Stabilising the Economy - The Role of the Fed

Fed Watch

• Analysts attempt to forecast Fed decisions about monetary policy

  • Greenspan briefcase indicator

  • Fed decisions have significant effects on financial markets and the macro economy

• Monetary policy is a major stabilization tool

  • Quickly decided and implemented

  • More flexible and responsive than fiscal policy

The Fed and Interest Rates

• Controlling the money supply is the primary task of the FOMC

  • Money supply and demand determine the interest rate

  • Fed manipulates supply to achieve its desired interest rate

• Portfolio allocation decisions allocate a person's wealth among alternative forms

  • Diversification is owning a variety of different assets to manage risk

• The demand for money is the amount of wealth held in the form of money

Demand for Money

Sometimes called an individual's liquidity preference

 Depends on:

• Nominal interest rate (i)

  • The higher the interest rate, the lower the quantity of money demanded

• Real income or output (Y)

  • The higher the level of income, the greater the quantity of money demanded

• The price level (P)

  • The higher the price level, the greater the quantity of money demanded

Money Demand Curve

• Interaction of the aggregate demand for money and the supply of money determines the nominal interest rate

• The money demand curve shows the relationship between the aggregate quantity of money demanded, M, and the nominal interest rate

  • An increase in the nominal interest rate increases the opportunity cost of holding money

    • Negative slope

• Changes in factors other than the nominal interest rate cause a shift in the money demand curve

• A change in demand for money can result from anything that affects the cost or benefit of holding money

  • An increase in output

  • Higher price levels

  • Technological advances

  • Financial advances

  • Foreign demand for dollars

Supply of Money

• The Fed primarily controls the supply of money with open-market operations

  • An open-market purchase of bonds by the Fed increases the money supply

  • An open-market sale of bonds by the Fed decreases the money supply

• Supply of money is vertical

• Equilibrium is at E

Equipment in the Money Market

• Bond prices are inversely related to the interest rate

• Suppose the interest rate is at i1, below equilibrium

  • Quantity of money demanded is M1, more than the money available

  • To get more money, people sell bonds

    • Bond prices go down, interest rates rise

  • Quantity of money demanded decreases from M1 to M

Fed Controls the Nominal Interest Rate

• Fed policy is stated in terms of target interest rates

  • The tool they use is the supply of money

• Initial equilibrium at E

• Fed increases the money supply to MS'

  • New equilibrium at F

  • Interest rated decrease to i' to convince the market to hold the new, larger amount of money

To Decrease the Money Supply

To Increase the Money Supply

The Fed Targets the Interest Rate

• The Fed cannot set the interest rate and the money supply independently

• Fed policy is announced in terms of interest rates because

  • Public is not familiar with the size of the money supply

  • Main effects of monetary policy on the economy work through interest rates

  • Interest rates are easier to monitor than the money supply

Role of the Federal Funds Rate (FFR)

• The rate commercial banks charge each other on short-term (usually overnight) loans

  • Banks borrow from each other if they have insufficient funds

  • Market determined rate – supply and demand

  • Targeted by the Fed

Decreasing the FFR

• The Fed conducts open market purchases

  • For example, when the Federal Reserve buys Treasury securities on the open market, it injects reserves into the banking system and lowers the FFR

  • Reserves increase; excess reserves can be loaned to other banks in the federal funds market

  • Banks holding excess reserves are incentivized to lend to other banks to avoid holding idle reserves, leading to a downward pressure on interest rates as they compete to offer lower rates

  • Interest rates tend to move together; consumer, mortgage, prime rates fall

Can the Fed Control the Real Interest Rate

• Fed controls the money supply to control the nominal interest rate, i

  • Investment and saving decisions are based on the real interest rate, r

    • Fed has some control over the real interest rate r = i - π

      • where π is the rate of inflation

• The Fed has good control over i

• Inflation changes relatively slowly

• Changes in nominal rates become changes in real rates

Open Market Operations

• The main tool of money supply

• Fed offers lending facility to banks, called discount window lending

  • If a bank needs reserves, it can borrow from the Fed at the discount rate

    • The discount rate is the rate the Fed charges banks to borrow reserves

    • Typically higher than the federal funds rate

    • Penalty rate that encourages bank to lend and borrow from one another instead

    • Commercial banks can only borrow from the discount window of they meet certain eligibility criteria and pay the penalty rate

• Lending increases reserves and ultimately increases the money supply

• Source of liquidity in times of distress or financial stability

• Changes in the discount rate signal tightening or loosening of the money supply

Money Supply

•  Determined by three things:

  • Money Supply = Public Currency + (Bank Reserves/Reserve-Deposit Ratio)

• The Fed can affect the money supply by affecting any of these three things:

  • Currency held by the public

  • Bank reserves

  • The desired reserve-deposit ratio

Reserve Requirements

• The Fed can also change the reserve requirement for banks

  • The minimum values of the ratio of bank deposits that must be held in reserves

  • It is rarely changed

• Bank reserves can also be affected by discount window

• lending

  • Banks short on reserves can borrow from the discount window

  • The discount rate on these loans is set by the fed

Quantitative Easing (QE)

• The Fed buys financial assets, lowering the yield or return of those assets while injecting liquidity.

