The Federal Reserve and MonetaryPolicy Making It Happen

The Federal Reserve and Monetary Policy: Making It Happen Every six weeks or so, the Federal Open Market Committee (FOMC) meets to determine U.S. monetary policy. The committee members discuss and vote on whether and/or how much interest rates in the economy should change. They issue their decision and “VOILA!” interest rates in the economy mysteriously change as directed. At least, that’s how it can seem to students studying introductory macroeconomics. However, understanding the mechanisms used to conduct monetary policy is crucial for understanding the banking and financial systems and the structure of the macroeconomy. The purpose of this article is to add the “how” to the “who, what, when, where and why” of monetary policy. The Who, What, When, Where and Why of Monetary Policy Most students come away from their first course in macroeconomics with a good understanding of the structure and functions of the Federal Reserve System, the goals of monetary policy and the causal relationship between the macroeconomic variables involved (e.g., money supply→interest rates→investment→aggregate demand→GDP). An outline of the answer to these basic questions is reviewed below. Who? The Federal Reserve System (commonly called the Fed) conducts U.S. monetary policy. More specifically, monetary policy is the role of the FOMC. The 12 voting members of the FOMC include the seven members of the Federal Reserve Board of Governors (BOG) and five of the 12 Federal Reserve Bank presidents (The New York Fed president always votes, the remaining 11 presidents rotate as voting members). All Federal Reserve Bank presidents participate in every FOMC meeting, but they only vote when it is their turn in the rotation. Members of the BOG are appointed by the president of the United States 3 and approved by the U.S. Senate to serve 14-year terms (the lengthy term is designed to insulate them from political pressure). Governors must each come from a different Federal Reserve district (there are 12), to spread representation across the country. A governor may serve the remainder of another governor’s term (e.g., if the other governor resigns) and then serve his or her own full 14-year term. The chairman of the Board of Governors is chosen from the seven governors to serve a four-year, renewable term. The chairman wields great power on the FOMC by serving as its spokesperson and setting its agenda. It is expected that, if a new chairman is chosen, the old chairman will resign as a governor, even if there are many years of his or her term remaining. Governors and Fed Bank presidents are often professional economists. What? Monetary policy refers to the FOMC’s management of the money supply and interest rates in the United States. In recent years, the FOMC has focused on setting interest rates (as opposed to their past focus on changes to the money supply). The Federal Reserve System manages the money supply in the economy to attain the desired level for interest rates, set by the FOMC. Lowering interest rates will increase investment and interest-sensitive consumption in the economy, leading to an expansion of GDP. Raising interest rates will decrease investment and interest-sensitive consumption, leading to a decrease in investment, a lower GDP and ultimately a slowing of economic growth (thereby limiting inflationary pressures in the economy). Introductory courses generally present the “three tools” the Fed may use to affect the money supply and interest rates: the reserve requirement, the discount rate and open market operations. However, open market operations are by far the most frequently used tool of the Fed. Reserve requirements are set by the Fed and require banks to keep a percentage of their deposits on hand at the bank or on deposit with the Federal Reserve District Bank in their region. Reserve requirements are generally used to serve the supervision and regulation function of the Fed. They are set to maintain safety and soundness in the banking system. The discount rate is the rate the Fed charges commercial banks for short-term loans. Discount rates are most often set above the federal funds rate (the rate banks charge each other for short-term loans). This ensures relatively little borrowing through the discount window, because commercial banks would rather borrow from one another at the lower federal funds rate. Open market operations refer to the Fed’s action of buying and selling government securities (e.g., Treasury bonds) on the open market. Government securities represent loans to the U.S. government and include Treasury bills, Treasury notes and Treasury bonds. Banks or individuals purchase securities (loan money to the government) and 4 are paid back the amount of the loan plus interest. Treasury bonds are issued in terms of 30 years and pay interest every six months until they mature. When a Treasury bond matures, the owner is paid the bond’s face value. The price and yield of a Treasury bond are determined at auction (e.g., in the open market). The price may be greater than, less than, or equal to the face value of the bond. Changes in the price paid reflect changes in interest rates in the economy. Treasury bonds are sold by the U.S. Treasury, banks, brokers and dealers. Owners may sell Treasury bills, notes or bonds before they mature. If the owner chooses to sell a Treasury bond through the U.S. Treasury, the request is sent to the Federal Reserve Bank of Chicago, which offers the security to different brokers, selling it to the highest bidder. The sale proceeds, minus a $45 fee, are deposited into the bank account designated by the seller. Bond owners may also sell their bonds through brokers. When the Fed buys bonds, bonds are taken out of the economy and money is injected into the economy as a result of