Download Monetary Policy Fall 2016 (material for last course outline)

Monetary Policy
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
The Fed uses the banking system to control the money supply and interest rates.
The Fed could conduct monetary policy by simply printing paper currency, but it does
not use this method. Rather, it creates special checking accounts for banks called
reserve accounts. The banks can use the funds in their reserve accounts just like
currency to make loans. When the balances in these reserve accounts rise, the money
supply expands and interest rates fall.
1. The Federal Open Market Committee (FOMC)

The key policy body that decides on course of monetary policy is called the Federal
Open Market Committee (FOMC). It consists of the members of the Board of
Governors and presidents of the Federal Reserve district banks. Only a subset of the
12 regional Fed presidents are voting members of the FOMC each year. The voting
rights rotate among the presidents, with the exception of the New York Fed president
who holds permanent voting status (because the New York Fed actually undertakes
the operations to meet the targets set by the FOMC).

The Board of Governors resides in Washington D.C.. Governors are appointed by the
president and confirmed by the Senate for 14 year terms. Their long terms serve to
shield the governors from political cycles. Unlike the governors, the district bank
presidents are appointed independently of the political process.
o
Some critics of the Fed have pointed out that this feature makes the FOMC
rather “undemocratic.” Others argue, however, that political independence of
the Fed is essential to avoid pressures to stimulate the economy excessively
and create inflation.

The current chair of the Board of Governors is Ben Bernanke, who succeeded longtime chair Alan Greenspan in early 2006. Ever since Paul Volcker’s appointment as
Chairman by President Carter in 1979 there has been a lot of deference towards the
Board Chairman. There are no formal reasons for the general voting consensus
observed between the Chairman and the Board members. It is just the practical
reality.

The FOMC meets 8 times per year to analyze, and possibly adjust monetary policy.
FOMC meetings often generate a fair amount of interest in the business press.
2. Bank reserves and the federal funds interest rate

The Fed could operate monetary policy in a variety of ways. In the early 1980s, the
Fed specifically tried to target a value for the money supply. At that time, the Fed
would inject reserves (open market purchase) or drain reserves (open market sale) in
an attempt to hit its quantity of money target.

Now, rather than targeting a particular value for any measure of the money supply,
the Fed runs monetary policy by setting an interest rate called the federal funds rate.

The federal funds rate is the interest rate at which banks lend each other reserves.
Reserve accounts at the Fed do not pay interest, so if a bank has excess reserves
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beyond what it needs to finance the loans it wants to make, it pays for the bank to
loan these reserves to another bank that may not have enough reserves to make all the
loans it desires.

Thus, the federal funds rate indicates the scarcity of reserves in the banking system.
If the Fed wants to stimulate the economy it will inject reserves with open market
purchases until the federal funds rate falls to a lower target. If the Fed wants to slow
down the economy, it will sell bonds on the open market and drain reserves until the
federal funds rate rises to a higher target. (See further discussion below.)

With the Fed’s current operating procedures, the federal funds rate is a direct
indicator of monetary policy.
a) Open-market purchase

When the Fed wants to lower the federal funds interest rate, it injects bank reserves
into the system. If the Fed wants to raise interest rates it will remove ("drain")
reserves from the banking system.

Suppose the Fed wants to inject reserves into the banking system. It does so by
purchasing government bonds from banks. It pays for the bonds with reserve
deposits. The Fed literally "creates" reserve deposits it needs to buy government
bonds from banks at a price set by the money markets.

The price of bonds adjusts in the open market (bond prices rise and interest rates
fall—we will not explore this reverse relationship in detail here). Reserves become
less scarce, and therefore the federal funds interest rate that banks charge to lend
reserves to other banks declines

Banks ultimately use excess reserves to make more loans to businesses and
consumers. To lend out the excess reserves banks have to reduce interest rates.
Although the Fed specifically targets the rather obscure federal funds rate, the open
market purchase will eventually cause the interest rates on consumer and business
loans to decline as well.

Note that by creating excess reserves in the banking system, open market purchases
will raise the money supply. In the past (mostly in the 1980s and earlier), the Fed
measured its policy by how quickly the measures of the money supply were growing.
Now, however, monetary policy is measured by the federal funds interest rate, which
gives an index of how “scarce” monetary reserves are. (When reserves are more
“scarce” their price, that is, the fed funds rate, goes up and vice-versa.)
b) Open-market sales

If the Fed wants to decrease the money supply and raise the federal funds rate (if it is
worried about inflation for example), it will sell government bonds to the banks.
Banks will use their reserve deposits to buy the government bonds.

