Monetary Policy: Mechanics, Tradeoffs, and Global Impact

Monetary Policy

Chapter Objectives

Describe the mechanics of monetary policy.
Explain the tradeoffs involved in monetary policy.
Describe how financial market participants respond to the Fed’s policies.
Explain how monetary policy is affected by the global environment.

Mechanics of Monetary Policy

Monitoring Indicators of Economic Growth

The Federal Reserve (Fed) consistently monitors various indicators to gauge economic growth:

Gross Domestic Product (GDP): Measures the total value of goods and services produced within a specific period.
National Income: Represents the total income earned by firms and individual employees over a specific period.
Unemployment Rate: The Fed aims to maintain a low unemployment rate in the U.S.
Other Indexes: Includes the Industrial Production Index, Retail Sales Index, and Home Sales Index.

There is generally an inverse relationship between unemployment and inflation.

Index of Leading Economic Indicators

Leading Economic Indicators: These indicators are designed to predict future economic activity, changing before the economy as a whole does.
Coincident Economic Indicators: These indicators tend to reach their peaks and troughs at the same time as business cycles, reflecting the current state of the economy.
Lagging Economic Indicators: These indicators typically rise or fall a few months after business-cycle expansions and contractions, confirming past economic trends.

Monitoring Indicators of Inflation

Inflation is primarily monitored through price indexes and other related factors:

Producer Price Index (PPI): Represents prices at the wholesale level.
Consumer Price Index (CPI): Represents prices paid by consumers at the retail level.
Other Inflation Indicators:
- Wage Rates: Periodically reported in various regions, indicating potential cost-push inflation.
- Oil Prices: Can signal future inflation due to their impact on production, transportation costs, and consumer gasoline prices.
- Price of Gold: Often moves in tandem with inflation, making it a closely monitored indicator.
Demand-Pull Inflation: Occurs when excessive aggregate spending in the economy causes prices to rise.

Implementing Monetary Policy

Once the Federal Open Market Committee (FOMC) assesses economic conditions, it formulates monetary policy to address economic concerns, primarily by changing the money supply to influence interest rates.

Effects of a Stimulative Monetary Policy

Supply Curve of Loanable Funds: A stimulative monetary policy involves the Fed increasing the supply of funds in the banking system. This shifts the supply curve of loanable funds to the right, increasing the quantity of funds available at any given interest rate.
Impact on Interest Rates: With an increased supply of loanable funds, the quantity of loanable funds supplied exceeds the quantity demanded at the initial interest rate. This surplus of funds puts downward pressure on interest rates, causing them to decline to a new equilibrium.
Logic Behind Impact on Interest Rates: Depository institutions experience an increase in their available funds. Consequently, they borrow less from the Fed or other banks and are able to provide more short-term loans at lower interest rates, reducing their cost of funds.
Effects on Business Cost of Debt: As interest rates (the cost of debt) decrease, firms find it cheaper to borrow money. This encourages them to implement more projects, increasing investment and aggregate spending. This spending generates more income for individuals and other firms, which can further fuel investment.
Effects on Business Cost of Equity: The firm's cost of equity is positively related to the risk-free rate. A lower risk-free rate, which results from a stimulative monetary policy, leads to a lower cost of equity for firms.
Summary of Effects:
- The Treasury (risk-free) rate is influenced, impacting both the cost of debt and cost of equity.
- The overall cost of capital for businesses is reduced.
- This reduction in capital costs encourages firms to spend more on new projects, expand operations, and hire more employees, thereby stimulating economic growth.

Fed’s Policy Focuses on Long-term Maturities: “Operation Twist” Strategy

From 2011 to 2012, the Fed implemented an “operation twist” strategy.
Mechanics: The Fed sold its holdings of short-term Treasury securities and used the proceeds to purchase long-term Treasury securities.
Theory: This action was intended to increase short-term interest rates while simultaneously decreasing long-term interest rates.
Expected Result: By reducing long-term Treasury yields, the Fed aimed to encourage businesses to borrow funds for long-term projects, thereby stimulating the economy and creating jobs.

