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Chapter 25 Understanding the Fed

Money and Power

In August 2011, these 10 individuals were among the most powerful people in the world.

• Ben S. Bernanke
• William Dudley
• Elizabeth Duke
• Charles Evans
• Richard Fisher
• Narayana Kocherlakota
• Charles Plosser
• Daniel Tarullo
• Janet L. Yellen

You may not have heard any of these names before. It is certainly unlikely that you have heard of more than one or two of these individuals. Yet they decide how easy or difficult it will be for you to get a job when you graduate. They decide how expensive it is for you to buy a car. They decide how many pesos you get for a dollar if you travel from the United States to Mexico. They decide if the Dow Jones Industrial Average is going to increase or decrease. They decide whether the stock markets in Tokyo, London, Hong Kong, and Frankfurt are going to increase or decrease. They decide the cost of your vacation abroad and the cost of the clothes that you buy at home.

So who are they?

They are the members of a group called the Federal Open Market Committee (FOMC). They are responsible for setting monetary policy in the United States. Of course, they do not literally decide all the things we just mentioned, but their decisions do have a major influence on everything we listed. This chapter is about what these people do and why their choices matter so much for our day-to-day life. We begin with an example of this group at work.

FOMC Policy Announcement: February 2, 2005

For immediate release

The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 2-1/2 percent.

The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity. Output appears to be growing at a moderate pace despite the rise in energy prices, and labor market conditions continue to improve gradually. Inflation and longer-term inflation expectations remain well contained.

The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal. With underlying inflation expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Ben S. Bernanke; Susan S. Bies; Roger W. Ferguson, Jr.; Edward M. Gramlich; Jack Guynn; Donald L. Kohn; Michael H. Moskow; Mark W. Olson; Anthony M. Santomero; and Gary H. Stern.

In a related action, the Board of Governors unanimously approved a 25-basis-point increase in the discount rate to 3-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.Federal Open Market Committee, “Press Release,” Federal Reserve, February 2, 2005, accessed July 20, 2011, http://www.federalreserve.gov/boarddocs/press/monetary/2005/20050202/default.htm.

This FOMC statement is from February 2005. We have deliberately chosen a statement from a few years ago because we want to begin with monetary policy prior to the economic crisis that began in 2008. This policy statement contains all the essential elements of monetary policy in normal times.

The 12 people listed in the second-to-last paragraph of this announcement were the FOMC members in February 2005. (These names are different from those we named at the start of the chapter because the composition of the FOMC changes over time.) The president of the United States was not one of them. And none of them are members of Congress. You did not vote for any of them. None of the three main branches of the US government (executive, legislative, or judicial) is involved in the setting of US monetary policy. The FOMC is part of a government body called the US Federal Reserve Bank, commonly known as the Fed. The Fed is independent: decisions made by the Fed do not have to be approved by other branches of the government.

In this statement we find the following phrases:

• “The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 2-1/2 percent.”
• “The Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal.”
• “In a related action, the Board of Governors unanimously approved a 25-basis-point increase in the discount rate to 3-1/2 percent.”

The first phrase indicates an action undertaken by the Fed: it changed its “target” for something called the “federal funds rate.” This is a particular interest rate related to the rate banks pay each other for loans. Although you will never borrow to buy a car or a house at this rate, the interest rates you confront are heavily influenced by the federal funds rate. For example, over the past few years, the federal funds rate has decreased from 5.25 percent in 2006 to a value of 0.25 percent at the time of writing (mid-2011). Over this same period of time, rates on other types of loans, including mortgages and car loans, decreased as well. For example, typical car loan rates were about 7–8 percent in 2006 and about 3–4 percent in mid-2011. In this way, the actions of the Fed affect all of us.

The second phrase contains the FOMC’s assessment of the state of the economy, expressed in terms of two goals: economic growth and the stability of prices. The Fed is charged with the joint responsibility of stabilizing prices and ensuring the full employment of economic resources. The final statement details another action with respect to a different interest rate, called the discount rate.

The FOMC issues statements such as this on a regular basis. Our goal in this chapter is to equip you with the knowledge to understand these statements, which will in turn help you make sense of the discussions of the Fed’s actions on television or in the newspapers. We want to answer the following questions:

What does the Federal Reserve do? And why are its actions so important?

The FOMC statement reveals that, to understand the Fed, we need to know both the goals and the tools of the Fed. From the statement, we learn that the goals of the Fed are sustainable growth and stable prices. The Fed cannot do much to affect the long-run growth rate of the economy, but it can and does try to keep the economy close to potential output. At the same time, it tries to ensure that the overall price level does not change very much—in other words, it tries to keep inflation low. The Fed pursues these goals by means of several tools that it has at its disposal. The FOMC statement informs us that these tools include two different interest rates.

We begin with a little bit of background information. We briefly explain what the Federal Reserve does, and we note that other monetary authorities are similar, although not identical, in terms of goals and behavior. Because we have seen that the Fed’s actions frequently revolve around interest rates, we make sure that we know exactly what an interest rate is.

We then get to the meat of the chapter, which discusses the workings of monetary policy. We explain how the Fed uses its tools to affect the things it ultimately cares about. Broadly speaking, we can summarize the cyclic behavior of the Fed as follows:

• The Fed observes current economic conditions.
• The Fed decides on policy actions.
• These policy actions affect real GDP (gross domestic product) and inflation.
• The Fed observes the new economic conditions.

