The Federal Reserve
II. Fed Policy: tools & critique
ECO 473 – Money & Banking – Dr. D. Foster
Goals of Monetary Policy
• Inflation goals:
– Low/no inflation with limited year-to-year
variability.
• Output goals:
– High and stable economic (GDP) growth.
• Employment goals:
– Stable employment growth with low
unemployment.
Federal Reserve Policy Tools
• Open Market Operations
– Buy/sell Treasury bonds to affect bank reserves.
– The major form of monetary policy.
– What will the Fed do if we run out of Treasury bonds?
• Discount Window
– Lend to member banks to affect bank reserves.
– Purpose is to target the “federal funds rate” – iff
• This is the rate that banks charge each other for very short term loans.
• Required Reserve Ratio (rrD)
–
–
–
–
Changing this affects bank excess reserves directly.
Used more to reflect structural changes.
Was used in 1937 and precipitates more Great Depression.
Time to let this go?
New policy? – Pay banks i for ER (!!)
Intermediate Targets of Monetary Policy
• The key rationale for intermediate
targeting:
– The limited long-term information about
the economy available to policymakers.
Choosing an Intermediate Target Variable
• Characteristics:
– Frequently observable
– Consistency with
ultimate goals
– Definable and
measurable
– Controllable
• Potential variables:
– Monetary aggregates
M1, M2, MZM
– Interest rates
(fed’l funds, prime …)
– Others:
• Nominal GDP
• Credit aggregates
• Exchange rates
Targeting the Federal Funds Rate of Interest
Is Policy the Right Choice?
 Time lags make effective policy uncertain.
 Discretionary policy promotes uncertainty.
 Rules and credible adherence can eliminate
bias.
 Independence is a likely key requirement.
Time Lags in Monetary (& Fiscal) Policy
• Policy time lags
– Recognition lag
– Response lag
– Transmission lag
Real
GDP
Business
cycle
time
Monetary Policy may be counterproductive
%
Real
GDP
time
Ideally, policy would dampen the business cycle…
But, dampening the business cycle may lower ave. growth!
Or, if policy kicks in at the wrong time, it could worsen
recessions and exacerbate inflationary periods.
Discretion versus Rules
(Milton Friedman)
• Discretionary policy is the source of instability.
• A policy rule can eliminate that instability.
– Set target for Bank Reserves, Monetary Base,
Money Supply to grow in LR sustainable fashion.
– This is a commitment to a fixed strategy no matter
what happens to other economic variables.
• To be successful, the commitment must be credible.
– The public believes the Fed will act this way.
Making Monetary Policy
Rules Credible
• Place constitutional limits on
monetary policy.
• Achieve credibility by establishing a
reputation.
• Maintain central bank
independence.
• Establish central banker contracts.
• Appoint a “conservative” central
banker.
Has the Fed maintained stable prices?
Has the Fed maintained the value of the $?
4%
Making Monetary Policy Transparent
FOMC - PR
Dec. 16, 2015
Yellen’s Press
Conference
Dec. 16, 2015
Quantitative Easing = Credible?
QE 1
QE 2
QE 3
Can the Fed undo the QEs?
• Inflation is a monetary phenomenon.
– Austrians: the only meaningful definition of inflation is w.r.t. the money supply.
• What happens if the economy starts growing?
– Banks will want to lend more, raising the MS and causing inflation.
– The Fed could try to stop it by raising interest on ER … to 3%? 5%? 10%?
– Inflationary expectations grow and become rooted in our economy, ala 1979.
– Fed starts to pull back by selling UST and MBS.
•
Their prices plummet; so Fed can’t buy back all the excess reserves!
– Interest rates will soar; investment will falter; a recession ensues.
– But, a recession accompanied by serious inflation, aka “stagflation.”
• Is it an “insurance policy” against massive sell-off?
The Federal Reserve
II. Fed Policy: tools & critique
ECO 473 – Money & Banking – Dr. D. Foster