Reserves become more scarce, and the price of reserves (the fed funds rate) therefore
rises.

Reduction in reserves forces banks to contract their loans and interest rates on
consumer and business loans rises.
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
Another way to look at the effect on loan interest rates is to think of the fed funds rate
as the cost of money to the banks. If the banks want more reserves to make loans,
they can borrow reserves from other banks at the fed funds rate. When the Fed
engages in open market sales, the fed funds rate rises. This raises the cost of money
to the banks, and they therefore will charge higher interest rates to their household
and business customers. (The opposite interpretation can be used for open market
purchases discussed above.)
c) Open-market operations are the key day-to-day instrument used by the Fed to
control the money supply

These purchases and sales are called “open market” because the Fed does not coerce
the banks to buy or sell bonds. The Fed offers a market price at which the banks
voluntarily make the transaction with the Fed.

The New York Fed is the agent that actually undertakes the monetary operations
directed by the FOMC.
3. Money Markets and Interest Rates
a) Banks’ incentive to lower interest rates when they have excess reserves

Consumers and businesses do not borrow at the federal funds rate. But changes in the
federal funds rate usually lead to changes in the same direction in various market
interest rates.

If the Fed injects reserves into the banking system to lower the federal funds rate, the
banks’ cost of loans decline. Competition among the banks will lead them to reduce
the interest rates they charge to their customers.

Another way to look at this process is to recognize that reserves pay very little
interest (they paid no interest at all prior to 2007). If the banks agree to sell interestbearing government bonds to the Fed, they must intend to loan the reserves out.
(They don’t want to just sit on the barren reserve deposits.) To get people to borrow
the new reserves, the banks must lower interest rates.
o Think about it this way: Suppose you are one of ten people selling apples at a
stand along the street. You have priced them so that the demand for apples is
the same as the supply. You and all the other apple stands suddenly get a new
shipment of apples which you would like to sell. In order to sell these
additional apples, you will have to lower the price. In addition, you will not
be able to charge a higher price for apples than your competitors because
consumers could always go to the competition instead.
o This example is a simplified explanation of how an open market purchase
works. Of course, instead of selling apples, the banks are selling loans. And
instead of having a price for apples, the banks have an interest rate at which
they lend.
b) Banks’ incentive to increase interest rates when reserves are in short supply

If the Fed reduces reserves and raises the fed funds rate, the banks’ cost of funds will
rise. They will have to raise interest rates and cut back on their lending.
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
Market interest rates paid by households and businesses do not move in lock-step
with the federal funds rate. There are other influences on these interest rates that
move them around independently of monetary policy. But market rates do tend to
move in the same direction as the federal funds rate.
o It is easier for the Fed to control short-term market interest rates than it is to
control long-term rates.
o This can create a problem for the Fed because some of the most important
interest rates for the economy, the 30-year mortgage rate for example, are long
term.
o In 2004 and 2005, the Fed increased the fed funds rate significantly, but the
30-year mortgage rate did not change much.
o The following graph provides interesting evidence. The lowest line is the
effective Fed funds rate. The changes in monetary policy are quite evident.
Notice the substantial drops in the Fed funds rate around the four recessions in
the period covered by the graph (designated by gray bars). Once the
recoveries of the mid 1990s and mid 2000s were underway, the Fed tightened
monetary policy again. Also notice how market interest rates somewhat
follow the Fed funds rate, but not at all in lock step. Indeed, when the Fed
raised the funds rate from 2004 to 2006, the long-term government bond rate
and 30-year mortgage rate rose very little. The short-term interest rate on 1year government bonds, however, moves in almost identical ways to the
policy-controlled federal funds rate.
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4. Monetary Policy and Real Output: The Transmission Mechanism

Obviously, the Fed tries to stimulate the economy when it is below potential output.
It also tries to hold back aggregate demand when it fears inflation is about to rise.
The process through which the Fed controls the economy is called the “transmission
mechanism” of monetary policy.
a) Effect of money supply changes on aggregate demand

The Fed affects aggregate demand by changing interest rates.

An increase in money supply and a reduction in the fed funds rate controlled by the
Fed tends to lower interest rates throughout the economy (although not in lock step,
as noted above).

Lower interest rates encourage consumption (the cost of consumer loans falls and the
reward for saving decreases).

Interest rates are a powerful effect on residential investment through the cost of
mortgages.

