Monetary Policy and the Federal Reserve

The Federal Reserve

  • The Federal Reserve System
  • The Federal Open Market Committee (FOMC)
  • Meetings occur every six weeks in D.C.
  • The Fed's actions impact events worldwide.

The Fed's Dual Mandate

  • Created by Congress to:
    • Promote maximum employment.
    • Maintain stable prices.
    • Moderate long-term interest rates.
  • Interpretation: Maximize employment while keeping inflation low and stable.
  • Challenge: The Fed cannot directly control inflation or employment.
  • Monetary policy: uses interest rates to influence the economy

Key Definition

  • The Federal Reserve is the central bank of the United States.
    • Controls monetary policy.
  • Monetary policy: the process of setting interest rates to influence economic conditions.
  • Chain of events:
    • The Fed uses monetary policy to encourage people and businesses to spend more or less.
    • This affects output, which in turn affects employment and inflation.
  • Example: Fed raises interest rates
    • Induces people to spend less today.
    • Reduces output.
    • Reduces inflationary pressure.
  • Example: Fed lowers interest rates
    • Induces people to spend more today.
    • Increases output.
    • Leads to higher employment
  • Dual mandate achieved when output is equal to potential output!

The Federal Reserve System

  • Comprised of:
    • The Board of Governors in Washington, D.C.
    • 12 Federal Reserve district banks across the country.
  • Regionally Diverse:
    • The 12 district banks are designed to avoid concentrating too much control in one part of the country.
  • Independent:
    • The Federal Reserve Board of Governors is an independent government agency.
    • Acts as a check for fiscal policy.
  • Government oversight:
    • Board governors are selected by the president and confirmed by the U.S. Senate.
    • The Fed is audited by the GAO.
    • The Fed chair testifies before Congress at least twice per year.

The Federal Open Market Committee

  • The Fed governors and the district Fed presidents form the Federal Open Market Committee (FOMC).
    • Goal: decide on U.S. interest rates.
  • All FOMC members participate in the discussion, but only some vote on policy.
    • Voting members: the Fed governors, New York Fed bank president, and a rotating group of four district Fed presidents.
  • Let’s step into the meeting and look at…
    • How the meeting works.
    • What they talk about:
      1. Forecasts for the U.S. economy
      2. Policy choices given the economic outlook
      3. How to communicate their plans to the public

How the FOMC Meeting Works

  • All FOMC members attend the meeting.
  • The Fed chair decides who’s going to speak and in what order.
    • Alan Greenspan’s meeting approach versus Ben Bernanke, Janet Yellen, and Jerome Powell’s approach.
  • Research shows greater gender and racial diversity in meetings can improve decision making.
    • Slowly made progress in bringing greater diversity to the FOMC

What They Talk About at the FOMC Meeting

  • Question 1: What are your forecasts for the U.S. economy?
    • Everyone shares their views on current economic conditions, and their short- and medium-term forecasts for the economy.
    • Track literally thousands of variables to aid in their analysis.
  • Question 2: What are the right policy choices given the economic outlook?
    • Raise or lower the real interest rate? By how much? Over what time period?
    • At the end the Fed chair typically recommends a course of action, and the FOMC votes on it.
  • Question 3: How should the Fed communicate effectively to the public?

Communicating with the Public (Fedspeak vs. Transparency)

  • Story time! A former Fed chair’s offhand comment to a CNBC anchor.
  • Fedspeak: a communication style that relied on intentionally vague and bureaucratic language.
    • The logic: Vagueness reduces market reactions to Fed comments because no one was sure what was really said.
    • Alan Greenspan: “If I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.”
  • New communication goal: transparency
    • Clearly communicate its analysis, decisions, and objectives.
    • Crucial for accountability!
    • Convince people the Fed will follow through and achieve its goals.
    • Shape expectations
    • Janet Yellen: “We’ve made a commitment… that we would do our best to communicate as clearly as we could.”

