THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 692

660 PA R T V I I Monetary Theory APP LI CAT IO N The Subprime Recession With the advent of the subprime financial crisis in the United States in the summer of 2007, the Fed and many other central banks around the world, including the Bank of Canada, began very aggressive easing of monetary policy For example, the Fed dropped the target federal funds rate from 5.25% to between 0% and 0.25% over a fifteen-month period from September 2007 to December 2008 At first, it appeared that the Fed s actions would keep the growth slowdown mild and prevent a recession However, the U.S economy proved to be weaker than the Fed or private forecasters expected, and a recession began in December of 2007 Why did the economy become so weak despite this unusually rapid reduction in the Fed s policy instrument? The subprime meltdown led to negative effects on the economy from many of the channels we have outlined above The rising level of subprime mortgage defaults, which led to a decline in the value of mortgage-backed securities and CDOs, led to large losses on the balance sheets of financial institutions With weaker balance sheets, these financial institutions began to deleverage and cut back on their lending With no one else to collect information and make loans, adverse selection and moral hazard problems increased in credit markets, leading to a slowdown of the economy Credit spreads also went through the roof with the increase in uncertainty from failures of so many financial markets The decline in the stock market and housing prices also weakened the U.S economy, because it lowered household wealth The decrease in household wealth led to restrained consumer spending and weaker investment, because of the resulting drop in Tobin s q With all these channels operating, it is no surprise that despite the Fed s aggressive lowering of the federal funds rate, the U.S economy still took a big hit LE SSON S FO R MO N ETARY P O LI CY What useful implications for central banks conduct of monetary policy can we draw from the analysis in this chapter? There are four basic lessons to be drawn It is always dangerous to associate the easing or tightening of monetary policy with a fall or a rise in short-term nominal interest rates Because most central banks use short-term nominal interest rates, typically the interbank rate, as the key operating instrument for monetary policy, there is a danger that central banks and the public will focus too much on short-term nominal interest rates as an indicator of the stance of monetary policy Indeed, it is quite common to see statements that always associate monetary tightenings with a rise in the interbank rate and monetary easings with a decline in the rate This view is highly problematic because movements in nominal interest rates not always correspond to movements in real interest rates, and yet it is typically the real and not the nominal interest rate that is an element in the channel of monetary policy transmission For example, we have seen that during the contraction phase of the Great Depression in the United States, shortterm interest rates fell to near zero and yet real interest rates were extremely