If business interest rates fall, the cost of capital declines, both through lower interest
rates on loans and a lower opportunity cost of firms’ own funds that are invested. A
lower cost of capital stimulates business investment.

Lower interest rates also tend to reduce the value of the dollar and stimulate net
exports.

Effects are reverse for tight monetary policy that increases the fed funds rate.
b) Monetary policy for macro stabilization
(1) Expansionary monetary policy to offset the effects of negative demand shocks

If output is below potential (Y*), the Fed will likely try to shift AD up through lower
interest rates. You should know how to demonstrate this policy with the Keynesian
Cross diagram.

Thus, if the economy experiences a negative demand shock, such as the decline in
business investment after the bursting of the technology bubble in 2000 or the
massive bust in residential construction that led to the Great Recession, the Fed is
likely to cut interest rates.

For example, when economic weakness became evident in late 2000 and early 2001.
The Fed lowered the federal funds rate quickly, in several separate steps, from 6.5 to
3.0 percent before the September 11, 2001 terrorist attacks. Immediately after the
attacks, the Fed lowered the rate half a percentage point to 2.5 percent. (When
talking about interest rate changes, one one-hundredth of a percentage point is often
called a “basis point.” Thus, one could say the Fed cut the federal funds rate by 50
basis points immediately after the terrorist attacks.)

Because of the disappointingly slow (“jobless”) economic recovery in 2002 and the
first half of 2003, the Fed continued to cut the federal funds rate. It reached 1.0
percent in the summer of 2003. At the time, this was the lowest the federal funds rate
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since the late 1950s suggesting that the Fed pursued exceptionally loose monetary
policy in the early 2000s.

Monetary policy was also loosened substantially as problems in housing finance
became evident. In the summer of 2007 (before the beginning of the official
recession in December 2007) rising mortgage defaults caused problems in financial
markets. In response to these concerns, the Fed began to cut the Fed funds interest
rate in August of 2007. Initially these cuts were small, from 5.25 to 5.00 percent.
But as the problems in finance and the broader economy multiplied the Fed reduced
interest rates rapidly. By the middle of 2008, the Fed funds rate was 2 percent.
Further cuts followed the dramatic failure of Lehman Brothers investment bank in the
fall of 2008.
o By late 2008, the Fed funds rate was effectively zero. (The actual target range
for this rate became zero to 25 basis points.) This low rate has been in effect
for over three years. When the Fed funds rate hits this “zero bound” it can go
no lower. The implication for monetary policy is significant. (This idea is
developed further below.)
(2) Potential output as the target for monetary policy

As we have discussed all semester, the best level of output for the economy is
potential output, Y*. At this level of output, all resources are fully utilized.
Resources are not over-utilized, which means that Y* is sustainable in the long run
and people are not working more than they desire. Potential output is a target of
monetary policy.

In this context, note the interaction of the supply side and the demand side. The Fed
affects the economy almost exclusively through the demand side by changing
(3) Flexibility of monetary policy relative to fiscal policy

Monetary policy is much more flexible than fiscal policy in meeting this goal.
Lengthy political debates about which changes in spending or taxes should occur
make fiscal policy very cumbersome. In contrast, the Fed is largely independent from
politicians. When economic weakness emerges or inflation fears rise, the Fed can
change monetary policy quickly, sometimes within a few days in an emergency
situation.
(4) Dangers of inflation from excessive monetary expansion

In addition to output, however, the Fed also wants to keep inflation low and stable. If
AD exceeds the level consistent with Y* (or the Fed fears that further increases in AD
might push it above Y*), the Fed can restrain inflation by raising interest rates and
lowering AD.

There is a trade-off between output and inflation at least over a short horizon. If the
economy starts at a recession, we do not worry too much about this trade off. As you
will remember, at high levels of unemployment the curvature of the Phillips curve is
flatter, indicating that even large reductions of unemployment as the economy gets
out of recession will only be accompanied by small increases in inflation. (Indeed, if
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inflation expectations fall during the recession, there may be no increases of inflation
at all.)

But if the economy is near Y*, the story changes. The KC diagram below shows the
possibility that AD may rise above AD*, the level associated with equilibrium at
point A and Y*:
AD
AS
AD1
B
AD*
A
Y*
Y

Although Y* represents the highest level of output that is sustainable over a long
period of time, it's possible that Y could rise somewhat above Y* temporarily.
People could work overtime; some people could work more than they really want to
in the long term; firms may put off maintenance and use their productive capital more
intensively than they really want to. Thus, output could rise to a point like B when
AD is too high.

