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Notes on the Federal Reserve System The key challenge is that the Fed controls only one interest rates, the overnight rate on federal funds. From a policy perspective, this raises several questions. First, how readily can interest rates be changed? Second, how do changes in the short term fed funds rate affect other interest rates. Third, so what? - do interest rates affect economic activity? In fact, the Fed has very little ability to affect the economy. Monetary policy is asymmetric in its impact: the Fed it is capable of raising interest rates high enough to slow the economy, but there is no guarantee that lowering interest rates will have any impact. That difficulty is accentuated when interest rates are low. When inflation is only two percent, it is possible for the fed to push short-term interest rates down to 0 percent. That is a very modestly negative real interest rate. However, in practice, that may be insufficient to offset dismal expectations. In sum, the Fed has very little ability to offset a recession. In sum, the Fed can in a crisis try to offset illiquidity, but it has no tools to address issues of solvency. ==== arrow flow charts for recent FP, MP under ideal situation, with forex and multiplier and (for FP) savings. ==== time horizon: The Fed. governors have a daily conference call. Policy to be changed but in the hours notice. The trading desk can begin to implement new policy immediately. Of course, this is restricted to trading hours, but that is what is most relevant for any actual impact of interest rate changes or shifts in liquidity. impact on interest rates: look at the data! (excel spreadsheet) So in conclusion: 1. Fed can react quickly 2. Fed can only affect short-term interest rates - these feed into the "prime rate" but the role of banks in corporate finance has diminished a lot over the past 20 years, so the prime rate is no longer very important. - the Fed cannot reliable push mortgage interest rates down 3. Fed impact is asymmetric - by pushing up interest rates a lot (look at the US data for 1979-1981!) the Fed can with certainty make it extraordinarily costly to borrow money, and thereby cut investment "I" and slow the economy - but investment is driven in large part by expectations, and when the economy is performing poorly, low interest rates will not reliably entice firms to boost investment. - likewise, when housing prices are falling, lower rates on mortgages will not entice lots of people to start building new houses – especially if they can't sell the house they're living in. Hence monetary policy is like a rope around the neck: if it yanks hard enough, the Fed can choke off growth. But it can't push on the rope to get the economy moving. [another common image is "you can lead a horse to water but you can't make it drink"] 4. Bernanke does command a very visible "bully pulpit." He's good at BS, too. But when the daily headlines are full of gloomy economic news, it is very difficult for him to shift expectations.