Chapter 18. Conduct of Monetary Policy

1. Chapter 18. Conduct of Monetary Policy • Goals of monetary policy • Using targets • A History of monetary policy • Policy Rules

2. I. Goals • desirable goals for the economy • Fed uses monetary policy to achieve these goals • directly control tools, to influence goals

3. High employment • i.e., low unemployment • federal government has a commitment to full employment • goal: natural rate of unemployment • about 4-5% • today: 5.1% (3/05) • 7.7% in Oswego Co.

5. Economic Growth • annual % change in real GDP • U.S. long run average -- 3% • 2004 GDP growth 4.4%

7. Price stability • i.e., low inflation • annual % change in CPI • primary goal of Fed since 1980s • how high is too high? • over 4% • goal: 2% or less • 2004

10. tradeoff • between price stability & economic growth • controlling inflation can mean slowing down economic growth

11. Financial Market Stability • stability of financial institutions • stability of interest rates • stability of exchange rates • Fed stabilized markets • October 1987 • Summer 1998 • September 2001

12. II. Using targets • Fed directly controls tools (like OMO), not goals • it can take a year for tools to impact the goals • how to gauge progress in between?

13. tool (OMO) operating target intermediate target Targets • related to tools and goals • used by Fed to judge if they are on track goal

14. operating targets • respond immediately to changes in the tools • examples • bank reserves • FF rate • Tbill rate

15. intermediate targets • affected by operating target • closely associated with goals • examples • M1, M2 or M3 • prime rate • Tnote or Tbond yields

16. example • Fed wants 5% nominal GDP growth • intermediate target 4% M2 growth • operating target 3% MB growth • conduct open market purchases to increase MB by 3%

17. effective targets • frequently and accurately measured • controllable by the Fed • predictably related to goals

18. 2 types of targets • monetary targets • reserves, MB • M1, M2, or M3 • interest rate targets • FF rate • other short or medium-term rates

19. target tradeoff • Fed can target money supply OR interest rates • NOT BOTH! • why?

20. i MS i’’ MD’’ M M* • suppose Fed targets M* for MS:

21. i MS i’’’ i’’ MD’’’ i’ MD’’ MD’ M M* • but as MD fluctuates, i will change:

22. i MS i’’’ i’’ MD’’’ i’ MD’’ MD’ M M* • so if target M*, lose control of i

23. i MS i* MD’’ M M’’ • suppose Fed targets i*

24. i MS MS’ MS’’’ i* MD’’’ MD’’ M MD’ M’’ M’ M’’’ • but as MD fluctuates, Fed must shift MS to maintain i*

25. i MS MS’ MS’’’ i* MD’’’ MD’’ M MD’ M’’ M’ M’’’ • Fed targets i*, lose control of M

26. Targets • If Fed targets MS, loses control of interest rates • If Fed targets interest rates, loses control of MS

27. III. A History of Fed Policy • Early years (1913-1929) • The Great Depression • WWII • 1950s, 60s • 1970s • 1979-82 • 1982-92 • 1992-present

28. The Early Years • 1913-1929 • main tool: discount loans • real bill doctrine • use discount loans for production loans • result: inflation

29. cut back on discount loans • recession/deflation 1920-21 • discovered OMO in 1920s • make up for lost revenue from discount loans by holding Treasuries

30. The Great Depression • Fed failed to act as lender of last resort and prevent bank failures 1930-33 • why? • initial failures were small banks • Fed failed to recognize domino effect on larger banks & economy

31. mid 1930s • recovering from GD but • Fed increases reserve requirement -- recession 1937-38

32. 1942-51 • during WWII Fed targeted Tbill rate • kept rate low to help finance war • large MS growth -- but price controls kept inflation low • post WWII inflation • Fed abandoned Tbill rate target

33. 1950s - 1960s • targeting “money market conditions” • short term interest rates • free reserves = excess reserves - discount loans • result: procyclical monetary policy • MS rose during expansions, fell during recessions.

34. interest rate rise income rises MD rises ER decline DL rise FR decline Fed increases MB increase MS Why? • chain reaction: economic expansion

35. procyclical money growth is not a good thing • rapid MS growth in expansion leads to inflation • slow MS growth in recession makes it worse

36. MS should be countercyclical • “lean against the wind” • keep inflation under control • help prevent or end recessions

37. 1970s • Fed announces target of money aggregates (M1, M2) • but FOMC targets both aggregates & FF rate -- cannot do both • Fed really targeting FF rate, & MS growth still procyclical

38. Fed criticized in 1970s for failure to control inflation • energy crisis of 1973-74 did not help

39. 1979-82 • inflation over 10% by 1979 • Paul Volcker • target nonborrowed reserves • reserves - discount loans • slow MS growth to bring down inflation • large interest rate fluctuations

40. recession 1981-82 • “Volcker recession” • inflation below 4% by 1982 • signaled change at Fed • price stability # 1 goal • fight inflation inflation before it gets to be a problem

43. 1982-92 • targeting “borrowed reserves” or interest rates • procyclical policy • stopped setting targets for M1, M2 • Alan Greenspan 1987 • intervened 1987 crash • slow to act for 90-91 recession

44. exchange rate markets • $ too high • Fed, with other central banks intervened to bring $ down

45. 1992 - present • 1990s longest expansion in U.S. history • announced FF rate target 1994 • 1994-95 “soft landing” • prevent rising inflation by increasing FF rate

46. 1994 exchange rates • this time Fed intervened for a $ that was too low • 1998 Russian debt/ Asia crisis • lower FF rate to keep U.S. economy expanding

47. 1999-2000 • Fed hiked FF rate to prevent inflation • 2000-2001 • Fed reversed FF rate hikes as economy slowed • 2002-present • FF rate targets have slowly risen • but not LT rates

48. IV. Policy Rules • how to choose a target for monetary policy? • how to respond to changing economic conditions?

49. The Taylor Rule • John Taylor • equation • FF rate target based on -- current inflation -- inflation target -- gap between actual GDP & full employment GDP

50. LR FF rate FF rate = inflation + + .5(inflation gap) + .5(output gap) Taylor rule • Fed responds to both • price stability • business cycle