According to the Phillips Curve, however, excessive AD will lead to higher inflation,
even if it reduces employment somewhat. In the diagram below, unemployment rises
from U* to U1 and inflation rises from 0 to 1 (point A to point B).

1
B
0
A
U1
U0
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
This rise in inflation is undesirable. The Fed may tighten monetary policy to restrain
AD. This policy would involve draining reserves from the banking system to raise
the target for the federal funds rate.
o Question: does this action require an open market purchase or sale?
o Answer: Open market sales of government bonds lead banks to buy bonds in
return for bank reserves. So open market sales reduce reserves in the banking
system.

What if the Fed cannot quickly bring inflation down? The worry is that inflation
expectations will rise. This will shift the Phillips Curve upward. Even if
unemployment returns to U* (which is the unemployment rate that corresponds to
potential output Y*), inflation may be permanently higher:

C
1
B
0
Phillips Curve (High E)
A
U1
U*
Phillips Curve(Low E)

With higher inflation expectations, the economy ends up at point C. Output and
unemployment are at the desirable levels of U* and Y*, but inflation has risen and
there is no internal force to bring it back down.

In this situation, if the Fed wants to lower inflation, it may have to create
unemployment above U* to reduce actual inflation and bring down inflation
expectations. This is the kind of situation the economy experienced in the early
1980s. The unemployment during the 1980-1982 period was very painful.

As we discussed earlier, the message for the Fed and other countries' central banks is
not to let inflation expectations rise in the first place.

Consider the desirability of different monetary policies.
o The best policy, in principle, would be never to let AD rise above AD* so the
economy never leaves point A on the Keynesian Cross diagram above.
However, the Fed might not have adequate information to pull off this feat.
o The Fed might not recognize the inflationary pressure until actual inflation
begins to rise. The economy might get to point B. But if the Fed acts quickly
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to restrain the inflation by tightening monetary policy, it might be able to
restore the economy to point A before inflation expectations rise.
o The worst scenario is that the Fed doesn't care about inflation or can't initially
tighten policy enough to reduce it. Inflation expectations rise. The Fed may
be able to achieve its target inflation rate by raising interest rates substantially,
most likely inducing a recession and the associated unemployment.
o Again, this is the most common interpretation of what happened in the early
1980s when the Volcker Fed fought inflation aggressively with the highest
interest rates in modern U.S. history. Inflation came down as the result of the
deep recession, and inflation expectations eventually followed actual inflation
downward. But the cost in unemployment and decimation of the U.S.
manufacturing sector was severe.
(5) Pre-emptive strikes against inflation

The best policy described above requires the Fed to act before inflation heats up.
Thus, the Fed would have to raise interest rates before actually seeing inflation. In
academic and policy discussions this is called a "pre-emptive" strike against inflation.

To implement such a policy effectively, the Fed has to see the rise in AD above Y*
before unemployment falls and inflation rises. This may be difficult.

Furthermore, the Fed might make a costly mistake with pre-emptive strikes.
Remember that in talking about the practical challenges of fiscal policy we discussed
how it is tough for policymakers to know the level of Y*. Suppose actual output
were below Y*, but the Fed thought Y* had been reached. If the Fed forecast a rise
in AD, they might raise interest rates to strike against inflation. But the economy
might actually be able to expand further without much more inflation. The Fed might
indefinitely keep the economy below its potential.
o This issue was significant in the 1990s boom. When the unemployment rate
fell below 5%, many economist felt the Fed should take a pre-emptive strike
against inflation. But Alan Greenspan refused to do much. The expansion
continued and unemployment fell further without any significant inflation
increase.
o In mid 1999, however, with the unemployment rate close to 4%, the Fed
finally did raise interest rates pre-emptively from about 5% to 6.5%. But by
late 2000, the economy slowed significantly and it entered a recession in
2001. The economy might have slowed anyway, but the Fed's tighter
monetary policy certainly did not help matters. In retrospect, it looks like the
Fed should not have launched a pre-emptive inflation strike in 1999 and early
2000.
o In mid 2004, the fed funds rate had been at the very low level of 1% for some
time. The Fed became concerned that interest rates this low would eventually
ignite higher inflation. Once the recovery seemed more solid in mid-2004, the
Fed began to raise the Fed funds rate by 25 basis points each meeting, even
though there was no strong sign of higher inflation. The rise in energy prices
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created by the continuing war in Iraq and Hurricane Katrina in August, 2005
may have exacerbated inflation concerns, but there was no significant increase
in actual inflation during this period. By the summer of 2006 it reached 5.25
percent. This rate is much higher than it was when the Fed was actively
stimulating the economy from 2001 through 2003, but it is still below the
level that prevailed through the 1990s boom.
5. Long-run monetary policy objectives
a) “New consensus” macroeconomics

