Recession Primer, Part Seven: What does the Fed do about Recessions?

David Frost // How To Invest, Market Outlook


February 29  

This is part seven of a series on recessions, specifically what economic factors impact the decisions of the Federal Reserve. Click here for part one. Click here for part two on what recessions look like. Click here for part three on why recessions occur. Click here for part four on recession signals. Click here for part five on recent recessions. Click here for part six on how to invest during recessions.

Whenever there is a recession, it is the job of the Federal Reserve to take steps to guide the economy out of it. The central bank can do this in a variety of different ways using various tools designed to ease conditions or increase the supply of money in the economy by making it easier for individuals and businesses to borrow money.

Whenever a recession occurs, the Fed starts to shift toward expansionary monetary policy, which is designed to spur economic growth by increasing the money supply. Expansionary policies are also aimed at increasing aggregate demand to address a shortfall in private demand. The Fed may also resort to expansionary measures if it looks like a recession is about to occur.

Cutting interest rates

One of the first steps in expansionary monetary policy is to cut interest rates. Specifically, the Fed reduces its target for the federal funds rate, which is the rate banks charge each other to take out overnight loans. Banks are required to keep a certain amount of money in their vaults and their accounts with the regional Federal Reserve bank, so when they come up a bit short, they must borrow from a bank that has extra funds. 

Banks which are borrowing from other banks pay interest in the form of the federal funds rate on the money they borrow overnight. The Federal Reserve reduces the target range for the federal funds rate and then pulls other levers to move the rate banks are charging each other toward the target range. 

Lowering the federal funds rate makes it easier and cheaper for banks to borrow money from each other, so it is considered an expansionary move because it expands the money supply. When it’s easier for banks to borrow money from each other, they are motivated to provide more loans to individuals and businesses. 

A lower federal funds rate also translates into lower interest rates on loans for consumers and business owners, thus also making it easier and cheaper for them to borrow money. Reducing the federal funds rate should trickle down to interest rates in the rest of the economy, although occasionally, banks might choose to sit on their reserve balances rather than loan them out.

Economic stimulus

Aside from interest rates, the Federal Reserve also takes more direct steps in an attempt to stimulate the economy. The reasoning behind economic stimulus is that the economy’s output is running behind its sustainable potential because demand has declined, usually due to a recession. Economic stimulus can take different forms, like increasing government demand, lowering taxes or conducting quantitative easing. The overall goal is to increase the amount of money that’s available in the economy, thus bolstering employment and supporting demand.

For example, the Economic Stimulus Act of 2008 stimulated the economy in multiple ways in an attempt to avoid a recession. The stimulus measures included tax rebates paid to individual taxpayers in the U.S. The goal of providing these rebates was to place more money in the hands of consumers, hopefully so they will spend the extra money, boosting demand. However, in this case, consumers spent only about one-third of the tax rebate, so it didn’t have the stimulating effect policymakers had hoped it would.

Stimulus measures may also include quantitative easing, which involves buying bonds and other debt securities to increase the money supply. The Fed turns to quantitative easing when standard expansionary policies are coming up short of helping spur economic growth. If interest rates are already at or near 0%, and the economy isn’t growing, quantitative easing is a last resort to spur growth.

The risks of fighting a recession

One of the economic factors the Federal Reserve works to keep in balance is inflation. The central bank usually targets an inflation rate of 2%, although the economy can usually manage a rate as high as 3%. If the Fed increases the money supply too much, it can result in runaway inflation. Hyperinflation is when prices increase 50% or more in only a month. 

Inflation of any kind occurs when too much money is injected into the economy. Money becomes so readily available that its value drops, and it takes more money to buy the same things as before. Thus, the Fed must be careful when increasing the money supply because runaway inflation can cripple the economy, making a difficult situation even worse. When inflation is running too high, the Federal Reserve must take steps to reduce the money supply by raising interest rates and holding back on debt purchases.

Dealing with the Great Recession

The Great Recession is freshest in the minds of economists and market watchers, and it took quite a bit of work by the Fed to get the economy out of it. The 2008 financial crisis tipped the global economy into a deep recession, and central banks around the globe had to enact a variety of measures to counteract it.

Among the tools used by the Fed during the Great Recession were quantitative easing, the Term Auction Facility, under which the central bank bought mortgage-backed securities from banks, and the Term Asset-Backed Securities Loan Facilities, under which the Fed bought subprime credit card debt from financial institutions. 

The Fed also reduced interest rates to near 0%, which is why it also had to resort to quantitative easing. The central bank also bailed out banks with an unprecedented $7.7 trillion in emergency loans. The American Recovery and Reinvestment Act also provided the economy with $787 billion in government deficit spending. 

The Great Recession is also an example of what happens when the Fed contracts policy too much. Between 2004 and 2006, the central bank hiked interest rates steadily to keep inflation steady. This moderated the flow of new credit, and the higher interest rates resulted in a difficult credit situation. It eventually popped the housing bubble, which helped trigger the Great Recession. 

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost