Fed and Monetary Policy

ESSAY TITLE: FED’S MONETARY POLICY???

Introduction

The global economy had been in its longest cyclical upturn in more than 30 years before the financial crisis in 2008. The upturn was possible through increasing productivity and also because of the effects of globalization. This kept the price increases moderate. Inflation expectations were about the same as the central banks’ inflation targets. The central banks follow the Taylor rule and therefore the interest rates were kept moderately low. /A/

Low interest rates meant cheap money for the banks and their customers. The homeownership rate boomed in the US. It reached its peak level in 2005. The homeownership rate was almost 70% at its highest level. Slowly rising interest rate ended the boom and the rate started to decrease. There was higher supply then demand which created a downward pressure on the housing prices. /B/

Figure 1. Housing boom /B/.

In 2008 the mortgages and housing equity loans accounted for 109% of the disposable personal income in the US. The homeowners started to have problems paying their loans back to the banks. At the same time decreasing housing prices made the mortgages riskier for the banks. In the US in case of the homeowner failing to pay the mortgage, the house goes to the bank and the debt is cancelled. The houses become toxic assets for the banks. /B/

One major player in the mortgage market was Lehman Brothers. Lehman had high degree of leverage and huge portfolio of mortgage securities. The firm reported big losses and write-downs in the beginning of September 2008 and its credit ratings were being reviewed. Finally it went to a bankruptcy on 15th of September 2008. /E/

Fed had already bailed out Bear Stearns Investment bank in March 2008, but Lehman Brothers was not saved. The global financial crisis started when Lehman Brothers collapsed. The stock markets fell globally following the drop of Dow Jones.

Fed’s monetary policy and Taylor rule before the...