the Fed’s paying bondholders for their bonds. When the Fed sells bonds, bonds enter the economy and money is removed from the economy as the buyer makes payment for the bonds. Through buying and selling bonds, the Fed can increase or decrease the money supply. When anything is scarce, its price goes up. Thus, when the money supply decreases, interest rates (the price of money) rise. As money becomes more available, its price falls — just as anything becomes cheaper as it becomes more available (ceteris paribus). When? The FOMC usually meets eight times a year (about every six weeks). Most meetings are scheduled well in advance, and the schedule is available on the website of the Board of Governors. The committee generally meets on a Tuesday between 9 a.m. and 2 p.m. Around 2:15 p.m. that day, there is a widely anticipated and closely watched public announcement about the outcome of the meeting. Individuals and businesses often make decisions based on the FOMC announcement, and there will frequently be an effect on the stock market when the FOMC issues its press release announcing a change, if any, and its “thinking” that was part of the discussion among members. The FOMC will take action and change interest rates when it believes there is potential for the economy to experience a problem with inflation or recession. When the FOMC believes that action is needed to prevent inflation, the committee will pursue contractionary monetary policy by raising interest rates. When the committee is concerned about the potential for recession in the economy, it will pursue expansionary policy by lowering interest rates. Where? The FOMC meets in Washington, D.C., at the Federal Reserve Bank there. Once the committee issues its decision, it is the Federal Reserve Bank of New York’s job to carry out the policy change. The New York Fed conducts open market operations (OMOs) to achieve and maintain the interest rate set by the FOMC. It is important to note that 5 open market operations are conducted continuously, not just in response to FOMC meetings every six weeks. At any time, market forces in the economy can push interest rates up or down. When the New York Fed conducts open market operations to offset the effects of other factors in the economy and keep interest rates where they were set by the FOMC, these actions are called “defensive OMOs.” “Dynamic OMOs” are undertaken to increase or decrease the money supply and change interest rates as directed by the FOMC. Monetary policy, whether through dynamic or defensive OMOs, has its effect on the economy through the banking and financial system throughout the economy. The banking and financial system is central to the “how” of monetary policy. Why? The goal of monetary policy is to manage money and interest rates to keep the economy healthy. According to the Fed, “Experience has shown us that the economy performs well when inflation is low. When inflation is low — and is expected to remain low — interest rates are usually low as well. Such an environment fosters low unemployment and allows the economy to achieve its growth potential.”2 The Fed conducts monetary policy in pursuit of the key macroeconomic goals: stable prices, low unemployment and economic growth. Contractionary policy is needed to control inflation in the economy, and expansionary policy can be used to increase employment and economic growth. Monetary Policy: Teaching the “How” Interest Rates: The Federal Funds Rate Instruction on modern monetary policy focuses on teaching that the Fed determines “interest rates.” However, there are many different interest rates throughout the economy (e.g., federal funds rate, discount rate, prime rate, mortgage rates, credit card rates). But all of these different interest rates tend to rise and fall together. This is sometimes discussed as the “web of interest rates” in the economy. The specific interest rate the FOMC targets is the federal funds rate (also known as the fed funds rate). This is the rate that commercial banks charge each other for overnight loans. For example, if one bank has more than necessary on deposit at the Fed and another bank needs to have more on deposit at the Fed (for example to maintain required reserves), the two banks can arrange an overnight loan. The bank borrowing the funds will pay the lending bank the fed funds rate of interest for the loan. If the fed funds rate changes, it means that the cost of borrowing changes for banks that borrow from another. The change in bank borrowing cost will eventually lead to a change in other interest rates in the economy. When banks have to pay higher rates to borrow funds, they will, in turn, charge higher rates for loans that they make to customers. 6 Another important interest rate, the discount rate, is the interest rate Federal Reserve Banks charge commercial banks for short-term loans. Since each Federal Reserve Bank controls the discount rate in its district (subject to approval by the BOG), students often mistakenly think that the interest rate targeted by the FOMC (i.e., the interest rate reported as being raised or lowered by the Fed) is the discount rate. While the discount rate can be used as a monetary policy tool, it generally is not used by the FOMC. The fed funds rate is generally below the discount rate, and therefore, banks prefer to borrow in the fed funds market. The discount rate is more often used by the Fed in serving its bank supervision and regulation function than in the conduct of monetary policy. In August 2007 the Fed took the very unusual step of lowering the discount rate in all districts to 5.75 percent from 6.25 percent. The move was made to narrow the gap between the discount rate and the fed funds rate (which was at 5.25 percent). The Fed lowered the discount rate in response to increased risk of a slowdown in economic growth