3

Monetary policy

This section discusses the following topics: (1) The Federal Reserve System (2) Federal funds target rate (3) Monetary policy tools (4) Impact of monetary policy (5) Di culty of implementing monetary policy (6) Balance sheet of the Fed Corresponding textbook chapter: Chapter 4.

3.1

The Federal Reserve System

The Federal Reserve System (the Fed) is the central bank of the United States. Its duties fall into four general areas: (1) Conducting the nation monetary policy by in s uencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates. (2) Supervising and regulating banking institutions to ensure the safety and soundness of the nation banking and nancial system and to protect the credit rights of consumers. s (3) Maintaining the stability of the nancial system and containing systemic risk that may arise in nancial markets. (4) Providing nancial services to depository institutions, the U.S. government, and foreign o cial institutions, including playing a major role in operating the nation payments system. s (Source: The Federal Reserve System: Purposes and Functions, 2005 edition)
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The Fed is considered to be an independent central bank because its decisions do not need to be ratied by the President or anyone else in the executive branch of government. The Fed is, however, subject to oversight by the U.S. Congress. The Fed is composed of the Board of Governors and twelve regional Federal Reserve Banks. The Board of Governors is a federal government agency. It is composed of seven members. Currently Ben Bernanke is the Chairman of the Board. The twelve regional Federal Reserve Banks are each responsible for a particular geographic area or district of the United States. They carry out a variety of functions, including operating a nationwide payments system, distributing the nation currency and coin, supervising and s regulating member banks and bank holding companies, and serving as banker for the Treasury.

3.2

Federal funds target rate

The term monetary policy refers to the actions taken by the Fed to in uence the availability and cost of loanable funds. The Fed sets monetary policy to promote two key objectives: (1) maximum employment, and (2) price stability. These two objectives are sometimes referred to as the Fed dual mandate. s In practice, maximum employment means high economic growth, and price stability means low in ation. The in ation target of the Fed is 2% over the longer run. An article published in The Wall Street Journal on October 4, 2011 reports that: In recent weeks, the Fed has faced criticism from both sides of the political aisle. Some Republican lawmakers and presidential candidates have said the Fed was doing too much and risking in ation, while some Democrats have said the central bank wasn t doing enough to combat unemployment.

The major economic variable targeted by the Fed is the federal funds rate. A major component of the Fed is the Federal Open Market Committee (FOMC). The FOMC is composed of the seven members of the Board of Governors and ve out of the twelve Reserve Bank presidents. Each year the FOMC holds eight regularly scheduled meetings. Approximately two weeks before each meeting, the Fed releases a special report informally called the Beige Book which summarizes information on current economic conditions. Immediately after each meeting, the FOMC announces whether to increase, decrease, or keep the target for the federal funds rate. This target is known as federal funds target rate. Currently federal funds target rate is a range: 0 to 0.25 percent.

Federal funds target rate (%)

Source: http://www.federalreserve.gov/monetarypolicy/openmarket.htm

3.3

Monetary policy tools

The Fed is able to keep the federal funds rate close to its target.

Source: http://www.federalreserve.gov/monetarypolicy/openmarket.htm http://www.federalreserve.gov/Releases/H15/data/Business_day/H15_FF_O.txt

The Fed has three tools. (1) Open Market Operation: The purchase or sale of securities, primarily Treasury securities, in the open market to in uence the supply and demand of federal funds. Open Market Operation is the main policy tool that the Fed uses to implement its monetary policy. For example, suppose that the Fed wishes to decrease the federal funds rate by purchasing certain amount of T-bills. Since T-bills are traded in over-the-counter market, the Fed needs to contact the primary dealers. Each dealer then provides a list of T-bills that are available for sale, including maturity and price. The Fed then purchases the target amount of T-bills at the lowest possible price. Finally, the Fed makes payments to the dealers that sold it the T-bills. These dealers can then make new loans to their customers. Consequently, at every level of federal funds rate, the supply of federal funds increases. According to the loanable funds theory, the federal funds rate will decrease.

An article published in The Wall Street Journal on August 10, 2007 reports that: Short-term money-market interest rates spiked above their target levels in both Europe and the U.S. In response, the European Central Bank, in an extraordinary step, injected
e94.8 billion in short-term funds into the system to get rates back down. The U.S.

