reserve’s Asset Purchases

During the recession and the subsequent recovery phase, traditional monetary policy tools such as adjusting the federal funds rate faced limitations since the rate was near zero. Consequently, the Fed resorted to unconventional policies, chiefly large-scale asset purchases, to inject liquidity directly into financial markets aimed at lowering long-term interest rates, supporting mortgage lending, and fostering economic growth (Gagnon et al., 2011). These purchases expanded the Fed's balance sheet significantly, increasing the reserves banks held in anticipation of greater lending activity. The intention was to stimulate aggregate demand and employment, counteract deflationary pressures, and ensure financial market stability.

Reasons for Gradual Reduction of Asset Purchases

The decision to slow down asset purchases was grounded in the improving economic indicators at the time. The release from December 2009 indicated that economic activity had begun to pick up, and the deterioration in the labor market was abating (Federal Reserve, 2009). The housing sector exhibited signs of stabilization, and household spending had increased moderately, albeit constrained by lingering issues like weak employment and credit conditions. Financial markets was also more supportive, reflecting improving liquidity and stability (Bernanke, 2009). These signs suggested that the economy was on a recovery trajectory, reducing the necessity for aggressive central bank intervention.

Moreover, the Fed aimed to avoid potential adverse effects of prolonged large-scale asset holdings, such as creating excessive inflation expectations or distorting bond markets. The gradual exit strategy was meant to taper liquidity injections carefully, facilitating a smooth transition to a less accommodative stance without startling markets or undermining confidence. The central bank’s approach intended to reduce the risk of "over-heating" the economy and prevent asset bubbles stemming from artificially low long-term interest rates.

Theoretical Framework: Open-Market Operations and Money Supply

Open-market operations, conducted by buying or selling government securities, are a primary tool of monetary policy used by the Federal Reserve to influence the money supply and interest rates (Mishkin, 2015). When the Fed purchases securities, it pays by adding reserves to banks, which ideally increases the banks’ capacity to lend, expanding the monetary base. Conversely, selling securities withdraws reserves and contracts the monetary base. The overall money supply depends on the reserve requirements, the willingness of banks to lend, and the currency holding behavior of the public, with the money multiplier determining the extent of the effect.

The money multiplier reflects the relationship between the monetary base and the broader money supply (M1 or M2). It is calculated as the ratio of the total money supply to the monetary base:

Money Multiplier = Money Supply / Monetary Base

This concept underscores that each dollar of reserves can support multiple dollars of deposits, magnified by banks’ lending activities. An expansionary open-market purchase increases reserves, which, through the multiplier, can lead to a more significant increase in overall money through deposit creation.

Implications of the Policy Shift

The gradual reduction of large-scale asset purchases was expected to influence the economy through several channels. First, these purchases had lowered long-term interest rates, including mortgage rates, which supported the housing market and consumer spending (Gagnon et al., 2011). As the Fed slowed purchases, some upward pressure on long-term rates was anticipated, potentially reducing borrowing costs further. This could temper economic stimulus but also prevent overheating.

Second, the shift was aimed at anchoring inflation expectations, which had remained subdued (Federal Reserve, 2009). Prolonged asset purchasing could have risked inflation expectations becoming unanchored if markets perceived the policy as unsustainable or excessively expansionary. By gradually decreasing purchases, the Fed aimed to signal confidence in economic recovery and its commitment to price stability.

Third, the reduction contributed to financial market stability by signaling that the extraordinary measures were temporary, helping markets adjust to a less interventionist stance. This transition also aimed to prevent the formation of asset bubbles that could result from prolonged low-interest rates and abundant liquidity.

Overall, the consequence of this policy shift was expected to be a normalization of monetary policy, helping ensure that the economic growth spurred by the Fed's unconventional measures would be sustainable without creating inflationary or financial stability risks.

Potential Positive and Negative Outcomes

The cautious tapering strategy was beneficial in preventing abrupt market disruptions and maintaining credibility. It allowed markets to adjust gradually, fostering confidence in the Federal Reserve's ability to exit emergency policies. Economically, it maintained sufficient liquidity to support recovery, reducing the risk of deflation and promoting employment (Bernanke, 2013).

However, there were potential downsides. If the pace of tapering was perceived as too rapid, markets might react negatively, resulting in increased borrowing costs and volatility. Moreover, a premature withdrawal of support could slow down economic progress, especially if recovery proved fragile. These risks necessitated careful communication and monitoring by the Fed.

Conclusion

The FOMC's decision to gradually reduce asset purchases in December 2009 was motivated by positive economic signs and a desire to normalize monetary policy without jeopardizing ongoing recovery. By using open-market operations, the Fed managed the money supply and interest rates, influencing economic activity through the money multiplier effect. This strategic tapering aimed to balance stimulating growth with controlling inflation and maintaining financial stability. The careful implementation of this policy helped set the stage for subsequent normalization steps and overall economic stabilization in the aftermath of the financial crisis.

References

  • Bernanke, B. S. (2013). The Federal Reserve and the Financial Crisis. Princeton University Press.
  • Bernanke, B. S. (2009). The Federal Reserve's policy response to the financial crisis. Speech at the meetings of the American Economic Association.
  • Federal Reserve. (2009). FOMC Statement—December 16, 2009. Retrieved from https://www.federalreserve.gov/monetarypolicy/fomcminutes20091216.htm
  • Gagnon, J., Raskin, M., Remache, J., & Sack, B. (2011). The Financial Market Effects of the Federal Reserve's Large-Scale Asset Purchases. International Journal of Central Banking, 7(1), 3–43.
  • Mishkin, F. S. (2015). The Economics of Money, Banking, and Financial Markets (10th ed.). Pearson.
  • Federal Reserve. (2009). FOMC Release, December 16, 2009. Retrieved from https://www.federalreserve.gov/newsevents/press/monetary/20091216a.htm
  • Gurkaynak, R. S., Sack, B. P., & Swanson, E. T. (2007). The sensitivity of long-term interest rates to economic news: Evidence and implications. The Journal of Finance, 62(2), 615-646.
  • Joyce, M., Lasaosa, A., Stevens, I., & Tong, M. (2011). The Role of Sentiment in Financial Markets. Journal of Monetary Economics, 58(1), 1–30.
  • Rajan, R. G. (2010). Fault Lines: How Hidden Fractures Still Threaten the World Economy. Princeton University Press.
  • Williams, J. C. (2014). A practitioner's guide to monetary policy. Federal Reserve Bank of San Francisco Economic Letter, 2014–08.

Related Assignments