The Federal Reserve – Part 2 – Monetary Policy

In The Federal Reserve System, we looked at the history of the Fed and its primary responsibilities. Now, we look at Fed operations beginning with the Federal Open Market Committee.

 

The Federal Open Market Committee (FOMC)

The FOMC is the Fed Committee that develops US Monetary Policy. The committee is made up of all 12 Reserve Bank Presidents and the 7 members of the Board of Governors for a total of 19 people.

Only 12 members of the FOMC are allowed to vote at any meeting. The voting members are the 7 Governors, the President of the New York Fed, and 4 other Bank Presidents who rotate on a yearly basis. All members, whether voting or not, participate in the discussions on policy at each meeting.

The FOMC typically meets eight times per year, where they will discuss the outlook for the U.S. economy and monetary policy options. (The number of meeting per year can increase when a financial crisis occurs.) The meeting follows a standard format.

  1. The New York Fed goes first. A senior official will do a presentation on developments in the financial and foreign exchange markets. Then activities of the New York Fed’s Domestic and Foreign Trading Desk since the last meeting are presented.
  2. Each member of the Board of Governors (BOG) present his/her own economic and financial forecasts for consideration.
  3. All Bank Presidents will then present their views on the economic outlook.
  4. The BOG’s Director of Monetary Affairs will discuss monetary policy options and then the other members discuss their policy preferences.
  5. The 12 voting members vote on actions to be undertaken until the next meeting.

At the end of the meeting, a statement is issued which details the federal funds rate target, the reason for the decision and the vote tally. A Policy Directive is then sent to the New York Fed’s Domestic Trading Desk which will begin implementation of the directive using the various tools available to them.

 

Monetary Policy

Monetary Policy (MP) are the actions taken by the FOMC to meet its goals for the U.S. economy. MP affects all people in the US and other countries. Whether one decides to purchase a home, buy a car, start up a business, invest in stocks or bonds or just to save money, each decision is heavily influenced by Monetary Policy. And because the US economy is so large and pervasive, other countries are effected as well.

The object of monetary policy is to influence the performance of the economy in the direction that the FOMC has deemed appropriate.  MP works by affecting demand across the economy—that is, people’s and firms’ willingness to spend on goods and services.

The goals of monetary policy are to:

  1. Promote maximum employment.
  2. Create Price Stability and keep Inflation in check.
  3. Provide for long term economic growth.
  4. Provide for reasonable long term interest rates.
  5. Ensure enough money (liquidity) present in the economy for growth without causing inflation.

All economies experience business cycles, ups and down. In these cycles, employment and wages may increase or decrease and Gross Domestic Product may go up or down. The goal of a Central Bank is to “mitigate” the harm done by the changes.

Monetary policy does not directly affect wages, employment or GDP. But what it does is to change the “environment” so that businesses are better able to respond to the challenges unique to themselves, and that influences wages, employment and GDP down the road.

For example, demand for Housing weakens. The Fed cuts rates making it more affordable to buy homes, and so demand for Housing is either stabilized or improves. This leads to other industries dependent upon a strong Housing Market becoming stabilized or growing in performance.  For this reason, stabilizing the economy is an important goal of any Central Bank.

 

What are the tools of monetary policy?

If the Fed is going to influence employment and keep a stable economy going, it needs specific “tools” from which it can act. Three instruments of monetary policy are available to the Fed to influence the economy: open market operations, the discount rate and reserve requirements.

Open market operations involve the buying and selling of government securities. The Fed will offer bonds for sale, and various primary dealers will bid on the bonds in auctions. (Only primary dealers are allowed to participate in the auctions.) Due to the “flexibility” of open market operations, this is the most frequent tool used by the Fed to influence the economy.

Open market operations is the primary tool used by the Fed to increase or decrease Bank Reserves. Buying bonds increases bank reserves and selling bonds decreases reserves of the primary dealers. So the Fed can increase or decrease bank reserves as needed, and quickly.

When the Fed wants to increase reserves, it buys securities and pays for them by making a deposit to the primary dealer Fed account and when they want to reduce reserves, they sell securities and withdraws the funds from the accounts. This allows the Fed to increase or decrease Reserves as needed, and on a temporary basis.

Since 2008, the Fed has used open market operations like QE 1, 2 and 3 to increase Bank Reserves. We can track Fed efforts to increase Bank Reserves by the chart below. And we can see how the ending of these programs in 2014 has caused Reserves to fall.

 

The Discount Rate or Federal Funds Rate is the second tool available to the Fed to influence the economy. The discount rate is the interest rate that Fed Banks charge commercial banks for short-term loans. By changing the overnight lending rate, the Fed can influence money and credit in the system. It can provide liquidity to commercial banks as needed to keep the banks from facing financial challenges.

Lowering the discount rate is expansionary because the discount rate influences other interest rates. Lower rates encourage lending and spending by consumers and businesses. Likewise, raising the discount rate is recessionary because the higher rates discourage lending and spending. We can see how the confluence of the Discount Rate and Open Market Operations have influenced Money Supply.

The federal funds rate is sensitive to changes in the demand for and supply of reserves in the banking system, and thus provides a good indication of the availability of credit in the economy.

 

Reserve Requirements are the third way that the Fed has to influence the money supply. Reserve requirements are the portions of deposits that banks must hold on account with the Federal Reserve to meet “fractional banking” requirements. Reserves are the least likely of approaches that the Fed will take with regard to money supply.

Banks are required to keep 10% of deposits as Reserves for liquidity protections. If the Fed decreases the percentage amount of reserves, it increases the amount of money in circulation in the economy. This can be expansionary because people or businesses would have access to more money to borrow. Increasing the Reserve percentage would be recessionary because it would decrease the money available for lending.

 

Summary

In order to carry out the Fed’s primary responsibilities, it has three different main tools that it can use to promote economic stability and full employment. Use of those tools will be dependent upon the needs of the economy.

In Part 3, we will look at how well the Fed has performed its functions since the 2008 Financial Crisis.

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