In late 2007, the bursting of the U.S. housing bubble triggered the worst financial crisis since the Great Depression of the 1930s. It resulted in the threat of total collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. The crisis caused the failure of businesses, huge declines in consumer wealth, and a downturn in economic activity that lead to the 2008-2012 global recession.
The Federal Reserve's response to the 2008 crisis saw the use of both conventional and new monetary tools in order to stabilize the economy, support market liquidity, and encourage economic activity. Conventional monetary policy suggests that in an economic downturn, a central bank should conduct open market operations in order to increase the money supply and lower interest rates. Lower interest rates stimulate loans, spending, and investment and help an economy escape from recession. Further, this type of financial crisis meant that banks' assets were suddenly worth far less; open market operations can ensure that these banks have the liquidity they need to carry out their financial activities.
Conventional Monetary Tools
The Federal Reserve (the Fed) did engage in these types of conventional operations in 2007 and 2008, cutting the target federal funds rate and the discount rate seven times. Normally, a low federal funds rate would encourage banks to borrow money in order to lend it out to firms and individuals, stimulating the economy, but in the aftermath of the financial crisis the Fed was unable to lower interest rates enough to successfully induce banks to make loans. One reason why traditional monetary policies failed is due to the zero lower bound and the low levels of inflation that accompanied the crisis.
The zero lower bound refers to the fact that the central bank cannot push nominal interest rates below 0%. This is because any creditor can do better by keeping their money in cash than by loaning it out at an interest rate below 0%. When inflation is high, however, central banks may be able to push the real interest rate below 0%. Recall that the nominal interest rate is the sum of the real interest rate and the expected inflation rate. If the nominal interest rate is 1% and inflation is 3%, the real interest rate is -2%. However, following the crisis, the U.S. experienced very low levels of inflation, and cutting the federal funds rate failed to provide enough economic stimulus to get the country out of the recession.
Unconventional Monetary Tools
Unable to create interest rates low enough to encourage banks to resume lending money, the Fed turned to other, untried policy tools to encourage economic activity. To deal with the shrinking credit markets, the Fed created a selection of new credit facilities. The Primary Dealer Credit Facility (PDCF) allows the banks that normally handle open market operations on behalf of the Fed to apply for overnight loans. The Term Asset-Backed Securities Loan Facility uses the primary dealers to give companies access to loans based on asset-backed securities, such as those related to credit card or small business debt. These new credit facilities were created based on the hope that increasing liquidity in the market would induce firms and consumers to borrow and spend.
The Fed also provided targeted assistance to bail out large financial institutions that would have otherwise collapsed. During the crisis, housing prices fell and the number of foreclosures increased dramatically. Investors, banks, and other financial institutions came under pressure as their mortgage-based assets lost value. The Fed provided credit to these institutions in an attempt to mitigate the effect of falling asset prices and stem the crisis. This included bailouts of two housing finance firms - Fannie Mae and Freddie Mac - which had been established by the government in order to encourage home ownership and stimulate the housing market.
The Fed also provided billions of dollars of assistance to AIG, an insurance firm that had invested heavily in mortgage loans . Without the assistance the firm would have collapsed, possibly causing a chain reaction of failing financial institutions. The Fed determined that these consequences were too severe to be allowed - that is, that AIG was "too big to fail. " Many argue that when the Fed provided this type of emergency aid, it encouraged banks to take even more extreme risks, safe in the knowledge that they would be bailed out if their investments failed. Others praise the Fed for avoiding an even deeper financial crisis.