The Federal Reserve

Policy Tools, Policy Tools, Objectives and Objectives and

Targets.Targets.

ECO 473 – Money & Banking – Dr. D. Foster

Federal Reserve Policy Tools

• Open Market OperationsOpen Market Operations– Buy/sell Treasury bonds to affect bank reserves.– The major form of monetary policy.– What will the Fed do if we run out of Treasury bonds?

• Discount WindowDiscount Window– Lend to member banks to affect bank reserves.

– Purpose is to target the “federal funds rate” – iff• This is the rate that banks charge each other for very short term This is the rate that banks charge each other for very short term

loans.loans.

• Required Reserve Ratio (rrRequired Reserve Ratio (rrDD)) – Changing this affects bank excess reserves directly.– Used more to reflect structural changes.– Was used in 1937 and precipitates more Great Depression.– Time to let this go? New policy – Pay banks i for ER (!!)

Goals of Monetary Goals of Monetary PolicyPolicy

• Inflation goals:Inflation goals:– Low/no inflation with limited year-to-year variability.

• Output goals:Output goals:– High and stable economic (GDP) growth.

• Employment goals:Employment goals:– Stable employment growth with low unemployment.

Intermediate Targets of Monetary Intermediate Targets of Monetary PolicyPolicy

• The key rationalekey rationale for intermediate targeting:

– The limited long-term informationinformation about the economy available to policymakers.

Choosing an Intermediate Target Choosing an Intermediate Target VariableVariable

• CharacteristicsCharacteristics:– Frequently

observableobservable– ConsistencyConsistency with

ultimate goals– Definable and

measurablemeasurable– ControllableControllable

• Potential variablesPotential variables:– Monetary aggregates

M1, M2, MZM– Interest rates

(fed’l funds, prime …)

– Others:• Nominal GDP• Credit aggregates• Exchange rates

Is Policy the Right Is Policy the Right Choice?Choice?

Time lagslags make effective policy uncertain.

Discretionary policy promotes uncertainty.

RulesRules and crediblecredible adherence can eliminate bias.

IndependenceIndependence is a likely key requirement.

Time Lags in Monetary (& Fiscal) Time Lags in Monetary (& Fiscal) PolicyPolicy

• Policy time lags– Recognition lagRecognition lag– Response lagResponse lag– Transmission lagTransmission lag

time

Real GDP

Business cycle

Monetary Policy may be Monetary Policy may be counterproductivecounterproductive

time

%Real GDP

Or, if policy kicks in at the wrong time, it could worsen recessions and exacerbate inflationary periods.

Ideally, policy would dampen the business cycle…

But, dampening the business cycle may lower ave. growth!

Discretion versus Discretion versus RulesRules

(Milton Friedman)(Milton Friedman)• Discretionary policy is the sourcesource of instability.

• A policy rulerule can eliminate that instability.

– Set target for Bank ReservesBank Reserves, Monetary BaseMonetary Base, Money SupplyMoney Supply to grow in LR sustainable fashion.

– This is a commitment to a fixed strategy no no matter whatmatter what happens to other economic variables.

• To be successful, the commitment must be crediblecredible.

– The public believes the Fed will act this way.

Has the Fed maintained stable Has the Fed maintained stable prices?prices?

Has the Fed maintained the value of Has the Fed maintained the value of the $?the $?

4%

Making Monetary Policy Making Monetary Policy TransparentTransparent

FOMC - PRFOMC - PR

Sept. 17, 2015Sept. 17, 2015

Yellen’s Press Yellen’s Press ConferenceConference

Sept. 17, 2015Sept. 17, 2015

Making Monetary Making Monetary Policy Policy

Rules CredibleRules Credible• Place constitutional limitsconstitutional limits on

monetary policy.

• Achieve credibility by establishing a reputationreputation.

• Maintain central bank independenceindependence.

• Establish central banker contractscontracts.

• Appoint a “conservativeconservative” central banker.

Quantitative Easing = Quantitative Easing = Credible?Credible?

QE QE 11

QE 2QE 2 QE QE 33

Can the Fed undo the QEs?Can the Fed undo the QEs?

• Inflation is a monetary phenomenon.– Austrians: the only meaningful definition of inflation is w.r.t. the money

supply.

• What happens if the economy starts growing?– Banks will want to lend more, raising the MS and causing inflation.

– The Fed could try to stop it by raising interest on ER … to 3%? 5%? 10%?

– Inflationary expectations grow and become rooted in our economy, ala 1979.

– Fed starts to pull back by selling UST and MBS.

• Their prices plummet; so Fed can’t buy them all back!

– Interest rates will soar; investment will falter; a recession ensues.

– But, a recession accompanied by serious inflation, aka “stagflation.”

• Is it an “insurance policy” against massive sell-off?

The Federal Reserve

Policy Tools, Policy Tools, Objectives and Objectives and

Targets.Targets.

ECO 473 – Money & Banking – Dr. D. Foster