Since the 1970s, the Federal Reserve has relied on manipulating expectations of short-term interest rates through cuts in its overnight policy rate in response to economic and manufacturing slowdowns. Reducing interest rates is thought to facilitate investment, which is necessary for economic growth and full employment.
Traditionally, the Fed has cut interest rates during downturns…
These cuts are meant to spur growth…
A cut in the Fed Funds rate has an effect on the entire yield curve by changing the market’s expectations for the path of short-term rates and the risk built into holding long-term securities.
The cuts affect the entire yield curve for Treasuries…
… by changing expectations among investors…
Because recoveries from financial crises have historically been long and arduous, the Fed turned to unconventional policies to drive long-term interest rates lower. The Fed began purchasing long-term bonds, a program known as quantitative easing, adding them to its balance sheet and in the process, reducing the supply of bonds. The effect was to drive up price of bonds and lower market yields.
Investors and policymakers should expect the Fed to reduce rates and possibly resume its quantitative easing program if the coronavirus has a sustained impact on domestic and global production and economic growth.
But with the financial crisis, the Fed needed new tools…
…so it bought bonds in an effort to lower yields and spur borrowing
