The Federal Open Market Committee (FOMC) holds the ultimate responsibility for setting federal fund rates, which in an ideal world, moderate the economy in the right direction. When recession strikes, people spend less, banks lend less, and the economy wanes. As a potential remedy, the FOMC will often elect to reduce the federal funds rate, with the hope that with money being easier to come by, banks will lend more, and individuals will spend more. When the economy is healthy, and spending and lending are high, the FOMC will increase the rate in an effort to curb inflation.
While lower lending rates do help inspire consumer confidence, it can take some time for confidence to increase. It may seem counter-intuitive that for the period of late 2001 through late 2002 the growth of money supply actually slowed despite the FOMC’s reduction in the target for the federal funds rate, however, one important factor may help explain this anomaly. In 2001, consumer confidence was already low in the face of a recession we’d been facing since March of that year. But with the destruction of a major symbol of financial strength—-The World Trade Center-—in September 2001, a psychological war was waged on our financial stability, and the result was a profound decrease in consumer confidence. The initial response, even with the lower interest rates, was for people to hold onto their money.
The country’s monetary base is increased when the Federal Reserve purchases bonds from banks in exchange for cash. However, significant growth in the money supply does not occur until banks lend the money. Lower interest rates help encourage people to borrow, but until they do, the money supply does not grow dramatically.
I believe it is fair to characterize the FOMC’s reductions of the federal rate as following an expansionary monetary policy. In fact, lowering the rate was only one of several actions taken by the Federal Reserve that qualify as expansionary monetary policy. (1) Following the attacks, the Federal Reserve issued a press release that same day stating that “The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs.” This was done to temper the public’s fears about liquidity by providing "easy money", and to put a stable face on our most important government-run financial entity. (2) In the three days following the attacks, the Federal Reserve injected an average of $100 billion each day into the economy through open market operations and by making discount window loans available to any banks that needed them. (3) They temporarily suspended penalties on daylight and overnight overdrafts and temporarily suspended the rules on securities lending to make more collateral available, as well. These measures all demonstrate an expansionary monetary policy. (Parry, 2001)
It’s difficult, if not impossible, to definitively determine the degree of effect that an economic tactic, such as a change in monetary policy, has on the economy, but for the most part, the Federal Reserve’s immediate response to the attacks seems to have worked in the short-run. The economy did not collapse, consumer confidence slowly increased, and the market rebounded permanently in Q2 – Q4 of 2003. Would the same effects have been achieved without the FOMC's actions? Maybe, maybe not. We'll never know for sure. But I believe the FOMC acted prudently, given the conventional wisdom that inspired the actions. However, we now know that during that period of low federal funds rates, banks made loans to increasingly risky consumers. This, of course, helped create and perpetuate the absurd lending policies which eventually led us into the "Great Recession" we find ourselves in now as a result of the housing bubble collapse. (Crain’s Cleveland Business, 2009)
(2009). Think twice. Crain's Cleveland Business, 30(33), 10. Retrieved from Regional Business News database.
Parry, R. (2001). The U.S. Economy after September 11. FRBSF Economic Letter, 2001(35), 1. Retrieved from Business Source Elite database.
Google Image Search. "lighting a fart". Retrieved from images.google.com on January 24, 2010.