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The Fed’s Unconventional Monetary Policy

Why Danger Lies Ahead

Federal Reserve Chairman Ben Bernanke and U.S. Treasury Secretary Timothy Geithner testify in the House Financial Services Committee Hearing in Washington, March 2009. Kevin Lamarque / Reuters

Now, almost a decade after the Great Recession hit, the story of its origins and course has become familiar. It began in December 2007, soon after the U.S. housing bubble burst, triggering the widespread collapse of the U.S. financial system. Credit dried up, as banks lost confidence in the value of their assets and stopped lending to one another. Consumer spending plummeted. At first, the U.S. Federal Reserve tried to boost spending through traditional monetary policy, by reducing short-term interest rates. Yet this proved ineffective, even though short-term interest rates fell close to zero. The government then turned to fiscal stimulus, with Congress passing a package of tax cuts and spending increases in 2009, but this, too, proved ineffectual.

After both standard monetary and fiscal policy had failed, the Federal Reserve turned to what it calls “unconventional monetary policy,” aiming to lower long-term interest rates by purchasing long-term financial assets and promising to keep short-term rates close to zero for a long period of time. This policy paid off, and the U.S. economy has at last rebounded. Today, the overall unemployment rate has dropped below five percent, and unemployment among college graduates stands at just 2.5 percent. The European Central Bank (ECB) followed the United States’ lead with massive bond purchases and extremely low interest rates (short-term interest rates are actually negative in many of the eurozone countries). Europe thus also began to dig itself out of recession, but its policy is not proving nearly as effective as similar moves did in the United States.

What is now clear, however, is that unconventional monetary policy and extremely low interest rates have also created major financial risks that could hurt the European and U.S. economies in the years ahead. These policies have driven up the prices of stocks, low-quality bonds, and commercial real estate, potentially setting the stage for another asset price collapse—the very phenomenon that led to the Great Recession in the first place. Unconventional monetary policy does

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