During the Great Moderation years (roughly the middle 1980s until the beginning of
the Great Recession in 2007) the mainstream of macroeconomic research converged
on a theoretical model with three key components:
o Aggregate demand drives economic fluctuations in the short run. The
interest rate is an important determinant of aggregate demand (for reasons
discussed earlier; you should know these reasons).
o Inflation is determined by two main variables: inflation expectations and
the level of aggregate demand relative to supply-determined potential
output (Y*)
o Monetary policy is an important determinant of interest rates. Monetary
policy should adjust to target a low level of inflation. It may also be
appropriate for monetary policy to respond to gaps between actual output
(Y) and potential output (Y*).

According to this model, monetary policy is the key mechanism for stabilizing the
economy.
o Note that fiscal policy does not appear prominently in the new consensus
relationships. According to the new consensus, monetary policy should be
adequate to get the economy close to Y* in a reasonable amount of time.
o In this model, fiscal policy should be set according to long-run
propositions about the appropriate size of government and taxes when the
economy is operating at Y*.
b) The Taylor Rule

Many economists argue that the Fed should adjust interest rates in response to two
main variables: the gap between actual and target inflation and the gap between
actual and potential output. In case either gap is positive, interest rate should rise. If
actual output and/or inflation are below target values, interest rates should fall.

This idea is embodied in a simple equation often called the “Taylor Rule,” after
Stanford economist John Taylor.

This behavior roughly describes how the Fed has behaved in recent years. The
Taylor Rule is one way of guiding the monetary policy piece of the new consensus
model discussed above.
c) Inflation targeting
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
Some economists believe the Fed should announce an explicit target for inflation.
Most proponents of this policy suggest a target of 1.5% to 2% per year.

The Fed currently tries to keep inflation low, so, in effect, it is "inflation targeting"
already. But the Fed does not explicitly announce a target number.

Why might an explicit inflation target help the economy? Consider the situation in
2003. The economy was recovering, especially in the second half of the year.
Interest rates were very low. Some people were worried that the Fed will raise rates
soon, which could hurt the recovery. If the Fed announced a 2% inflation target,
however, people would not have to worry so much about higher interest rates.
Inflation was lower than 2%, so there would be no reason to expect higher rates. In
effect, the inflation target commits the Fed not to take a pre-emptive strike.
o This situation illustrates the concept of transparency. Many monetary
economists believe that it is important for households and businesses to
understand what the Fed is doing and what its objectives are. That is, they
argue that Fed policy should be “transparent.” This helps people form
good expectations. Policy surprises may cause uncertainty that reduces
household and business confidence, which might lower aggregate demand
(as we discussed some time ago).

Another benefit of an explicit target is that it would help to anchor inflation
expectations. Even if the inflation rate increased temporarily (due to a supply shock
for example), inflation expectation might not rise because people will trust the Fed to
bring inflation down to its target.

Note that an inflation target is similar to the Taylor Rule. The Taylor Rule explicitly
implies that interest rates should rise if inflation is above target levels. If inflation is
below target, the economy is likely weak, and interest rates should decline.

There are two possible disadvantages with the inflation target policy
o The economy is complicated and we might not be sure what the best policy
will be in future, possibly difficult, circumstances. Announcing an explicit
inflation target limits the Fed's flexibility to respond as it thinks best in each
situation. This criticism is similar to Alan Greenspan’s views. He did not
favor explicit inflation targets.
o When a big negative supply shock hits, like an increase in the cost of energy,
not only does inflation rise, but the economy might experience a recession, or
at least slower growth. (Remember the "stagflation" of the 1970s.) Strict
inflation targeting in the face of a negative supply shock would force the Fed
to tighten policy when the economy is weak. This action would be difficult to
take, and it may lead to bad political outcomes.

Ben Bernanke, the successor to Greenspan (in early 2006) as the chair of the Fed was
a strong advocate of inflation targets in his academic work. The Fed has now
explicitly stated that the target for U.S. inflation is about 2%.
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6. Limitations of monetary policy
a) Problem if spending is inelastic to interest rates
b) The “zero bound” for interest rates
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