The way that raising and lowering interest rates works is through the liquidity effect. The Fed buys treasuries with new money. That money gets deposited at the banks. And, since the banks have more reserves as a result, there is less demand for cash in the overnight bank borrowing market, and short term rates decline.
The broader effect of a cash injection should be to raise rates, because the new money should raise inflation. So, the liquidity effect is a temporary effect. Over longer periods of time, interest rates should rise and fall with inflation rates.
It is true that they were making emergency loans to banks, but they were purposely selling a dollar of Treasuries for each dollar of lending in order to prevent interest rates from declining. In April 2007, the Fed held $902 billion in assets supplying reserve funds. From April 2007 to August 2008, the total balance sheet of the Fed, including emergency loans and treasuries, grew by only about $2 billion per month.
In a falling rate environment, demand for cash should have been increasing, so, I think, if anything, it seems like the Fed would have needed to increase their holdings by more than usual in order to maintain a neutral stance. But, in any case, how can anyone describe this period as a period where the Fed was dropping rates through the liquidity effect?
Furthermore, if the liquidity effect had anything to do with rates at the time, why were 3 month treasury rates well below the Fed Funds rate? The Fed was injecting cash into the banking system through loans and it was selling hundreds of billions of dollars worth of short term treasuries. If they were lowering rates through the liquidity effect, wouldn't treasury rates have been higher while the Fed Funds rate declined?
In the same graph, moved forward a few years, it looks like there is a similar problem with the QEs. One of the Fed's stated goals with the QEs was to push down long term rates. Yet, with each round, what we see is rates falling in the period before the round of QE and then rising during the implementation.
One might argue that rates were anticipatory. But, the liquidity effect can't be anticipatory. The liquidity effect happens because of frictions in the market that allow real-time changes in supply to temporarily overwhelm other factors that determine price, including expectations. If markets can anticipate the liquidity effect, then they should anticipate all temporary movements.
It seems to me that the normal explanations for Fed policy during this period don't hold up. Am I missing something?