and to address uncertainty in global markets. Along with the potential slowdown and uncertainty, there was a decrease in commercial banks’ willingness to lend. To increase banks’ willingness to lend, the Fed cut its discount rate to make loans to commercial banks from the Fed cheaper and provide liquidity to the financial system. This made credit easier for businesses and consumers to obtain, and helped reduce uncertainty and prevent an economic slowdown. This was a very unusual use of the discount rate as a monetary policy tool (it was also a move to maintain the safety and soundness of the banking system). After each meeting, the FOMC issues a directive to the New York Fed’s domestic trading desk, informing them of the FOMC’s objective for monetary policy (e.g., raising or lowering the fed funds rate and by how much). The fed funds rate is generally increased or decreased by 25 or 50 basis points. There are 100 basis points in a percentage, so 25 basis points is one-quarter percent and 50 basis points is one-half percent. The committee also releases a statement describing the reason for the decision and its assessment of economic conditions. The committee statement gives the public an idea of what the Fed anticipates as the direction for future monetary policy and the key factors it is watching to determine changes the FOMC may make in the future. How Interest Rate Changes Affect the Economy Changes in interest rates that result from the FOMC’s adjusting the federal funds rate affect the economy through the chain of events described in the following paragraphs. This shorthand is fairly common and can be very helpful to students learning the causal “chain of events” set in motion by monetary policy. It can help students learn the relationships between variables and help them organize concise explanations (i.e., save them time on the AP Exam, while providing clearer answers). 7 1) i%   I/C*  AD  GDP  PL 2) i%   I/C*  AD  GDP PL C* = interest-sensitive consumption3 When interest rates change, it affects the level of investment in the economy. Higher interest rates make investment purchases by businesses more expensive. Either businesses will have to pay higher interest rates to borrow money for investment projects or, if they have the funds for the investment project, the opportunity cost of spending for the project rather than loaning the money to someone else, will be higher. Therefore, higher interest rates decrease the level of investment, as fewer investment projects have a rate of return that is greater than the increased cost of the investment. This is called contractionary policy. Investment is a component of aggregate demand, so if investment decreases, aggregate demand will decrease. As shown in the graph below, the decrease in aggregate demand will put downward pressure on prices in the event the economy is experiencing inflationary pressures. This chain of events also works in the opposite direction, when expansionary policy (decreased interest rates leading to increased aggregate demand) is used to combat recessionary pressures. This explanation of how interest rate changes translate to effects on the macroeconomy does not help students understand how the Fed controls interest rates. Exactly what happens that leads to the decrease in interest rates? Students frequently know that buying bonds increases the money supply and therefore decreases the interest rate (while selling bonds decreases the money supply and increases interest rates), as shown in the following graphs. 8 Image 1 Image 2 Differences Between the Money Market and the Loanable Funds Market $S $S2 InterestRate Rate Interest Real = Nominal Real=Nominal i% i%2 $D $Q $Q2 $Q Money Market Money Market Slf Interest Rate Real S2lf r r2 Dlf Qlf Q2lf $Qlf Loanable Funds Market That there are two different (but related) graphs can be confusing for students. The money market graph comes from the liquidity preference model of interest rates, and illustrates how actions by the Fed (and other central banks) lead to changes in interest rates in the economy in the short run. The loanable funds market is a hypothetical market that illustrates how the demand for loanable funds (generated by those who want to borrow funds) and the 9 supply of loanable funds (provided by lenders through saving) interact to determine the equilibrium price of loanable funds — the interest rate. In the short run, a change in the supply of money will lead to a change in the supply of loanable funds, and the equilibrium interest rate in the two markets is the same. Notice that, because it refers to the short run, the real and nominal interest rates in the money market are the same. However, in the long run, aggregate output will be equal to potential output. A change in the money supply and interest rates will not affect output or saving in the long run. In the long run, it is the market for loanable funds that determines the equilibrium real interest rate. However, even if students master the difference and relationship between the money market and loanable funds market, they often still don’t have an understanding of what goes on in the banking and financial system that sets all these effects in motion. How the Fed Achieves the Targeted Fed Funds Rate The Fed controls interest rates through commercial bank reserves. This is why students need to understand the role of the banking system to fully understand the conduct of monetary policy. Bank reserves are currency held by banks either in their vault (this is sometimes called vault cash) or deposited in an account with one of the 12 Federal Reserve Banks. Reserves are divided into two types: required reserves (a percent of commercial bank deposits that the Fed requires banks to keep on hand or in reserve) and excess reserves (any reserves held by banks above the required