National Financial Policy ''The Perfect Storm''
The Great Recession is considered the most notable economic crisis since the Great Depression. The economic crisis was caused by a lack of liquidity, which resulted it the collapse of big financial institutions and a significant decline in the financial markets worldwide. There are numerous reasons for the “perfect storm,” which led to the recession. Experts suggest that 2008 recession mainly resulted from the credit crisis, which in turn was a result of the bursting of the housing bubble. The principal causes of the housing bubble were low interest rates on mortgages and short-term loans, irrational exuberance, and less strict regulations on mortgage loans (Holt, 2009). A host of government policies ad hoc bailout policies perpetuated before and during the recession can be linked to the financial crisis (Taylor, 2014). Monetary policy is linked to financial stability. The fall of the federal fund rate to a historic low is one of the main reasons for the financial crisis.
Monetary Policy Subject Area
After a financial crisis, it is easy to establish the relationship between monetary policy and financial stability. According to Billi and Vredin (2014), it is practically impossible to separate monetary policy from financial stability. Central banks can play a vital role in stabilizing inflation rates and thus reducing financial and economic volatility and promoting financial stability. The financial crisis of 2008-2009 leading to the Great Recession was caused by a host of causes, including the actions of the central bank that led to financial imbalances (Billi & Vredin, 2014). However, monetary policy effects are difficult to predict accurately and are also characterized by long time lags, which affects the reaction of the Federal Reserve to certain economic trends such as inflation.
Contribution of Monetary Policy to the Great Recession
The monetary policy of the United States around the time of the financial crisis was a significant contributing factor to the Great Recession. Monetary policy affects inflation rates; a persistent attempt to maintain low short-term real interest rates ultimately leads to higher inflation with no permanent output growth. Prior to the financial crisis, lax monetary policy affected the housing sector in the United States; the interest rates had been held at a very low level by the Federal Reserve. This evidently deviated from the US monetary policies of the 1980s and 1990s, which were perceived to have worked effectively. Holding the federal funds rate higher for the same rate of inflation, as observed in the late 1960s – a period in which monetary policy was failing, was an effective policy in the two successive decades. For instance, the federal funds rate in 1997 was 5.5% with inflation of 2% (Taylor, 2014). In 2003, the inflation rate equaled 2%, whereas the federal funds rate was only 1%. This monetary action accelerated the housing boom as the policy allowed for low rates on adjustable-rate mortgages, which led to risk-taking behavior and a search for yield (Taylor, 2014).According to Billi and Vredin (2014), bank lending in the United States, specifically to households and firms, led to a surge in credit in the pre-crisis years. The credit crisis that ensued was characteristic of the financial crisis that later led to the Great Recession.
Dodd-Frank Act Provisions and Monetary Policy
The Dodd-Frank Wall Street Reform and Consumer Protection Act advance certain provisions of monetary policy. The Dodd-Frank Act is aimed at revamping the Federal Reserve’s regulatory duties (Taylor, 2014). The Financial Stability Act of 2010 led to the establishment of the Financial Stability Oversight Council, which was tasked with spotting financial stability threats as well as introduced stricter regulations that restrained risk-taking of institutions to enhance financial stability.
Implementing the Dodd-Frank Act
The Federal Reserve has been instrumental in implementing the Dodd-Frank Act provisions on the area of monetary policy. The Act affected both the authority of the Federal Reserve as well as its mode of operation. During the financial crisis, the Federal Reserve caused the federal fund rate to drop to near zero, prompting the need for new techniques to stimulate lending (Taylor, 2014). The Federal Reserve has the power to effect monetary policy as well as a regulatory role shared with the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC). This regulatory role entails promoting financial institutions in terms of their safety and soundness. With numerous banks involved in risky lending to consumers during the financial crisis, the Federal Reserve is perceived to have failed to fulfill its regulatory duties. To solve this situation, the Federal Reserve adopted new tools such as paying interest over excess reserves (IOER) and Asset Purchasing. These two controversial tools are meant to stimulate lending. Since the enactment of the Federal Reserve Act of 1913, the Federal Reserve has mainly employed the discount rate, the federal funds rate, and reserve requirements to achieve its goals. The enactment of the Dodd-Frank Act, however, has led to the need for reliance on additional measures due to the fall of federal funds rate during the financial crisis (Billi & Vredin, 2014).
Possible Changes in Monetary Policy
Effective changes in monetary policy are essential for financial stability as well as economic growth. Currently, the United States is experiencing a slow economic growth, as expressed by Janet Yellen, the Federal Reserve chair. In a congressional hearing in June, she announced before the Senate Banking Committee that there is a little chance of increasing the target federal funds rate in the near future. The reason for this is that the present conditions do not threaten a recession which often results from tightened monetary policy and rising inflation (Shwartz, 2016).
Effectiveness of the “Financial Stability Act of 2010” Provision
The enactment of the “Financial Stability Act of 2010” provision of the Dodd-Frank Act has been instrumental in resolving a number of issues in the finance industry and mitigating the recession. The provision might not resolve all the concerns caused by the recession, but it helps to govern financial institutions through the creation of new more effective boards. Introduction of stricter regulations for specific institutions led to a significant decrease in the level of risk financial institutions are willing to make as well as to a reduced shadow banking (Billi & Vredin, 2014). The creation of the Financial Stability Oversight Council has facilitated monitoring of financial institutions.
The current financial era is characterized by a challenging regulatory change worldwide. In the United States, this change presents an opportunity to alter policies wisely so as to suit the present of the nation as well as make necessary changes to the regulatory system to ensure both financial and economic stability. The American economy suffered considerably in the wake of the financial crisis and the Great Recession; the financial industry should thus streamline its operations to ensure the new regulatory landscape favors the economy of the United States.
The Dodd-Frank Act offers both short-term and long-term solutions. In a short term, the Dodd-Frank regulatory reform creates an opportunity to increase both the capital flows to the United States and the resilience of the American capital markets. Despite a presumption that this reform simply serves to remedy the recession, it provides an opportunity to reap long-term benefits. In the long-term, the Dodd-Frank Act can offer a way to resolve the issue of ineffective monetary policy, especially with regard to the federal fund rate. By setting forward focus and effective regulatory goals, the United States can make significant improvements to its financial sector. The regulations enacted with regard to the financial crisis, specifically the Dodd-Frank Act have received considerable opposition; however, antagonism is not the answer. Policy makers such as the Senate Banking Committee and the House Financial Services Committee should take further actions to ensure the success of such regulations. First, they should actively devote efforts to increase regulatory convergence with global counterparts. Secondly, it is also necessary to augment the level of association with global standard setters and institute a Regulatory Review Authority to monitor financial policy.
In summary, enacting regulatory changes in response to the Global Financial Crisis of 2008 is a current trend. In the United States, the Dodd-Frank Act is one of the most notable regulations implemented as a result of the crisis. The provisions provided by the Dodd-Frank Act regarding monetary policy relate to financial stability. The link between monetary policy and financial stability is evident, as suggested by many experts. Monetary policy in the United States at the pre-crisis era can considered the main cause of the financial crisis. Thus, the declining federal fund rate at the time triggered the bursting of the housing bubble and consequently the credit crisis. The Federal Reserve has taken action to introduce different instruments of monetary policy to remedy this failure. The Dodd-Frank Act has been relatively effective; however, there is more to be done in terms of improving relations with global and regional regulatory bodies in order to improve financial regulations in the United States.
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