Federal Reserve injected $24 billion through its Open Market operations.

Sometimes, the Fed may wish to temporarily increase or decrease the aggregate amount of federal funds. For example, holiday deposit withdrawals can create temporary imbalances in the level of bank reserves. In this case, the Fed often uses repurchase agreements. With a repo, the Fed purchases securities from a dealer with an agreement that the dealer will repurchase the securities at a specied price and on a specied future date. An article published in The Wall Street Journal on September 7, 2007 reports that: The Federal Reserve added far more reserves to the system than was expected, matching similar liquidity injections carried out by overseas central banks. The New York Fed, which carries out the central bank market operations, supplied a s total of $31.25 billion in three separate operations yesterday, following several days of more meager injections. On Wednesday, the Fed added just $8.5 billion in an overnight repurchase agreement and Tuesday just $5 billion in a two-day repo.

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(2) Discount Window Lending: The Fed can lend directly to depository institutions through its discount window lending facility. Doing so can increase the supply of federal funds. The interest rate on discount window loans is called discount rate. By law, all discount window loans must be secured by collateral. It is up to each depository institution to decide whether (and how much) to borrow from the discount window. Thus, it is di cult to quantify the impact of changing discount rate on the supply of federal funds. As a result, discount window lending is rarely used by the Fed as a monetary policy tool.

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(3) Reserve Requirements: All depository institutions are required to meet reserve requirements. If the Fed lowers the reserve requirements, depository institutions are able to lend out more funds, thus increasing the supply of federal funds. But it is di cult to quantify the impact of changing reserve requirements on the supply of federal funds. As a result, it is rarely used by the Fed as a monetary policy tool.

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3.4

Impact of monetary policy

A change in the federal funds rate, or even a change in expectations about the future levels of the federal funds rate, will aect other interest rates, bond prices, stock prices, and the foreign exchange value of the dollar. Changes in these variables will then aect the real economy. Dierent interest rates have a tendency to move in tandem. Thus, when federal funds rate decreases, other interest rates (such as the interest rate on commercial paper and bank prime rate) are likely to decrease as well.

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Source: http://www.federalreserve.gov/datadownload/Choose.aspx?rel=H15

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An article published in The Wall Street Journal on August 7, 2010 report that: 1%: the interest rate on IBM most recent three-year bond. s This week, IBM set a sort of milestone in the bond market recovery from crisis: The s iconic computer company borrowed $1.5 billion at the bargain-basement interest rate of only 1%. IBM cheap money, though, exemplies the costly trade-os involved as the Federal s Reserve seeks to nurse the economy back to health. With markets expecting the Fed to keep its target rate somewhere between zero and 1% for at least the next two years, borrowing for short and long periods is extremely cheap. That great for big companies and banks, but it coming at the expense of savers a s s group whom, in the longer term, the U.S. needs to encourage.

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Changes in interest rates aect bond prices. Typically, when interest rates decrease, the required rate of return by investors for holding a bond will also decrease. Accordingly, bond prices will increase, and yields will decrease. An article published in The Wall Street Journal on January 23, 2008 reports that: Investor anxiety following the Asian marketsplunge this week depressed the Dow Jones Industrial Average more than 460 points at the opening of trading yesterday. But the Fed emergency 0.75-point rate cut helped the Dow industrials recover much of their s losses, to end the day down 128.11 points, or 1.1%, at 11971.19. That leaves the bluechip index 15% below its peak, hit last fall. Meanwhile, the bond market rallied strongly, with yields on 10-year Treasurys sinking below 3.5%, its lowest yield since mid-2003.

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Changes in interest rates also aect stock prices. When interest rates decrease, bond yields decrease. Thus, all else being equal, the returns on stocks will exceed the returns on bonds. Accordingly, investors will purchase stocks and bid up stock prices. In addition, lower interest rates may imply that the borrowing cost of companies will be lower, and their prots will be higher, which further lifts stock prices. An article published in The Wall Street Journal on August 23, 2007 reports that: Investors expecting a cut in the Federal Reserve key overnight lending rate sent U.S. s stock prices surging.