There is a long chain of connections between the Fed’s tools and the ultimate state of the economy. To make sense of what the Fed does, we follow these connections, step by step. As we do so, we create a framework for understanding the effects of monetary policy, called the monetary transmission mechanism. We must also look at the connection in the other direction: how does the state of the economy influence the Fed’s decisions? Figure 25.1 "The Links between Monetary Policy and the State of the Economy", which we use as a template for the chapter, summarizes the interaction between the monetary transmission mechanism and the behavior of the Fed. We conclude the chapter by looking at the tools of the Fed in more detail and by discussing some historical episodes through the lens of monetary policy.

Figure 25.1 The Links between Monetary Policy and the State of the Economy

The Federal Reserve looks at current economic conditions and decides on a policy response. This policy affects the state of the economy. The Fed then observes the new economic conditions and decides on a new policy response, and so forth.

25.1 Central Banks

Learning Objectives

After you have read this section, you should be able to answer the following questions:

1. When and why was the Federal Reserve System created in the United States?
2. What are the connections between the Federal Reserve System and the executive and legislative branches of the US government?
3. How does our study of monetary policy apply to other central banks around the world?

We start our discussion with institutions.

The Federal Reserve

The Federal Reserve System was formally established in an act of Congress on December 23, 1913, called the Federal Reserve Act (http://www.federalreserve.gov/aboutthefed/fract.htm). The stated purpose of the act was as follows: “To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”The Federal Reserve Act is found at “Federal Reserve Act,” Board of Governors of the Federal Reserve System, accessed September 20, 2011, http://www.federalreserve.gov/aboutthefed/fract.htm, and the structure of the Federal Reserve System is presented at “The Structure of the Federal Reserve System,” The Federal Reserve Board, accessed September 20, 2011, http://www.federalreserve.gov/pubs/frseries/frseri.htm. The Federal Reserve System is built around a 7-member Board of Governors together with 12 regional banks. The members of the board are appointed by the president and approved by Congress to serve for 14 years. The FOMC, which is instrumental in the conduct of monetary policy, has 12 members.

Although the president and Congress play a role in the appointment of members of the Fed, their direct control stops there. The Fed is an independent body. The executive and congressional branches of the government have no formal input into the determination of monetary policy. Congressional control is limited to the fact that the chair of the Fed is required to report to Congress periodically and to Congress eventually having the power to change the laws governing the Fed’s conduct.

The goals of the Fed are specified in the section of the Federal Reserve Act titled “Monetary Policy Objectives”: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”“Federal Reserve Act: Monetary Policy Objectives,” Federal Reserve, December 27, 2000, accessed August 6, 2011, http://www.federalreserve.gov/aboutthefed/section2a.htm. These objectives provide guidance to the Fed: it is required to pay attention to the level of economic activity (“maximum employment”) and to the level of inflation (“stable prices”). Exactly how the Fed promotes these goals—and chooses among them if necessary—is not specified. In some cases, the different aims of the Fed may conflict. For example, promoting employment may not be consistent with low inflation. The February 2, 2005, statement explicitly notes the balance between these goals.

The Fed has three main ways of affecting what goes on in the economy. The first was alluded to, although not mentioned by name, in the February 2, 2005, policy announcement. It is called open-market operations and represents the main way that the Fed influences interest rates. A second tool—the discount rate—was mentioned explicitly in the policy announcement. The third tool—reserve requirements—was not mentioned on February 2, 2005, but is nonetheless an important weapon in the Fed’s arsenal. Later on in this chapter, we examine the tools of the Fed in detail. For the moment, it is enough to know that the Fed affects the economy through changes in interest rates.

Central Banks in Other Countries

Our discussion in this chapter applies to not only the United States but also other countries. Wherever there is a currency, there is a monetary authority—a central bank—charged with the control of that currency. For example, in Europe, the European Central Bank (ECB; http://www.ecb.int/home/html/index.en.html) dictates monetary policy for all those countries that use the euro. In Australia, the Reserve Bank of Australia (RBA; http://www.rba.gov.au) manages monetary policy.

Different central banks do not all function in exactly the same way. To illustrate, here are policy announcements from the Bank of England (BOE; http://www.bankofengland.co.uk/publications/news/2006/078.htm), the Central Bank of Egypt (CBE; http://www.cbe.org.eg/public/PRESS_Release_For_Monetary_Policy/2011/MPC_PressRelease_09_06_2011_E.pdf), and the RBA (http://www.rba.gov.au/media-releases/2011/mr-11-09.html). The details of the announcements are not critical. However, all have a “Monetary Policy Committee” rather than an FOMC. The different banks target slightly different interest rates: the BOE targets the “Bank rate paid on commercial bank reserves”; the CBE refers to overnight deposit and lending rates, the “7-day repo,” and the discount rate; and the RBA refers to the “cash rate.” You do not need to worry about exactly what these different rates are. All three banks are looking at the overall state of the economy, in terms of both output and inflation, and are setting interest rates to pursue broadly similar goals.

News Release: Bank of England Raises Bank Rate by 0.25 Percentage Points to 4.75 Percent, 3 August 2006“News Release,” Bank of England, August 3, 2006, accessed July 20, 2011, http://www.bankofengland.co.uk/publications/news/2006/078.htm.

The Bank of England’s Monetary Policy Committee today voted to raise the official Bank rate paid on commercial bank reserves by 0.25 percentage points to 4.75 percent.