Why a Stimulative Monetary Policy Might Fail

Limited Credit Provided by Banks: Even if the Fed increases the money supply and bank reserves, commercial banks might be unwilling to extend credit due to perceived risks or stricter lending standards, thus hindering the transmission of monetary policy.
Low Return on Savings: Very low interest rates can reduce the income individuals earn from savings. This lower interest income might lead to reduced spending rather than increased consumption.
Adverse Effects on Inflation: An aggressive increase in the money supply, intended to stimulate the economy, could lead to an increase in inflationary expectations. If individuals and businesses anticipate higher inflation, they may adjust their behavior (e.g., demand higher wages or raise prices), potentially negating the stimulative effects and resulting in actual inflation without significant economic growth.

Effects of Restrictive Monetary Policy

Primary Impact: A restrictive monetary policy involves the Fed decreasing the money supply. This causes an increase in the risk-free interest rate.
Corporate Cost of Financing: The higher risk-free rate increases the corporate cost of financing (both debt and equity).
Business Investment: With higher financing costs, businesses become less willing to undertake new investment projects, leading to a decrease in the level of business investment.
Economic Growth and Inflation: As economic growth is slowed down dueer t reduced investment and spending, inflationary pressure in the economy may be reduced.

Lagged Effects of Monetary Policy

Monetary policy effects are not instantaneous and are subject to three main lags:

Recognition Lag: The time delay between when an economic problem actually arises and when policymakers (the Fed) officially recognize its existence.
Implementation Lag: The time delay from when a serious economic problem is recognized until the Fed designs and implements a policy to resolve that problem.
Impact Lag: The time delay from when a monetary policy is implemented until it has its full, measurable impact on the economy.

Tradeoff in Monetary Policy

Ideally, the Fed aims to achieve a very low level of unemployment and a very low level of inflation concurrently. However, a fundamental tradeoff often exists.

Inverse Relationship between Inflation and Unemployment

Historically, there has been an inverse relationship (sometimes referred to as the Phillips Curve concept) between inflation and unemployment.
- Strong Economic Conditions: Often characterized by high inflation and low unemployment.
- Weak Economic Conditions: Typically associated with low inflation and high unemployment.

Impact of Other Forces on the Tradeoff

Historical data indicates that when one of these problems (inflation or unemployment) worsens, the other does not automatically improve. Various other economic forces can influence this dynamic, making a simple inverse relationship not always absolute.

Shifts in Monetary Policy over Time

The Fed's policy focus has shifted historically in response to prevailing economic conditions:

2001-2003: Policy focused on improving a weak economy (stimulative).
2004-2007: Policy shifted to reducing inflation (restrictive).
2008-2013: Policy again focused on improving a weak economy, notably during and after the financial crisis (highly stimulative).

How Monetary Policy Responds to Fiscal Policy

The Fed's monetary policy decisions are frequently influenced by the administration’s fiscal policies (government spending and taxation).
Fiscal Pressures: If large budget deficits arise from fiscal policy, they can put upward pressure on interest rates by increasing the demand for loanable funds.
Fed's Reaction: In such scenarios, the Fed might feel pressured to implement a stimulative monetary policy to counteract the upward pressure on interest rates and prevent them from rising too sharply.
Interaction: While fiscal policy primarily shifts the demand for loanable funds, monetary policy has a larger, more direct impact on the supply of loanable funds.

Proposals to Focus on Inflation: Inflation Targeting

Some economists and policymakers advocate for the Fed to explicitly target a specific inflation rate.

Advantages of Inflation Targeting:
- No Trade-off Dilemma: The Fed would no longer face the perceived trade-off between controlling inflation and controlling unemployment, as its primary mandate would be clear.
- Independence from Fiscal Policy: The Fed would not have to consider or respond to fiscal policy actions, allowing it to maintain greater independence.
- Transparency and Certainty: The Fed’s role would become more transparent and easier to understand for the public and markets, potentially leading to less uncertainty in financial markets.
Disadvantages of Inflation Targeting:
- Loss of Credibility: The Fed could lose credibility if the U.S. inflation rate consistently deviated substantially from its stated target, undermining public trust.
- Higher Unemployment Risk: A strict focus on inflation control might lead to policies that result in a much higher level of unemployment during periods when economic stimulus might otherwise be warranted.