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Finally, changes in interest rates aect the foreign exchange value of the dollar in currency markets. For example, if interest rates decrease in the U.S., the yields on dollar assets will look less favorable, which will lead to a decline in the foreign exchange value of the dollar. An article published in The Wall Street Journal on September 17, 2008 reports that: The dollar rose broadly as the Federal Reserve left interest rates on hold and markets hopes grew for a solution to the cash- problems at American International Group ow Inc. The Fed policy-setting committee decided to keep rates steady at 2% after its meeting s Tuesday, despite market expectations that it would cut by at least a quarter percentage point to aid battered U.S. stock markets. While lower Fed rates can help stocks, they tend to hurt the U.S. dollar because they reduce yields on dollar-based assets. So by keeping rates steady Tuesday, the dollar found support.

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3.5

Di culty of implementing monetary policy

In practice, it is often di cult for the Fed to decide whether to increase, decrease, or keep the federal funds target rate, because changing interest rates can have opposite eects on unemployment rate and in ation.

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Source: http://data.bls.gov/timeseries/LNS14000000 http://data.bls.gov/timeseries/CUUR0000SA0

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In November 2001, the Fed was facing the following situation: September 2001 October 2001 November 2001 Unemployment rate (%) In ation (%) Federal funds target rate (%) 5.0 2.6 2.5 5.3 2.1 2.5 5.5 1.9 2.5

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On November 6, 2001, the Fed cut the federal funds target rate by 0.5%. An article published in The Wall Street Journal on November 7, 2001 reports that: WASHINGTON The Federal Reserve cut interest rates by half a percentage point to their lowest level since 1961, and citing the deteriorating overseas economy, suggested more cuts could be in store. The Fed cut its benchmark federal funds rate target to 2% from 2.5%, its 10th rate cut this year and the third half-point cut since the Sept. 11 terrorist attacks. ... Economic reports in recent weeks have been almost uniformly dismal, suggesting the economy could be contracting at a rapid clip. The unemployment rate shot up to a ve-year high of 5.4% in October from 4.9% in September, manufacturing activity is falling at its fastest pace since the depths of the 1990-91 recession, and an unrelenting drumbeat of layo announcements suggest unemployment could shoot higher.

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In March 2009, the Fed was facing the following situation: January 2009 February 2009 March 2009 Unemployment rate (%) In ation (%) Federal funds target rate (%) 7.6 0.0 0 to 0.25 8.1 0.2 0 to 0.25 8.5 -0.4 0 to 0.25

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Many interest rates are in uenced by the yields on Treasury securities.

Source: http://www.freddiemac.com/pmms/ http://www.federalreserve.gov/DataDownload/Choose.aspx?rel=H.15

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Source: http://www.ustreas.gov/o ces/domestic-nance/debt-management/interest-rate/yield.shtml

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3.6

Balance sheet of the Fed

An article published in The Wall Street Journal on March 20, 2012 reports that: WASHINGTON (MarketWatch) The Federal Reserve and its district banks earned the second-highest amount in its history last year as the central bank proted from increasing its balance sheet to boost the U.S. economy. The Federal Reserve and its district banks said Tuesday that it earned $77.4 billion, down from $81.7 billion in 2010. The bumper earnings allowed the Fed to distribute $75.4 billion to the U.S. Treasury, also the second-highest level ever. Its balance sheet reached $2.92 trillion in 2011, up from $2.43 trillion in 2010.

Note: JPMorgan Chase the largest commercial bank in the U.S. had total assets of $2.27 trillion and net income of $19 billion in 2011. (Source: JPMorgan Chase 2011 Annual Report)

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Consolidated Balance Sheet of the Fed (millions of dollars), December 31, 2004 Assets Securities Repurchase agreements Loans to depository institutions Float All other assets 737,819 33,000 43 927 56,130 Liabilities and Equity Federal Reserve notes Reverse repurchase agreements Balances, all depository institutions Balance, Treasury account Other liabilities and capital 719,436 30,783 24,043 5,912 27,745

Source: The Federal Reserve System: Purposes and Functions, 2005 edition Note: The major assets of the Fed are securities (such as Treasury securities), and the major liabilities are Federal Reserve notes.

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