Strategies the Federal Reserve Deploys during Economic Downturns
The Federal Reserve's Fight Against Economic Downturns
The Federal Reserve, also known as the U.S. central bank, holds a demanding job: it wants to keep unemployment low and ensure a steady price level throughout the economy. During recessions, when unemployment soars and prices could fall in the process called deflation, the Fed gets creative to fight these economic adversities. They have tools at their disposal to tackle these challenges and provide a lifeline to the U.S. financial system and overall economy.
A prolonged economic slump can see businesses fail, usually due to a mix of economic shocks and diminishing demand. As a result, businesses may lay off workers, sell assets, or default on their debts, potentially triggering a devastating process of debt deflation.
Deflation, in itself, isn't inherently harmful to the economy or businesses. However, it scares central banks and the financial sector, especially when it involves debt deflation. This is because debt deflation increases the real value of debts and risks to debtors, particularly banks. The Fed doesn't hesitate to take action to protect these institutions, all in the name of protecting financial stability.
The Federal Reserve has several tools in its arsenal to manage the economy during a recession, aiming to achieve their goals with precision. These tools can be grouped into several categories:
Open Market Operations (OMO)
The Fed can reduce interest rates by buying debt securities on the open market, in return for newly created bank credit. This newly accessible credit enables banks to lend money to each other at a lower federal funds rate—the rate at which banks lend to each other overnight. By lowering interest rates, the Fed hopes to spread cost savings throughout the financial system, making borrowing cheaper for businesses and consumers.
Lower rates make it easier for companies to take on debt, helping them avoid defaulting or shedding employees. In addition, cheaper credit encourages consumers to make more purchases on credit, which helps keep consumer prices high.
There are instances when interest rates drop so low that banks prefer to hold on to fresh reserves as a safety net against their debt obligations. In such cases, the Federal Reserve can continue OMO, buying bonds and other assets to flood the banking system with credit, a process referred to as quantitative easing (QE)—the direct purchase of assets by the Federal Reserve to inject increased funds into the economy, expanding the money supply.
The Fed has employed QE on several occasions since 2008, including in March 2020, when the central bank launched an ambitious $700 billion QE plan to prop up the financial system's debts, on top of most of the nearly $4 trillion in QE that was created during the Great Recession.
Lowering Capital Requirements
Regulating banks is another tool the Fed can use to achieve full employment and stable prices during recessions. Historically, the Fed was responsible for ensuring that banks maintained adequate liquid reserves to meet redemption demands and stay solvent. When the Fed wants to give breathing room to banks, it can lower requirements, allowing them to run their reserves down, potentially increasing their financial vulnerability.
Post-2007 financial crisis, QE resulted in banks holding massive ongoing balances of reserves, far exceeding the required reserve ratio. In the wake of the COVID-19 pandemic, the Fed eliminated all reserve requirements for banks, leaving the Fed without any further room to use this tool for future recessions.
Discount Lending
The Fed can lend funds directly to banks in trouble through the discount window. This type of lending used to function as a bailout loan of last resort for banks out of options, and it came with a steep interest rate to protect the interests of taxpayers due to the risky nature of the loans.
In recent decades,though,the practice of discount lending by the Fed has shifted to offer these risky loans at lower interest rates to prioritize the interests of the financial sector. The Fed has also rolled out a series of new lending facilities tailored to support specific sectors of the economy or the prices of certain asset classes.
In March 2020, the Fed lowered its discount rate to an unprecedented 0.25% to provide extremely favorable lending terms to high-risk borrowers. However, by March 2025, a series of aggressive rate increases from the Fed aimed at curbing high inflation had returned the discount rate to 4.5%.
Expectations Management (Forward Guidance)
Expectations management, or forward guidance, is an important part of the Fed's arsenal, as market expectations can greatly influence the financial sector and the economy as a whole. Uncertainty about whether the Fed will intervene to save banks or keep asset prices stable can fuel pessimism among investors, banks, and businesses in addition to real economic challenges.
When the economy is struggling, the Fed's clear and confident communication can help reassure market participants and provide support during challenging times.
Keeping Inflation at Bay While Fighting Recession
Inflation, marked by rising prices and eroded purchasing power, is a concern for the Fed as it targets around 2% inflation per year. During a recession, inflation may remain below this target, allowing the central bank to maintain accommodative monetary policy.
However, overly accommodative monetary policy can also result in inflation. When the economy is operating at capacity and there aren't enough workers to fill all jobs available or wages are growing faster than productivity growth, more people may turn to borrowing to fund increased consumption.
Lower unemployment levels empower workers to negotiate for higher wages, potentially launching a wage-price spiral as businesses increase prices to match their higher labor costs. Moreover, cheap credit could encourage increased borrowing, spending, and investments, resulting in both economic growth and higher prices, inflationary forces within the economy.
To combat inflation, central banks will raise interest rates or implement contractionary policies, such as increasing bank reserve requirements or raising interest rates.
- During recessions, the Federal Reserve uses tools such as Open Market Operations (OMO) and lowering capital requirements to keep unemployment low and ensure price stability, with the goal of achieving full employment and stable prices.
- In some cases, the Fed may employ quantitative easing (QE), the direct purchase of assets to inject increased funds into the economy, when interest rates drop so low that banks prefer to hold onto reserves instead of lending.
- The Fed also provides discount lending to struggling banks through the discount window, offering risky loans at lower interest rates to support the financial sector during economic downturns.
- Expectations management, or forward guidance, is a key part of the Fed's strategy, as clear and confident communication can reassure market participants and help stabilize the economy during challenging times, while keeping inflation at bay.