Key Take-Aways: The Federal Reserve

  • The Federal Reserve (the Fed): the U.S. central bank.
    • Determines the country’s monetary policy.
    • Monetary policy: the process of setting interest rates in an effort to influence economic conditions.

The Fed’s Dual Mandate

  • Fed’s two goals:
    1. Stable prices
    2. Maximum sustainable employment
  • Fed’s goal as of 2021:
    • Aim to achieve 2% inflation on average.
    • Achieved when inflation is near or at the Fed’s inflation target (2%).
    • Want the inflation rate to be low and predictable enough such that it doesn’t play much of a role in people’s decisions.
  • The Fed is trying to set in motion a virtuous cycle:
    • If people believe inflation will be low and stable
    • Price increases will be small
    • Inflation remains low and stable

Why is the Fed Targeting Inflation Instead of Employment?

  1. Because inflation is easily targeted by monetary policy.
  2. Because hitting the inflation target also promotes maximum sustainable employment!
    • Inflation and unemployment are interdependent.
  • High unemployment means the economy is operating with excess capacity…
    • Leads inflation rate to decline below Fed’s target.
  • Low unemployment means the economy will hit its capacity constraint…
    • Leads inflation rate to rise above Fed’s target.

Why Not Target Zero Inflation?

Four reasons why the Fed doesn’t target zero inflation:

  1. Inflation greases the wheels of the labor market.
  2. The Fed can lower real interest rates by more when inflation is above zero.
  3. A 0% inflation target runs the risk of deflation.
  4. Measured inflation may be overstated.
  • Reason 1: greasing the wheels
    • Employers often find it difficult to cut nominal wages.
      • But with 2% inflation, they can quietly cut real wages by simply not giving that employee a raise.
    • Potential result of zero inflation:
      • Lay off more workers than otherwise would.
      • Higher unemployment during a recession.
  • Reason 2: greater ability to lower rates
    • Zero lower bound: The Fed can’t set nominal interest rates below zero.
      • Savers would never pay to keep their money in the bank!
    • If inflation were 0%, then the Fed would be unable to stimulate a recovery from a recession by lowering real interest rates.
  • Reason 3: risk of deflation
    • Vicious cycle of deflation starts if people expect future prices to fall further and further.
  • Reason 4: overstated measure
    • Many economists believe the measured inflation rate overstates the actual inflation rate.
      • Fails to account for quality improvements and new products that reduce the true cost of living.
    • Thus, a measured inflation rate of zero would actually mean deflation!

Four Factors That Shape Fed Policy

  1. The neutral real interest rate
    • When the economy is in neutral.
    • Not operating above nor below its potential.
  2. The nominal interest rate
    • The Fed controls a nominal interest rate called the federal funds rate, which the Fed uses to influence the real interest rate.
    • nominal[interest[rate = real[interest[rate + inflation
  3. The difference between actual inflation and target inflation
    • Use the gap between inflation and the target inflation rate to assess how to change the real interest rate.
  4. The output gap
    • Use the gap between actual and potential output to assess whether the Fed should take steps to cool or stimulate the economy.

Inflation vs. Inflation Target

  • If inflation is higher than the target…
    • Fed set real interest rates higher than the neutral interest rate
    • Encourages people to spend less
    • Reduces excess demand and inflationary pressure.
  • If inflation is lower than the target…
    • Fed set real interest rates lower than the neutral interest rate
    • Encourages people to spend more
    • Boosts demand and inflation.

Actual vs. Potential Output

  • If actual output exceeds potential…
    • Fed set real interest rates higher than the neutral interest rate
    • Encourages people to spend less
    • Cools the economy
  • If actual output is lower than potential…
    • Fed set real interest rates lower than the neutral interest rate
    • Encourages people to spend more
    • Stimulates the economy.