The pace of economic activity has quickened in the past few months…As a result, over the past few quarters GDP [gross domestic product] growth has been at, or a little above, its long-run average and business surveys point to continued firm growth.…

CPI [Consumer Price Index] inflation picked up to 2.5 percent in June, and is expected to remain above the 2.0 percent target for some while. Higher energy prices have led to greater inflationary pressures, notwithstanding muted earnings growth and a squeeze on profit margins.…

Against the background of firm growth, limited spare capacity, rapid growth of broad money and credit, and with inflation likely to remain above the target for some while, the Committee judged that an increase of 0.25 percentage points in the official Bank rate to 4.75 percent was necessary to bring CPI inflation back to the target in the medium term.

Press Release, June 9, 2011: The Central Bank of Egypt Decided Not to Raise Its Policy Rates“Press Release,” Central Bank of Egypt, June 9, 2011, accessed July 20, 2011, http://www.cbe.org.eg/public/PRESS_Release_For_Monetary_Policy/2011/MPC_PressRelease_09_06_2011_E.pdf.

In its meeting held on June 9, 2011, the Monetary Policy Committee (MPC) decided to keep the overnight deposit and lending rate unchanged at 8.25 and 9.75 percent, respectively, and the 7-day repo at 9.25 percent. The discount rate was also kept unchanged at 8.5 percent.

Headline CPI increased by 0.20 percent in May [month to month] following the 1.21 percent in April, bringing the annual rate down to 11.79 percent from 12.07 percent registered in April. …

Meanwhile, real GDP contracted by 4.2 percent in 2010/2011 Q3 which marks the first negative year-on-year growth since the release of quarterly data in 2001/2002. …

Against the above background, the slowdown in economic growth should limit upside risks to the inflation outlook. Given the balance of risks on the inflation and GDP outlooks and the increased uncertainty at this juncture, the MPC judges that the current key CBE [Central Bank of Egypt] rates are appropriate.

Media Release Number 2011-09: Statement by Glenn Stevens, Governor: Monetary Policy DecisionGlenn Stevens, “Media Release,” Reserve Bank of Australia, June 7, 2011, accessed July 20, 2011, http://www.rba.gov.au/media-releases/2011/mr-11-09.html.

At its meeting today, the Board decided to leave the cash rate unchanged at 4.75 per cent.

The global economy is continuing its expansion, led by very strong growth in the Asian region, though the recent disaster in Japan is having a major impact on Japanese production, and significant effects on production of some manufactured products further afield. Commodity prices have generally softened a little of late, but they remain at very high levels, which is weighing on income and demand in major countries and also pushing up measures of consumer price inflation. …

Growth in employment has moderated over recent months and the unemployment rate has been little changed, near 5 per cent. Most leading indicators suggest that this slower pace of employment growth is likely to continue in the near term…

CPI inflation has risen over the past year, reflecting the effects of extreme weather and rises in utilities prices, with lower prices for traded goods providing some offset. The weather-affected prices should fall back later in the year, though substantial rises in utilities prices are still occurring. The Bank expects that, as the temporary price shocks dissipate over the coming quarters, CPI inflation will be close to target over the next 12 months.

At today’s meeting, the Board judged that the current mildly restrictive stance of monetary policy remained appropriate. In future meetings, the Board will continue to assess carefully the evolving outlook for growth and inflation.

In this chapter, we talk, for the most part, about the Federal Reserve. We focus on the United States principally because we do not want to get too bogged down in learning the different languages used by different central banks. From looking at the statements of the Fed, the BOE, the CBE, and the RBA, we see that the terminology of monetary policy varies greatly from country to country, the names of the key interest rates differ, and so forth. The underlying principles of monetary policy are largely the same in all countries, however.

Key Takeaways

1. The Federal Reserve System of the United States was created in 1913. A key motivation for the creation of a central bank was to manage the stock of currency and thus influence the state of the aggregate economy, particularly output and prices.
2. In the United States, the central bank is independent. Decisions about monetary policy are made within the Federal Reserve System. Members of the Board of Governors of the Federal Reserve System are nominated by the president and approved by the Senate.
3. There are central banks around the world, conducting monetary policy with similar tools and with the same basic model of the aggregate economy in mind.

1. What is the input of the US president in determining monetary policy?
2. By learning about how the Federal Reserve System in the United States conducts monetary policy, what can we learn about other countries?

25.2 The Monetary Transmission Mechanism

Learning Objectives

After you have read this section, you should be able to answer the following questions:

1. What is the link between the actions of the Fed and the state of the economy?
2. What interest rate does the Fed target?
3. What components of aggregate spending depend on the interest rate?

The actions of monetary authorities, such as the Fed and other central banks around the world, influence interest rates and thus the levels of employment, output, and prices. The links between a central bank’s actions and overall economic performance are far from straightforward, however. The process is summarized by the monetary transmission mechanismA mechanism explaining how the actions of a central bank affect aggregate economic variables, in particular real GDP. (shown in Figure 25.2 "The Monetary Transmission Mechanism"), which is the heart of this chapter. The monetary transmission mechanism is more than just some theory that economists have devised to try to make sense of monetary policy. It summarizes how the Fed thinks about its own actions.

Figure 25.2 The Monetary Transmission Mechanism

The Fed targets a short-term nominal interest rate. Changes in this rate lead to changes in long-term real interest rates, which affect spending on investment and durable goods, ultimately leading to a change in real GDP.

