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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