Putting All Four Factors Together: The Fed Rule-of-Thumb

  • Formula for the Fed rule-of-thumb:
    • Federal[funds[rate − Inflation = Neutral[real[interest[rate + \frac{1}{2} × (Inflation − 2\%) + Output[gap
  • General framework the Fed uses for setting the real interest rate:
    • Real[interest[rate = Neutral[interest[rate + Adjust[for[deviations[from[inflation[and[output[targets

Key Take-Aways: The Fed's Policy Goals and Decision-Making Framework

  • Federal funds rate: The interest rate that the Fed uses as its policy tool, which is the nominal interest rate that banks pay to borrow from each other overnight in the federal funds market.
  • A Fed rule-of-thumb approximates what it does:
    • Federal[funds[rate - Inflation = Neutral[real[interest[rate + \frac{1}{2} * (Inflation - 2\%) + Output[gap

The Overnight Market for Interbank Loans

  • Monetary policy: the process of setting interest rates in an effort to influence economic conditions.
  • Federal funds rate: the nominal interest rate the Fed uses as its policy tool.
    • The nominal interest rate that banks pay to borrow from each other overnight in the federal funds market.
    • The Fed influences the federal funds rate by taking actions that shift the supply or demand for loans in this market.

Banks Face a Trade-Off

  • Banks make money by lending out the funds you deposit and charging interest on those loans…
    • But banks need to have enough cash on hand so depositors like you can use their funds to make payments.
    • Reserves: the cash that banks need to keep on hand to make payments.

Why Do Banks Borrow Money From Each Other Overnight?

  • Demand for funds: Sometimes banks don’t have enough ready cash to make payments on a given day.
  • Supply for funds: Other banks may have more cash on hand than they need.
  • The price: The forces of supply and demand determine the interest rate changed on these overnight loans.
    • i.e., the federal funds rate

Tools the Fed Uses to Influence the Federal Funds Rate

  1. Pays interest to banks on their reserves.
  2. Borrows money overnight from financial institutions.
  3. Lends directly through the discount window.
  4. Buys and sells government bonds.

Tool 1: The Fed Pays Interest on Reserves

  • Creates a minimum interest rate that banks will charge before loaning funds overnight.
    • Serves as a floor!
  • A bank with extra cash has two options:
    1. Leave it in the reserve.
      • Earn the rate the Fed is paying.
    2. Lend it out.
      • Earn the federal funds rate.
  • Result: only lend out the extra cash if the bank can get more than what the Fed’s paying.
  • Current approach à Tool 1: The Fed pays interest to banks on their reserves.
    • If the Fed wants to increase the federal funds rate:
      • The Fed raises the interest rate it pays on reserves.
      • Greater incentive for banks to hold reserves (less incentive to loan to other banks).
      • Supply of loanable funds shifts left, and the federal funds rate increases.
  • Old approach à The Fed simply told banks how much they had to hold in reserves.
    • Raised or lowered the reserve requirement to influence the federal funds rate.
    • Discontinued the reserve requirement in March 2020.

Tool 2: The Fed Borrows From Financial Institutions Overnight

  • How it works: When the Fed engages in overnight borrowing as a demander…
    • Increases demand for overnight loans.
    • Leads to higher interest rates.
  • The details: The Desk, a trading desk at the Federal Reserve Bank of New York, buys and sells government bonds to a bank or financial institution overnight with an agreement to buy it back the next day at a higher price.
    • Overnight reverse repurchase agreements

The Floor Framework

  • The floor framework is how the Fed effectively sets a lower bound (i.e., a floor) on how low the federal funds rate will go.
    • The Fed uses tools 1 and 2 to raise the opportunity cost of lending in the federal funds market.

Tool 3: Lending Through the Discount Window.

  • How it works: Banks offer collateral and get a loan from the Fed that helps them meet their reserve requirement.
    • Like a pawn shop for banks.
    • It’s a backup source for banks that need to borrow cash.
  • The discount rate: The interest rate that the Fed offers through the discount window.
    • Typically set higher than the federal funds rate.
    • Acts as an upper bound for the federal funds rate.

Tool 4: Open Market Operations Through Buying and Selling Bonds.