The monetary transmission mechanism explains how the actions of the Federal Reserve Bank affect aggregate economic variables, and in particular real gross domestic product (real GDP). More specifically, it shows how changes in the Federal Reserve’s target interest rate affect different interest rates in the economy and thus influence spending in the economy. Through open-market operations, the Fed targets a short-term nominal interest rateThe number of additional dollars that must be repaid for every dollar that is borrowed.. Changes in that interest rate in turn affect long-term nominal interest rates. Changes in long-term nominal rates lead to changes in long-term real interest ratesThe rate of return specified in terms of goods, not money.. Changes in long-term real interest rates affect investmentThe purchase of new goods that increase capital stock, allowing an economy to produce more output in the future. and durable goodsGoods that last over many uses. spending. Finally, changes in spending affect real GDP. We will examine every step of this process.

This chapter focuses on the effects of Fed actions, but essentially the same analysis applies to the study of monetary policy in other countries. The channels of influence are to a large degree independent of which country we study, although the magnitudes of the policy effects might differ across countries. Monetary policy differs across countries more through the targets set by different central banks than through the transmission mechanism.

How Well Can the Fed Meet Its Target?

On February 2, 2005, the Federal Open Market Committee (FOMC) decided to increase the target federal funds rate to 2.5 percent. The word target is critical here. If you listen to television news, you might get the impression that the Fed sets interest rates. It does not. It influences them, with greater or lesser success at different times.

Figure 25.3 "Target and Actual Federal Funds Rate, 1971–2005" shows the monthly target and actual federal funds rate between 1971 and 2008. From this picture, it is evident that the target and actual federal funds rates move together. We can conclude that the first stage of the monetary transmission mechanism is reliable. The Fed can influence the federal funds rate. So far so good—at least for this period of time. As we shall see later, when we consider more recent events, the Fed was much less successful in targeting the federal funds rate during the periods of financial distress in 2007 and 2008.

Figure 25.3 Target and Actual Federal Funds Rate, 1971–2005

The target and actual federal funds rates move closely together.

From Short-Term Interest Rates to Long-Term Interest Rates

The next question is, do movements in the federal funds rate lead to corresponding movements in long-term interest rates? By “long-term,” we mean the rates on assets that have a maturity of at least 1 year and, in particular, assets that have a maturity of 5 years, 10 years, or even longer. ArbitrageThe act of buying and then selling an asset to take advantage of profit opportunities. among different assets means that annual interest rates on assets with different maturitiesThe term in which an asset comes due. are linked. As a result, the actions of the Fed to influence short-term rates also affect long-term rates.

Figure 25.4 "Short-Term and Long-Term Interest Rates" shows the relationship between the federal funds rate and longer-term interest rates. Broadly speaking, these long rates move with the federal funds rate. But it is also clear that the longer the horizon on the debt, the less responsive is the interest rate to movements in the federal funds rate.

This is one of the difficulties faced by the Fed: it can target short-term rates very accurately, but its influence on long-term rates is much less precise. Since—as we shall see—many economic decisions depend on long-term rates, the Fed’s ability to influence the economy is imperfect. Some writers have suggested that the Fed is an all-powerful organization that can move the economy around on a whim. There is no doubt that the Fed wields a great deal of power over the economy. Nevertheless, the Fed’s influence is substantially limited by the fact that it cannot control long-term interest rates with anything like the same precision that it brings to bear on the federal funds rate.

Figure 25.4 Short-Term and Long-Term Interest Rates

The Fed’s ability to influence long interest rates is much more limited than its ability to affect short rates.

From Nominal Interest Rates to Real Interest Rates

So far in this section, we have been considering nominal interest rates, but we know that the decisions of firms and households are based on real interest rates. The link between nominal and real interest rates is given by the Fisher equation:

real interest rate ≈ nominal interest rate − inflation rate.

To use this relationship, we simply subtract the inflation rate from the nominal interest rate. So if the nominal interest rate were 15 percent, as it was in the early 1980s, and the inflation rate were 12 percent, then the real interest rate would be 3 percent. But if the inflation rate were higher—say, 18 percent—then the real interest rate would be minus 3 percent.

The toolkit reviews the derivation of the Fisher equation.

Figure 25.5 "Real and Nominal Interest Rates" shows the nominal and real rates of return for a one-year Treasury bond. Because inflation is positive, the nominal interest rate exceeds the real rate. The figure shows that the nominal and real rates typically move closely together. In the early 1980s, for example, the real interest rate was negative. Presumably when households lent money in the early 1980s, they did not expect a negative return on their saving but instead expected that the nominal interest rate would exceed the inflation rate. From that perspective, the negative real interest rate is a consequence of higher than anticipated inflation.

The Fed’s ability to influence longer-term nominal rates through its influence on the federal funds rate apparently extends to the real interest rate as well. The connection is not perfect, however. On some occasions, movements in nominal rates are decoupled from movements in real rates.

Figure 25.5 Real and Nominal Interest Rates

Changes in nominal interest rates generally lead to changes in real interest rates, but the link between the two is imperfect.

From Real Interest Rates to Spending on Durable Goods

Real rates of interest influence spending by both households and firms. The main categories of purchases that are affected by interest rates are as follows:

• Investment spending by firms
• Housing purchases by households
• Durable goods purchases by households

What do these have in common? In each case, the purchase yields a flow of benefits that extends over some significant period of time. If a firm builds a new factory or purchases a new piece of machinery, it typically expects to be able to use that plant and equipment for years or decades. When a household buys a new home, it expects either to live there for a long time or else to sell it to someone else who can live there. If you buy a durable good such as a new car or a refrigerator, you expect to obtain the benefits of that purchase for several years.

