In my last post I showed that the second half of 2008 was when an ordinary recession got turned into the Great Recession. Starting about July, 2008 market sentiment began to significantly deteriorate as the economic outlook got markedly worse. Consequently, total dollar spending starts falling in July in anticipation of this economic weakening. Through two FOMC meetings the Fed did nothing and watched this development turn into a full-blown panic by mid-September. I noted that the Fed allowed this deterioration in expectations to occur by doing nothing. This failure to act, in turn, spawned the worse phase of the financial panic and the emergence of the Great Recession. By doing nothing, the Fed was doing something: passively tightening monetary policy at the worse time possible.
A number of observers have questioned me as to what the Fed could have done differently during this time. What difference would cutting the federal funds rate have made?
As noted in my last post, the key was to change the expected path of monetary policy. That means far more than just changing the federal funds rate. It means committing to keeping the federal funds rate target low for a considerable time like the Fed did in 2003 and signalling this change clearly and loudly. With this approach, the Fed would have provided a check against the market pessimism that developed at this time. Instead, the Fed did the opposite: it signaled it was worried about inflation and that the expected policy path could tighten. So the correct response was about far more than just cutting the federal funds rate, it was about setting the proper expectations of the future path of policy and to stem the deteriorating economic outlook.
Recall that Gary Gorton provides evidence that many of the CDOs and MBS were not subprime, but when the market panicked a liquidity crisis became a solvency crisis. This is especially true in late 2008. Had the Fed responded to the falling market sentiment in the second half of 2008 the financial panic in late 2008 may have never happened and the resulting bankruptcies been fewer. Again, the worst part of the financial crisis took place after this period of passive Fed tightening. This is very similar to the Great Depression when the Fed allowed the aggregate demand to collapse first and then the banking system followed. Unlike the Great Depression, though, the Fed did eventually get aggressive with its QE programs so outcome was better.
So yes, the Fed could have done a lot during this time. Because it did not act it spawned the Great Recession.