  • Used to stimulate the economy by purchasing assets of longer maturity thereby raising their price and lowering longer-term interest rates

  • Lower long-term interest rates incentivize households and businesses to borrow and invest more, which stimulates economic activity and jo creation

  • Fed has purchased trillions worth of assets since 2008 and during Covid-19

• Forward Guidance: The Fed gives indications of its future policies so that markets will react

• Interest on Reserves: Even at an interest rate of zero, the Fed can offer interest on its reserves to give banks a reason to keep money at the Fed

Excess Reserves

•  Bank reserves in excess of the reserve requirements set by the central bank

• As a result, the money supply may not change even if the fed changes the supply of reserves

• Risk aversion and low interest rates made commercial banks hold onto their reserves instead of lending them

Zero Lower Bound

• A level, close to zero, below which the central bank can't further reduce short-term interest rates

• Can’t go far below zero – would you pay someone to lend them money?

• The fed has some tools it can use in this case (QE, Forward Guidance, Negative Rates on Excess Reserves)

• At the zero lower bound, agents are indifferent between holding money and bonds, thereby resulting in a liquidity trap

• People and businesses hold onto their money instead of spending or investing it, despite the low interest rates

• This results in a situation where even though there is ample liquidity in the market, the demand for it is low, and the economy remains stuck in a low-growth or no-growth phase

• Limits the effectiveness of traditional monetary policy tools, such as the federal funds rate or the discount rate, in stimulating the economy

Planned Spending and Real Interest Rate

• Planned aggregate expenditure has components that are affected by r

  • Saving decisions of households

    • More saving at higher real interest rates

    • Higher saving means less consumption

  • Investment by firms

    • Higher interest rates mean less investment

      • Investments are made if the cost of borrowing is less than the return on the investment

• Both consumption and planned investment decrease when the interest rate increases

The Fed Fights a Recession

How Effective is Monetary Policy? Money Supply to Interest Rates

Fed Fights Inflation

• Expansionary gap can lead to inflation

  • Planned spending is greater than normal output levels at the established prices

  • Short-run unplanned decreases in inventories

  • If gap persists, prices will increase

• The Fed attempts to close expansionary gaps

  • Raise interest rates

  • Decrease consumption and planned investment

  • Decrease planned aggregate expenditure

  • Decrease equilibrium output

The Stock Market and the Fed

• Fed gets credit for sustained economic growth and rising asset prices in the 1990s

  • S&P 500 increased 233% between January 1995, and March 2000

  • Stocks buoyed consumption; supported growth

• Possible stock speculation led to sharp decreases

  • If the Fed had acted sooner, the run-up would have been curtailed and the crash moderated

  • Greenspan's response is

    • Separating speculation from growth is difficult

    • The Fed could not have timed the stock market

The Stock Market and Monetary Policy

• The Fed has limited ability to manage the stock market

  • Fed does not know the "right" prices

    • Information available to the Fed is publicly available

  • Monetary policy is not well suited to addressing an asset bubble (a speculative increase in asset prices over their underlying market value)

    • Fed can raise interest rates and slow the economy

    • Could result in a recession and rising unemployment

• The debate over the Fed's role in asset prices got attention after the mortgage meltdown of 2007 – 2008

Monetary Policy Communication - Forward Guidance

• Clear communication from the central bank can help make monetary policy more effective by helping investors better understand policy goals and better anticipate future policy actions

• The Fed also begun providing guidance to investors and the public about how it expects to adjust the federal funds rate in the future, given current information about the economic outlook

• This forward guidance strategy helps the public better understand the Fed’s views and policy

The Effect of Crises on Central Bank Practice

• In the decades before the financial crisis, central banks often viewed financial stability policy as the junior partner to monetary policy

• The crisis underscored that maintaining financial stability is an equally critical responsibility

• Financial crises will always be with us. But as much as possible, central banks, governments and other regulators should try to anticipate and defuse threats to financial stability and mitigate the effects when a crisis occurs

• The Great Recession served as a primary lesson for Central Banks in how to respond to the Covid-19 economic fallout

• The unconventional tools used in both the Great Recession and Covid-19 helped to prevent the repeat of the 1930s Great Depression

• These should set the stage for a slow but continuing economic recovery

Policymaking - Art or Science

• Macroeconomic policy works best with

  • Accurate knowledge of current economic conditions

  • Knowledge of the future path of the economy without policy

  • Precise value of potential output

  • Good control of fiscal and monetary policies

  • Knowledge of how and when the economy will respond to policy changes

• Recent Great Recession and Covid-19 economic meltdown show that a financial and/or health crisis can cause major damage to the economic activity.

• Macroeconomic stabilization policy is required to limit the size and scope of the economic meltdown