Figure 25.6 "Real Interest Rates and Spending on Durable Goods" shows the relationship between the real interest rate and spending on durable goods. The higher the real interest rate is, the lower is the amount of spending on durable goods. Of course, the relationship need not be a straight line; we have just drawn it this way for simplicity. As you might imagine, monetary policymakers are very interested in the exact form of this relationship. They want to know exactly how big a change in durable goods spending is likely to follow from a given change in interest rates.

Figure 25.6 Real Interest Rates and Spending on Durable Goods

At higher interest rates, firms are less likely to borrow for investment projects, and households are less likely to borrow to purchase housing and durable goods such as new cars. Thus spending on durable goods is lower at higher interest rates and vice versa.

Discounted Present Value and Spending on Durable Goods

To understand in more detail why interest rates affect spending on durable goods, consider the purchase of a machine by a firm. Firms carry out such investment spending because they expect the machine to yield a flow of profits not only in the present but also for several years into the future. A machine is a capital good; it is used in the production of other goods and is not used up during the production process. The fact that the returns from the machine accrue over several years is what we mean by the term durable.

2. in the ratio of 12 per centum, or in such other ratio as the Board may prescribe not greater than 14 per centum and not less than 8 per centum, for that portion of its total transaction accounts in excess of $25,000,000, subject to subparagraph (C) [which stipulate that the reserve requirements could be changed]. Suppose the Fed were to increase the reserve requirement from 10 percent to 20 percent. In the previous example, all else being the same, a bank with deposits of$1,000 would be required to have at least $200 on deposit, rather than the$100 that was required originally. To fulfill this larger reserve requirement, the bank would be allowed to lend only $800 at most. Banks therefore respond to an increase in the reserve requirement by holding a larger fraction of deposits on reserve and lending out a smaller fraction of their deposits. This reduces the supply of credit in the economy since a smaller fraction of saving is actually being lent. As shown in Figure 25.22 "An Increase in Reserve Requirements", the supply of credit shifts inward, and the interest rate increases. This picture is exactly the same as Figure 25.21 "An Increase in the Discount Rate". When we think about the credit market, the increase in the discount rate and the increase in the reserve requirement have the same effect. Thus we learn that the Fed can increase interest rates by increasing the reserve requirement. Often, increases in the reserve requirement are coupled with other measures, such as open-market operations, to increase interest rates. A decrease in the reserve requirement works in a symmetric fashion, though in the opposite direction. Figure 25.22 An Increase in Reserve Requirements An increase in reserve requirements reduces the supply of credit and therefore increases the real interest rate. Key Takeaways 1. Banks act as intermediaries, taking the deposits of households and making loans to firms and households who wish to borrow. Banks also borrow from other banks and from the Fed. 2. The main tools of the Fed are as follows: (a) open-market operations, (b) lending at the discount rate to member banks, and (c) setting the reserve requirements on member banks. Checking Your Understanding 1. Can a bank borrow from the Fed? 2. What are reserve requirements? 3. In an open market sale, does the money supply increase or decrease? 25.6 The Fed in Action Learning Objectives After you have read this section, you should be able to answer the following questions: 1. What monetary policy did the Fed pursue during the Great Depression? 2. Why is stabilization of the economy through monetary policy so difficult? We finish this chapter by going back to the actual actions of the Fed and focusing on two periods. First, we consider the Great Depression from a monetary perspective.Chapter 22 "The Great Depression" discusses that period in more detail and pays more attention to fiscal policy. Then we consider the period leading up to the February 2005 announcement. The Great Depression Revisited The Fed was in fact not very active during the Great Depression (some commentators might even say that this section should be titled “The Fed Inaction”). Yet monetary events were still critical. A key short-term interest rate at that time was the so-called commercial paper rate. This rate decreased from about 6 percent in 1929 to a low of 0.8 percent by 1935. At first glance, therefore, it seems as if the monetary authority was implementing cuts in interest rates that could stimulate the economy. On closer examination, however, the picture is not so simple. During the Great Depression the inflation rate was negative—prices were decreasing on average. From the Fisher equation, a negative inflation rate means that the nominal interest rate understates the cost of borrowing. Decreasing prices mean that the nominal interest rate is smaller than the real interest rate. Even though nominal interest rates were decreasing in the early 1930s, the inflation rate was decreasing faster. As a result, the real interest rate increased. It became more expensive for households and firms to borrow, so spending decreased. When prices decrease, the obligations of borrowers increase in real terms. People at the time did not typically anticipate these decreasing prices, so there was unanticipated deflation. Unanticipated deflation redistributes wealth from borrowers to lenders. Many firms, banks, and households were left with large (real) debts during the Great Depression. These led to bankruptcies and contributed to the contraction in economic activity. Thus along with the high real interest rates came a series of bank failures. In addition, banks tended to hold more in excess reserves during this period, and thus loans, relative to deposits, decreased. These banking problems meant that the financial markets became less effective at connecting the savings of individual households with the investment plans of firms. It is perhaps not surprising that investment and spending on consumer durable goods decreased so much during the Great Depression. In retrospect, the monetary authority could have been much more aggressive in dealing with the high real interest rates. They could have conducted open-market operations, buying bonds and decreasing interest rates. At the