Fed Influence Expands Since Great Recession

There was a time in U.S. history when the chairman of the Federal Reserve wasn’t one of the most frequently mentioned names on the news. While a central bank has always been a key institution in a modern economy, the Fed’s role drastically expanded with the Great Recession. Other than an economic catastrophe, what happened during this time that led to the growing influence of this unelected but independent body? I’ll tell you: continuously low interest rate policy and quantitative easing.

Prior to the Great Recession, the Fed changed the overnight federal funds rate by a combination of announcing its target level and making small changes in the supply of aggregate reserves as needed. Since the Fed didn’t pay interest on reserves, bank reserve balances were much lower then—usually less than $10 billion compared with the current level of over $3 trillion. With reserves being scarce, changing the fed funds rate was a much simpler business back then. The Fed’s balance sheet was also a lot smaller and included short-term instead of long-term Treasury issues. The Fed didn’t directly impact long-term rates, which were largely driven by expectations for short-term rates over the duration of a given long-term bond. Thus, the Fed only indirectly influenced long-term rates by changing expectations for short-term rates. 

After the economy fell into the Great Recession, the Fed dropped the federal funds rate to near zero, leaving it with no more room to stimulate the economy. It then conducted unprecedented large-scale security purchasing known as quantitative easing, aiming to increase prices and reduce yields on the assets bought, including mortgage-backed securities and long-term Treasury issues. 

Beneath this unprecedented level of expansionary monetary policy was expansionary fiscal policy. With the Fed playing a direct role in the long-term Treasury market, long-term yields declined drastically. For example, the 10-year yield decreased from a range of 4%–5% pre-Great Recession to mostly below 2.5% post-Great Recession. This meant the U.S. government was given license to borrow at low rates. When the pandemic started in 2020, the Fed doubled down on quantitative easing, bringing its balance sheet to $9 trillion in 2022. Meanwhile, yields were at all-time lows, giving the U.S. government an unprecedented spending spree. 

Currently the largest single holder of U.S. debt, the Fed now finds itself significantly entwined with the U.S. government, from whom it’s supposed to be independent. Now that the Fed wants to shrink its balance sheet, one may understand if the U.S. government takes it personally when the central bank says it’s no longer interested in buying more U.S. debt.