Debt, Deregulation and Financial Crises
Chapter 21: How eroding monetary tools facilitated debt creation
With the explicit introduction of capital requirements in 1983, the Federal Reserve shifted away from traditional monetary and regulatory tools such as reserve requirements and gave market forces a greater role in determining the supply and demand for credit. Slipping into a passive role, it ignored the link between mounting liquidity, credit growth, and inflated asset prices. As it came to rely primarily on changes in interest rates to dampen demand, it failed to address the pro-cyclical effects of interest rate changes that resulted in outcomes that were the opposite of those intended. In 2005, when long-term interest rates fell lower than they had been before it started raising the short-term policy rate, the Fed expressed surprise. For some, however, it was clear that monetary policy could no longer perform its countercyclical function; that attempts to do so tended to exacerbate instability.
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