same time, this would have provided additional funds (sometimes called liquidity) to the banking system. Yet the Fed did not do so. Many observers now think that the severity of the Depression can be blamed in large part on these failures of the Fed. If so, this is good news, for it tells us that we are much more likely to be able to avert similar economic catastrophes in the future. Monetary Policy from 1999 to 2005 Here is a brief summary of the target federal funds rate over the period from June 1999 to May 2005. Remember that these are nominal interest rates. • Starting in June 1999, the target federal funds rate increased from 4.75 percent to 6.5 percent by January 2001. • Starting in February 2001, the target federal funds rate decreased from 6.5 percent to a low of 1 percent by July 2004. • In August 2004 the target federal funds rate was increased to 1.25 percent and was increased steadily to a level of 2.75 percent by May 2005. We have already examined these targets, together with the actual federal funds rates, in Figure 25.3 "Target and Actual Federal Funds Rate, 1971–2005". The time of tighter monetary policy, from June 1999 to January 2001, was a period of inflation concern. In the first part of 1999, the inflation rate averaged about 2 percent, and the unemployment rate was decreasing, reaching 4 percent in May 1999. Even though inflation was low, the Federal Open Market Committee (FOMC) statement from June 1999 called for an increase in the target federal funds rate, pointing to potential inflation as a rationale for increasing the target rate: “The Committee, nonetheless, recognizes that in the current dynamic environment it must be especially alert to the emergence, or potential emergence, of inflationary forces that could undermine economic growth.”Federal Open Market Committee, “Press Release,” Federal Reserve, June 30, 1999, accessed August 8, 2011, http://www.federalreserve.gov/boarddocs/press/general/1999/19990630/default.htm. The Fed’s tightening had the effect of reducing durable spending and thus bringing gross domestic product (GDP) down closer to potential output. As a consequence, there was less pressure on prices. This policy continued through January 2001. By that point, the United States was very close to recession. (According to the National Bureau of Economic Research Business Cycle dating group, a recession began in March 2001.) From December 2000 to January 2001, the unemployment rate jumped from 3.7 percent to 4.7 percent. The Fed responded by allowing the federal funds rate to decrease steadily, starting in February 2001. This policy led to a federal funds rate of 1 percent by July 2003, a level that was maintained for a year. Historically, this was a very low rate. Over the year, inflation averaged about 2.3 percent, so the real federal funds rate was actually negative. A turnaround in Fed policy occurred in August 2004. Inflation had started to increase somewhat in early 2004, and the unemployment rate had decreased to 5.3 percent in May 2004. So in August 2004, the Fed started a gradual increase of the target federal funds rate. Look back at Figure 25.4 "Short-Term and Long-Term Interest Rates". Recall that part of the monetary transmission mechanism is the link between the nominal federal funds rate, which is very short term, and much longer-term rates. Figure 25.4 "Short-Term and Long-Term Interest Rates" shows the federal funds rate along with the 1-year and 10-year Treasury bond yields. The loosening of monetary policy in February 2001 is evident from the decrease in the federal funds rate and the 1-year Treasury rate. But the long-term Treasury rate seems not to follow the short-term rates that closely. In fact, it seems that the long-term rates started to decrease before the reductions in the federal funds rate began, and then the long-term rates did not decrease nearly as much over the February 2001–August 2004 period. After that time, although the federal funds rate was increased, the long-term rate did not respond much at all. This reminds us of one the biggest challenges of monetary policy. Although the Fed is able to closely target the federal funds rate, it has much less ability to control longer-term rates. Someone making a loan for a long period of time will try to anticipate economic events over the course of the entire loan period. As a consequence, the loan rate may reflect anticipated events (such as the Fed’s loosening of monetary policy in February 2001) and may also not respond as much to rate changes that are seen as temporary. Why Do Central Bankers Get Paid So Much? We have made monetary policy look easy. The effects of the actions of the monetary authority are summarized by Figure 25.2 "The Monetary Transmission Mechanism". Given a choice of a target inflation rate and a target level of economic activity, the Fed (and other central banks) ought to know exactly what to do to reach these goals. So why are central bankers so vital to the functioning of the macroeconomy? What Is the State of the Economy? In Section 25.3.3 "Closing the Circle: From Inflation to Interest Rates", we described the Taylor rule as relating the target federal funds rate to the state of the economy, specifically the inflation rate and the output gap. As a matter of theory, this is straightforward to describe. The practice is rather harder. First, it is a significant challenge simply to know the current state of the economy. In the United States, part of the preparation for FOMC meetings is an attempt to figure out the current output gap and other variables. The Board of Governors of the Federal Reserve has a large staff of professional economists, as do the various regional Federal Reserve banks. These economists spend much of their time helping the members of the FOMC understand the current state of the economy. One particular problem is that the level of real GDP itself is calculated only on a quarterly basis. Potential GDP, meanwhile, is a theoretical construct that requires some guesses about “full employment.” It is not directly measured. So if the Fed learns that real GDP is growing rapidly, it has to judge whether this is because potential GDP is growing rapidly or because actual GDP is above potential. Since the Fed does not meet to determine policy each day and the Fed’s policies themselves take time to work through the economy, it is not even enough to know the current state of the economy. The FOMC must also forecast the state of the economy for the near future. One talent of the previous Fed chairman, Alan Greenspan, was apparently his use of relatively unorthodox sources to get a sense of the state of the economy. What Are the Effects of Monetary Policy? Even if there were no uncertainty about the current state of the