Monitoring the Impact of Monetary Policy

Impact on Financial Markets

Monetary policy changes, particularly those affecting interest rates, have significant impacts on financial markets.

Bond Values: Bond prices are inversely related to interest rates. When interest rates rise, existing bond prices fall, and vice-versa.
Stock Values: Stock values are indirectly affected by interest rate movements. Lower interest rates generally reduce the cost of capital for firms, boosting their profitability and increasing the present value of future earnings, which can support higher stock prices.
Fed’s Communication: After each FOMC meeting, the Fed announces its conclusions through an official FOMC statement, providing guidance to financial markets.
Impact of the Fed’s Response to Oil Shocks: Any event that disrupts global oil production (e.g., geopolitical conflicts) can trigger concerns about inflation due to rising energy costs. While the Fed cannot control oil prices, it can influence overall inflation by slowing economic growth through restrictive monetary policy if necessary.

Impact on Financial Institutions

Financial institutions are particularly sensitive to changes in monetary policy.

Interest Rate Sensitivity: When interest rates rise, the cost of funds for financial institutions often rises faster than the return they receive on their assets, potentially compressing their profit margins.
Portfolio Effects: Financial institutions, including commercial banks, bond mutual funds, insurance companies, and pension funds, hold large portfolios of bonds. These portfolios are adversely affected (experience value depreciation) when the Fed raises interest rates.
Indirect Stock Effects: Stock mutual funds, insurance companies, and pension funds also maintain large portfolios of stocks. While not directly impacted by interest rates like bonds, their stock portfolios are indirectly affected by changes in interest rates through their impact on corporate profitability and economic growth.

Global Monetary Policy

Monetary policy decisions in the U.S. are increasingly influenced by and have an impact on the global economic environment.

Impact of the Dollar

Weak U.S. Economic Conditions, Weak Dollar: A weaker U.S. dollar can stimulate the U.S. economy by making U.S. exports cheaper for foreign buyers and making imports more expensive for U.S. consumers. This encourages domestic consumption and production.
Weak U.S. Economic Conditions, Strong Dollar: A strong dollar makes U.S. exports more expensive and imports cheaper. This does not provide the necessary stimulus for a weak U.S. economy. In such cases, the Fed may need to implement a stimulative monetary policy to counteract the contractionary effects of a strong dollar.

Impact of Global Economic Conditions

Given the high degree of economic integration across countries, the Fed must consider prevailing global economic conditions when formulating domestic monetary policy.
Example (2008 Credit Crisis): The Fed’s decision to significantly lower U.S. interest rates and implement stimulative policies during the 2008 credit crisis was partly driven by the widespread weakness in global economic conditions, aiming to prevent a deeper global downturn.

Transmission of Interest Rates

Global Interest Rate Variation: Interest rates naturally vary between countries due to differences in economic conditions, monetary policies, and risk premiums.
Investor Flows: Countries offering higher interest rates tend to attract investors from countries with lower rates, leading to capital flows.
Fed's Response to Capital Outflows: If U.S. rates are falling, potentially causing investors to move funds to countries with higher returns, the Fed may feel compelled to act to prevent U.S. rates from falling too low, which could destabilize financial markets.
Global Crowding Out: Due to the international integration of money and capital markets, a government’s large budget deficit (which increases the demand for loanable funds) in one country can affect interest rates in various other countries, a phenomenon referred to as global crowding out.

Impact of the Crisis in Greece on European Monetary Policy

In the spring of 2010, Greece faced a severe economic crisis characterized by a weak economy and a large budget deficit.
Creditor Concerns: Creditors became increasingly unwilling to lend funds to the Greek government due to fears of default.
ECB's Response: The European Central Bank (ECB) was compelled to adopt a more stimulative monetary policy than it might have otherwise preferred. This was done to ease concerns about the Greek crisis, provide liquidity, and stabilize the eurozone, even though it raised other concerns about potential inflation within the eurozone.