amount). The Fed affects bank reserves through open market operations. Open market operations involve the Fed policy action of buying and selling U.S. government securities (e.g., Treasury bonds). This action is called “open market” operations because the Fed does not decide on its own which securities dealers to deal with. Various securities dealers compete in the open market to buy/sell securities based on the price. When prices are high, dealers buy fewer bonds; when prices are low, they buy more bonds. When the Fed purchases bonds, it takes bonds out of the economy as bondholders submit their bonds for sale. The Fed pays for them with a check. This action puts more money into the economy. When the Fed sells bonds, it puts more bonds into the hands of banks and individuals and takes money out of the economy as payment. By changing the amount of money in the economy, the Fed changes the supply of funds available for loans. When there is plenty of money available for loans, the price of loans (the interest rate) will be low. When there are few funds available for loans, borrowers will compete for the limited funds, driving up the price. $s  Slf  i% $s  Slf  i% 10 How the Effect of a Policy Change Multiplies For any initial change in bank reserves, the money supply will change by some multiple of that amount. In introductory economics courses, students are first introduced to the simple money multiplier, equal to 1 over required reserve ratio. Using the simple money multiplier: ∆ in checkable deposits = 1/r * ∆ in excess reserves An injection of new deposits into the banking system will have a “multiplier” effect on bank deposits. When a bank receives a new deposit, it must keep a certain percentage of the new deposit either as vault cash or on deposit with the Fed (these are the required reserves dictated by the Fed). The remainder of the deposit becomes excess reserves and may be loaned out by the bank. Because banks are profit-maximizing firms that earn profits from making loans, they will generally loan out as much of their excess reserves as possible. Thus, the excess reserves from the new deposit become loans. When the loan check is deposited into the borrower’s account (either at the same bank or another bank) the loan amount becomes another new deposit. Because the required reserves are held at each stage, the amount becomes smaller as it multiplies through the banking system. The bank must hold the required amount of reserves from the new deposit, and the remainder become excess reserves that can be loaned out. This process continues until there are no further new deposits/loans to be made. However, the size of the effect of an open market purchase of bonds on the economy depends on whether or not the funds from the Fed’s purchase end up in the banking system. There are two important ways in which the amount of the bond purchase could “leak out” of the multiplier process. If the proceeds of the purchase are held by the seller as cash (rather than deposited in a bank account), the injection of money into the economy will not multiply. This is sometimes called “currency drain.” The payment also will not multiply if the bank into which the proceeds of a bond purchase are deposited holds the payment as excess reserves (rather than loaning it out). This may be the case if banks cannot locate “creditworthy” borrowers. The actual money multiplier will be smaller if the open market purchase is held as currency or excess reserves and is not allowed to “multiply” through the banking system. The actual money multiplier is 1/(r + e + c) Where: r = the percentage of deposits banks are required to hold e = the percentage of deposits banks hold as excess reserves c = the percentage of deposits borrowers hold as cash Depositors’ decisions about holding currency, banks’ decisions about holding excess 11 reserves, and the Fed’s decision about the reserve requirement all impact the size of the multiplier effect on changes in open market operations. As can be seen using the actual money multiplier, the ultimate effect of the Fed’s open market purchase (or sale) of bonds is different depending on whether the purchase (or sale) is from a bank or from the nonbank public. If the Fed purchases $1,000 of bonds from a bank, the securities held by the bank decrease by $1,000 and the Fed pays the bank with a $1,000 check. The check represents a $1,000 increase in the bank’s excess reserves (the entire amount is excess reserves, because the check does not represent a deposit into an individual’s bank account — so no required reserves must be held). The bank has merely changed from holding a bond to holding excess reserves. The bank may then loan out the excess reserves. The change in excess reserves that can be multiplied is $1,000. The maximum increase in the money supply is $1,000 times the multiplier (1/r). If, however, the Fed purchases bonds from the nonbank public, the result is different. The securities held by the nonbank public will decrease by $1,000 and the Fed pays the nonbank public with a $1,000 check. The person receiving the check MAY deposit the $1,000 in a bank account but may also cash the check and hold currency. If the person holds the $1,000 as currency, reserves are unchanged. But if the person deposits the $1,000 in a bank account, reserves increase by $1,000, but the reserves are NOT all excess reserves. The bank accepting the deposit must hold the required percentage of the deposit as required reserves. Therefore, the maximum increase in the money supply is [$1,000 – ($1,000 x r)] * 1/r For example, if the reserve requirement is 10 percent, the bank must hold $100 as required reserves and only has an additional $900 to loan. Thus the multiplier process starts with $900 rather than the full $1,000 (as when the Fed purchased the bonds directly from the bank). 12