economy—that is, the inflation rate and the output gap—monetary policy is still difficult for other reasons. First, as we emphasized earlier, the Fed does not have direct control over the long-term real interest rates that matter for durable goods spending. The Fed can influence a short-term nominal rate, which in turn influences the long-term real rates. But the exact link from one interest rate to the other is not known by the Fed and may change over time. The Fed may fail to achieve the long-term rate that it is aiming for. Second, the Fed does not have perfect knowledge of the monetary transmission mechanism. Consider again the links between real interest rates and output, as shown in Figure 25.10 "The Relationship between the Real Interest Rate and Real GDP". In reality, the Fed does not know exactly what the relationship between interest rates and output looks like. Reality looks more like Figure 25.23 "Controlling the Economy". In this picture the Fed is aiming for a high level of output. However, it misses its target real interest rate and actually ends up setting a higher real rate than it wanted. In addition, real GDP is more sensitive to interest rates than it thought, so the high rate leads to a big reduction in GDP. Thus because the Fed fails to achieve its target interest rate and also misjudges the monetary transmission mechanism, it ends up with much lower real GDP than it wanted. Finally, the Fed has imperfect knowledge of the link between economy activity and price adjustment. Recall that the price setting equation stipulates that inflation depends on the output gap and something called autonomous inflation. As we have seen, this last term captures several factors, including the influence of expectations about the future on current price-setting behavior. This presents a double challenge to the Fed. First, to evaluate the effects of its policy on prices, the Fed needs to know the expectations that underlie autonomous inflation. Second, the Fed must recognize that its actions and statements influence these expectations. This is why the individuals involved in the making of monetary policy are so careful both about what they do and about what they say about what they do. Figure 25.23 Controlling the Economy The Fed’s ability to control the economy depends on how knowledgeable it is about the state of the economy and on how accurately it can target interest rates. What Should the Fed Do When Its Goals Are in Conflict? We know that the goals of the Fed include price and output stability. Sometimes these goals conflict, and when they do, the task of central bankers becomes even more complicated. The FOMC statement with which we opened this chapter stated that the “Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal.” But what if instead it had said the “Committee perceives the risks of low output growth and high inflation for the next few quarters to be roughly equal”? What would the appropriate monetary policy be in this case? Should the Fed use its power to stabilize prices or to promote economic activity? The tension is evident from the Taylor rule. Here is an example: the target real interest rate increases when inflation is high and decreases when the output gap is high: real interest rate = −(1/2) × (output gap) + (1/2) × (inflation rate − 4 percent). Remember that a positive output gap means that that the economy is in a recession: actual GDP is below potential. When the economy is in recession and inflation is not very high, the Taylor rule says that the Fed should reduce the real interest rate. And—from this same rule—the Fed should increase the real interest rate in the face of high inflation and a negative output gap. But what should the Fed do when inflation is high and there is a recession? High inflation argues for increasing real interest rates, but a positive output gap argues for a cut in rates. The Fed—and, indeed, monetary authorities throughout the world—faced exactly this conflict in the mid-1970s when oil prices increased substantially as a result of actions by the Organization of Petroleum Exporting Countries. Researchers who have examined data over the past three decades have found that an increase in oil prices is typically met with an increase in the federal funds rate.The following discussion elaborates on the Fed’s response to oil price increases: Federal Reserve Bank of Cleveland, accessed July 20, 2011, http://www.clevelandfed.org/Research/inflation/Readingroom/Viewpoint/2005/oil-prices-economy04-05.cfm. A speech by then Fed Governor Ben Bernanke in 2004 provides more details: “Remarks by Governor Ben S. Bernanke at the Distinguished Lecture Series, Darton College, Albany, Georgia,” Federal Reserve, October 21, 2004, accessed July 20, 2011, http://www.federalreserve.gov/boardDocs/speeches/2004/20041021/default.htm. Thus, when faced with conflicting goals stemming from an oil price increase, the Fed seems to have put more weight on the goal of price stability. When Things Go Badly Wrong Everything that we have talked about in this section helps to explain why central bankers must be skilled and knowledgeable individuals with a good grasp of both economics and the workings of financial markets. Still, we have essentially been describing the job of a technocrat. Central bankers really earn their salaries in abnormal rather than normal times. Starting in 2007 and stretching well into 2008, the United States and other countries began to experience financial crises that were similar in some ways to those experienced in the Great Depression.The financial crisis of 2008 is discussed in Chapter 19 "The Interconnected Economy" and Chapter 30 "The Global Financial Crisis". The crisis seemed to begin innocently enough, with a decrease in housing prices that left some people unable or unwilling to cover their mortgage payments. But because of the way financial markets work, it became very hard for lenders to work out which of their assets were “nonperforming”—that is, unlikely to be repaid. As a result, financial markets froze up. Part of the Fed’s response was an aggressive use of the tools that we have described in this chapter. For example, the Fed reduced the federal funds rate down to 0.25 percent. At that point, the Fed had just about reached the limit of what was possible with monetary stimulus. The problem is that nominal interest rates cannot go below zero because cash has a nominal interest rate of zero. If you keep a dollar bill from this year to next year, it is worth$1 next year. Therefore it would always be better just to keep cash rather than invest in an asset with a negative nominal return. The Fed had hit what is known as the zero lower boundThe fact that the Fed cannot push nominal interest rates below zero..