  • How it works: When the Fed sells bonds…
    • Increases demand for overnight loans and decreases supply.
    • Federal funds rate is pushed up.
  • The details: When the Fed sells a bond to a bank, the money is taken from the bank’s reserve.
    • Fewer reserves
    • Bank is now more likely to need to borrow reserves AND less likely to be able to supply them to other banks.

The Ripple Effect Throughout The Economy

  • The Fed’s adjustment of the federal funds rate eventually affect nearly every corner of the economy!
    • Other interest rates
      • Banks reset the rates they charge borrowers, and some rates move directly with the federal funds rate, like the rates on most credit cards.
    • Consumption today versus tomorrow
      • Your choices about saving or borrowing change because now the interest rates on your savings account and credit cards have changed.
      • Returns on saving for businesses also change!
    • Value of the U.S. dollar
      • When U.S. interest rates fall, investing in the U.S. becomes less attractive.
      • Imports fall and exports rise, thus increasing net exports.

Key Take-Aways: How the Fed Sets Interest Rates

Tools the Fed uses to influence the federal funds rate:

  1. Pays interest to banks on excess reserves
    • Sets a floor on the federal funds rate
  2. Borrows money overnight from financial institutions
    • Sets a floor on the federal funds rate
  3. Lends directly through the discount window
    • Sets a ceiling on the federal funds rate
  4. Buys and sells government bonds
    • What it used to do

Alternative Tools the Fed Can Use to Affect The Economy

  • Primary tool: The federal funds rate.
    • Limitation: zero lower bound!
  • Other tools: encourage additional spending by pushing longer-term rates interest rates down.
    • Forward guidance
    • Quantitative easing

Forward Guidance

  • Forward guidance: providing information about the future course of monetary policy in order to influence market expectations of future interest rates.
    • Use communication to shape expectations about the future path of interest rates.
    • A tool the Fed can use to encourage additional spending even if the federal funds rate is at zero.
  • Scenario: If the Fed promises that rates will stay low in the future…
    • Banks can lower the interest rates they charge for longer-term loans:
      • Home mortgages
      • Five-year car loans
      • Longer-term business loans
    • Leads more people to buy houses, cars and make business investments.
    • Result: Additional spending takes place!

Quantitative Easing

  • Quantitative easing: the Fed’s strategy of purchasing large quantities of longer-term government bonds and other securities in an effort to put downward pressure on long-term interest rates, including mortgages.
    • Aims to push interest rates below zero
    • Reduction in long-term interest rates helps the Fed convince banks that it’s committed to keeping rates low for a long period.
  • Scenario: When the Fed buys longer-term government bonds…
    • Reduces the amount of government debt available for savers like you to purchase.
    • Encourages savers to supply their saving to other long-tern borrowers (i.e., businesses and homeowners who need mortgages).
    • This increased supply of longer-term loans pushes down interest rates.

Lender of Last Resort

  • The Fed as the lender of last resort
    • The place financial institutions turn to when they need cash right away, but they’re having trouble getting a loan elsewhere.
  • Purpose: to prevent widespread bank runs, business failures, and general financial panic.
  • BUT… there are potential downsides:
    • The Fed can lose money when it acts as the lender of last resort.
    • The Fed’s willingness to be a lender of last resort can incentivize borrowers to take bigger risks.
    • After 2008, passed Dodd-Frank to hopefully make financial institutions a bit more cautious.

Key Take-Aways: Alternative Tools the Fed Uses to Meet Its Dual Mandate

Monetary policy choices when nominal interest rates are zero:

  • Forward guidance: Providing information about the future course of monetary policy in order to influence market expectations of future interest rates.
  • Quantitative easing (QE): Purchasing large amounts of longer-term government bonds and other securities in an effort to put downward pressure on longer-term interest rates.

Summary of key points

  1. The Federal reserve is the central bank of the U.S. and determines the country’s monetary policy.
  2. Dual mandate: stable prices and maximum sustainable employment.
  3. The Fed uses various tools to influence the federal funds rate.
  4. Forward guidance and QE can be used to further enact monetary policy.