How Federal Reserve lowers the interest rates
In a normal scenario, Federal Reserve uses its monetary policy tools in order to manage interest rates. These tools operate on the basis of double mandate of the central bank to maintain stable inflation and maximize employment. Its three instruments of monetary policy control are open market operations, the discount rate and reserve requirements. Through open market operations it buys and sells government securities. The discount rate is the interest rate charged by Federal Reserve Bank to depository institutions on short-term loans. And finally, the reserve requirements, which are the portions of deposits that banks must maintain either in their vaults or on deposit at the Federal Reserve Bank.
However, the credit crisis which started in 2007 weakened the U.S. banking sector. The traditional monetary policy tools fell short in supporting the economy and boosting confidence. The interest rates were already near zero; therefore conventional monetary policy lost its relevance in such situation. The banking sector woes soon swept across the economy and engulfed the whole nation into a deep recession. The situation had far reaching impact on global asset management and wealth management sector. The borrowing cost among the banks increased to historically high levels, as banks were unable to trust each other. Since the banks were unable to arrange liquidity for themselves, they stopped lending. The overall confidence in the U.S. economy was shattered. Debt markets and equity markets froze with minimal trading across asset classes.
In this troubled scenario, the Federal Reserve came to the forte and took unconventional measures to restore the market confidence. It introduced quantitative easing one (QE1) in 2008-2009, which was essentially purchase of assets from the banks in order to provide them with the necessary liquidity. This also in effect reduced the yields on the asset purchased on account of increased demand due to the QE. The QE1 involved purchase of trillion of dollars of combined balances of mortgage backed securities, agency debt / mortgage and treasury. This had an impact of lowering borrowing costs in the economy. Subsequent to this, the central bank unravelled further monetary easing in November 2010 through the QE2 of USD 600 bn. The QE2 lasted till June 2011. Thereafter, in September 2011, it introduced USD 400 bn operation twist, which basically involved purchase of long dated bonds in order to lower the long-term interest rates. In 2012, the central bank announced the QE3, which the central bank has committed to follow until a specific level of inflation and employment target is reached. The above unconventional policies have ensured the commitment of the central bank towards maintaining low rates till the economy shows growth on a sustained basis.
However, the credit crisis which started in 2007 weakened the U.S. banking sector. The traditional monetary policy tools fell short in supporting the economy and boosting confidence. The interest rates were already near zero; therefore conventional monetary policy lost its relevance in such situation. The banking sector woes soon swept across the economy and engulfed the whole nation into a deep recession. The situation had far reaching impact on global asset management and wealth management sector. The borrowing cost among the banks increased to historically high levels, as banks were unable to trust each other. Since the banks were unable to arrange liquidity for themselves, they stopped lending. The overall confidence in the U.S. economy was shattered. Debt markets and equity markets froze with minimal trading across asset classes.
In this troubled scenario, the Federal Reserve came to the forte and took unconventional measures to restore the market confidence. It introduced quantitative easing one (QE1) in 2008-2009, which was essentially purchase of assets from the banks in order to provide them with the necessary liquidity. This also in effect reduced the yields on the asset purchased on account of increased demand due to the QE. The QE1 involved purchase of trillion of dollars of combined balances of mortgage backed securities, agency debt / mortgage and treasury. This had an impact of lowering borrowing costs in the economy. Subsequent to this, the central bank unravelled further monetary easing in November 2010 through the QE2 of USD 600 bn. The QE2 lasted till June 2011. Thereafter, in September 2011, it introduced USD 400 bn operation twist, which basically involved purchase of long dated bonds in order to lower the long-term interest rates. In 2012, the central bank announced the QE3, which the central bank has committed to follow until a specific level of inflation and employment target is reached. The above unconventional policies have ensured the commitment of the central bank towards maintaining low rates till the economy shows growth on a sustained basis.