Even though it was at the zero lower bound, the Fed still had other options. In normal circumstances, it operates in the economy by buying and selling short-term government debt, one of the many assets in the economy. But these were highly abnormal circumstances, and it is possible for the Fed to buy and sell other assets as well. This is what the Fed did. During the crisis, the Fed started purchasing many other assets, such as commercial paper. In other words, instead of just lending to banks, the Fed started lending directly to firms in the economy. Central banks in some other countries, such as the United Kingdom, pursued similar policies.Explaining what happened in 2008 involves understanding the actions of the Fed, but it requires many of our other tools as well. For that reason, we take up this crisis in more detail in Chapter 30 "The Global Financial Crisis".

Key Takeaways

1. Despite the large reduction in aggregate economy activity and deflation during the Great Depression, the Fed did not pursue a very aggressive policy. The effectiveness of the Fed was hampered by the unwillingness of households to deposit funds in banks and the unwillingness of banks to make loans.
2. The conduct of monetary policy is made difficult by uncertainty over the current state of the economy and the inexact nature of the effects of interest rates on real GDP and prices.

1. In what ways was the Fed not very aggressive during the Great Depression?
2. How could the goals of the Fed be in conflict?
3. Does the Fed know the current state of the economy when it makes decisions?

25.7 End-of-Chapter Material

In Conclusion

A driving analogy is sometimes used to illustrate the problems of the Fed. In the best of all worlds, we would drive a car in perfect weather along straight, wide, dry roads. We would look out crystal clear windows with complete knowledge of exactly where we are on the road and what driving conditions are like up ahead. Then, with complete control over the car, we could adjust speed and direction to reach our destination.

This is not the right picture for monetary policy. Instead, the windshield is very dirty, obscuring current conditions and making predictions almost impossible. Although the driver is well trained, the connection between the tools of the car and its direction and speed is haphazard.

Suppose the driver sees a steep downhill in the distance that requires some slowing down. Putting on the brakes will eventually slow the car down, but the delay is hard to predict. Making matters worse, by the time the car slows, the road may be going uphill again.

More precisely, the first challenge for the Fed is determining the current state of the economy. The Fed must rely on economic data to determine the current state of the economy. This is not easy; data often arrive with lags and with measurement error. Furthermore, the data often provide conflicting signals about the current state of the economy.

The second challenge for the Fed is that the transmission mechanism is not cast in stone. Reducing real interest rates by, say, one percentage point does not create the same response in spending at all times. Instead, the links in the monetary transmission mechanism change over time and depend on numerous other variables in the economy. Understanding these links remains a key area of research in economics and is also a challenge for those responsible for the conduct of monetary policy.

Exercises

1. Have you ever noticed that banks are often housed in big imposing buildings? Why do you think this is the case?
2. Consider a Taylor rule given by

real interest rate = −(1/2) × (output gap) + (1/2) × (inflation rate − 4 percent).
1. Describe this rule in words. What is the target inflation rate in this rule?
2. If the inflation rate is 6 percent and the GDP gap is −2 percent, what should the real interest rate be? What nominal interest rate should the Fed set?
3. (Advanced) Draw a version of Figure 25.15 "The Taylor Rule" where you show how to relate the target interest rate to the output gap. Explain in words what it means to move along the curve. What shifts the curve you have drawn?
4. What would happen if the Fed set the discount rate below the rate of return on government bonds?
5. Do open-market operations have to be in the form of the Fed buying and selling government debt? Could an open-market operation occur with the Fed buying the stock of a company?
6. Explain why an increase in interest rates reduces the demand for durable goods.
7. Suppose the relationship between investment and interest rates is investment = 100 − 4 × real interest rate and suppose the multiplier is 2. If the interest rate decreases by one percentage point, what happens to real GDP (assuming no change in the price level)?
8. Give two reasons why it is difficult to conduct monetary policy.
9. Suppose the central bank in country A is more worried about inflation than the output gap, but the opposite is true in country B. What differences in the Taylor rule would you expect to see in the two countries? Must it be the case that country A has a lower target inflation rate than country B?
10. Explain why a positive output gap does not necessarily lead to decreasing prices.

Economics Detective

1. Find the most recent announcement of the Federal Open Market Committee (FOMC). How does it differ from the one from February 2, 2005? Who is currently on the FOMC?
2. Use the site http://www.hsh.com/calc-payment.html to calculate how your monthly payment would change as you vary the interest rate charged on a car loan for a \$30,000 car. This will give you a sense of how actions of the Fed would affect your monthly payments on a loan.
3. Find the names of five other central banks in the world economy. Find some information about their history (when were they established, for example), their design (are they independent?), and their operating procedures.
4. Find the web page for the Board of Governors of the Federal Reserve System and read about the tools of monetary policy. Based on your reading, (a) how often does the FOMC meet, and (b) how is its membership determined?
5. If you live in the United States, find the web page for the regional Fed closest to you. Try to find its most recent report on local economic conditions. Do you agree with this assessment of the local economy? What can you learn about the president of the regional Fed? What about the director of research, who is the staff member most likely to give advice to the president of the regional Fed about monetary policy?
6. Using your web research skills, find a discussion of Fed policy during times of high oil prices. How did the Fed resolve the tensions between increasing rates to combat inflation and decreasing rates to deal with unemployment? Try to find data on (real) oil prices and the federal funds rate. Did these two economic variables move together during periods of high oil prices?
7. In March 2008, the Fed opened the discount window to add liquidity into the financial system. Find the policy statements associated with this action and describe exactly what the Fed did.
8. Get data on the US economy to see how well the Taylor rule,

real interest rate = −(1/2) × (output gap) + (1/2) × (inflation rate − 4 percent),

fits the facts for the past five years.

9. Find an occasion when the Fed has changed reserve requirements. Did it also make other policy adjustments at the same time?