Federal Monetary Policy Goals: Dual Mandate, Price Stability, High Employment, Economic Growth

2. Fed Monetary Policy Goals - Dual Mandate (inflation, employment) 1.Price Stability - inflation erodes value of $ as medium of exchange & unit of account. Problems: a) Prices less useful as signals for resource allocation. b) Uncertain prices complicate households & firms decisions. c) Arbitrarily redistribute income. d) Hyperinflation can severely damage econ’s productive capacity. 2. High Employment - unemployment ↓ GDP & causes fin & personal distress. Congress & POTUS responsible for high employment. Frictional & structural or natural unemployment (5-6%) - monetary policy ineffective. Fed focused on cyclical unemployment = f(business cycle). 3. Economic Growth- GDP ↑ over time = f(high employment). The only source of sustained real increases in household incomes. High unemployment => unused productive capacity & investments less likely. Stable econ growth allows accurate planning & stimulates long-run investment. 4. Stabile Fin Markets & Institutions- inefficient fin system => econ loses resources. Fed underestimated fin crisis severity, couldn’t avoid 2007-09 deep recession. 2007-09 recession made fin stability (asset bubble deflation) more important. 5. Interest Rate Stability - help stabilize fin system & planning 6. For-Ex Market Stability - help transactions planning & international competitiveness. Treasury originates & Fed implements for-ex policy changes.

3. Monetary Policy Tools & Federal Funds Rate Traditional policy tools are: 1.Open market operations (Fed’s securities usually Treasuries trading) 2.Discount policy (setting discount % & discount lending terms, for banks liquidity) 3.Reserve requirement (% of checkable deposits held as vault cash or Fed deposits) During fin crisis Fed introduced two new tools connected with bank reserve accounts: 1.Interest on reserve balances (Complaint: no interest on reserve deposits = tax. By ↑ % it pays, Fed can ↑ banks’ reserve holdings, potentially ↓ landing & money supply. ) 2.Term deposit facility (Similar to CDs, Fed offers them to banks in periodic auctions. Rates slightly above rate Fed pays on reserve balances. The more banks buy the less available to expand loans. E.g. in October 2010 Fed auction $5B 28-day term deposits w/ 0.27%, while rate on reserve deposits was 0.25%.) Federal funds % banks charge each other on very short-term loans is function of demand (banks determined) & supply for reserves (Fed determined). The target for federal funds rate is set at FOMC meetings.

4. Equilibrium in Federal Funds Market Equilibrium reserves (R*) & federal funds rate (i*ff) at intersection of demand for reserves (D) & supply for reserves (S). Fed determines reserves (R), discount % (id) (iff ceiling: borrow from banks/Fed if iff </= id, S horizontal) & % on banks’ reserves at Fed (irb) (floor for iff : arbitrage if iff < irb, D horizontal). S vertical because supply of reserves independent of federal funds rate due to Fed’s control over reserves. Home mortgage & corporate bond rates move w/ federal funds rate.

5. Effects of Open Market Operations on the Federal Funds Market Sales Raise Federal Funds % Supply curve shifts left (S1→S2). Equilibrium reserves ↓ (R*1→R*2) while equilibrium federal funds % ↑ (5→5.25%). Discount % also ↑ (6→6.25%). Purchases Lower Federal Funds % Supply curve shifts right (S1→S2). Equilibrium reserves ↑ (R*1→R*2) while equilibrium federal funds % ↓ (1.5→1%). Discount % also ↓ (1.75→1.25%).

6. The Effect of Changes in the Discount Rate and in Reserve Requirements Changes in the Discount Rate Since 2003 Fed kept discount rate > target for the federal funds rate. So, discount rate is penalty rate, as banks pay a penalty when borrow from Fed rather than other banks. Changes in the Required Reserve Ratio Fed rarely changes required reserve ratio. Likely combined w/ offsetting open market operations to keep target federal funds rate unchanged.

7. Analyzing the Federal Funds Market Use graphs for federal funds market to analyze the following two situations: How can Fed offset ↓ in bank demand for reserves to keep equilibrium federal funds % =. Assume equilibrium federal funds % = % Fed pays on reserves. Show effect of open market purchase on equilibrium federal funds %.

8. Open Market Operations Open market purchase ↑ Treasuries prices & ↓ their yield (interest %), ↑ both monetary base & money supply - expansionary policy. Open market sale is contractionary policy. Economists generally supported the 1st round of quantitative easing but the 2nd & 3rd rounds in Nov. 2010 & Sep. 2012 were controversial. Opponents: monetizing national debt ↑ risk of inflation w/o effectively stimulating growth. Supporters: like traditional open market purchases (↓ federal funds %) to stimulate econ. However, since federal funds % ≈ 0, it ↑ Fed’s balance sheet or the monetary base. Implementing Open Market Operations FOMC issues policy directive to Fed Reserve System’s account manager (NY Fed VP). Each morning, trading desk notifies primary dealers on size of trades & asks for offers. Dealers have just a few minutes to respond. Fed’s account manager accepts the best offers & trading desk trades until reserves reaches Fed’s desired goal. Dynamic open market operations change monetary policy as directed by FOMC (usually outright Treasuries trading w/ primary dealers). Defensive open market operations offset temporary fluctuations in reserves (↑ due to check clearing delays from snow or US government purchases), not to change monetary policy (usually repurchase agreements).

9. Why Can’t the Fed Always Hit Its Federal Funds Target? Fed sets target for federal funds %. Demand/supply for reserves determines actual %. NY Fed uses open market operations to keep actual & target federal funds % close. Open market operations give Fed control, flexibility & ease of implementation w/o administrative delays. Discount loans depend on banks’ willingness to request loans (not completely under Fed’s control). Changing discount % or reserve requirements takes longer. Fannie Mae & Freddie Mac (government agencies - major buyers of residential mortgages - frequently drive federal funds % below interest on reserve deposits. Why do banks lend in federal funds market when they could receive higher % by keeping deposit at Fed? Some fin institutions that can borrow/lend in federal funds market ineligible to receive interest on deposits with the Fed.

10. Discount Policy Since 1980, all depository institutions had access to discount window. Each Federal Reserve Bank maintains its own discount window, although all charge same rate. Categories of Discount Loans Primary credit available to healthy banks experiencing temporary liquidity problems. Secondary credit to banks that are not eligible for primary credit. Seasonal credit to smaller banks in areas where agriculture or tourism is important. Discount Lending during the Financial Crisis of 2007–2009 Initially fin crisis involved shadow banks, Fed’s problem - it typically lends to banks. Then Fed set up temporary lending facilities (↑ landing from few $100M to $993.5B): Primary Dealer Credit Facility:Loans for investment banks & large securities firms. Term Securities Lending Facility: For financial firms to borrow against illiquid assets. Commercial Paper Funding Facility:Direct purchased from firms to continue operations. Term Asset-Backed Securities Loan Facility (TALF):NY Fed extended 3 or 5 year loans to investors for purchase of asset-backed securities. Term Auction Facility: Auctioned discount loans at rate determined by banks’ demand.

11. Monetary Targeting and Monetary Policy Fed faces trade-offs to reach its goals (high growth & low inflation) & timing difficulties: Information lag is Fed’s inability to observe instantaneously changes in econ variables. Impact lag is time required for monetary policy affect output, employment or inflation. Possible solution to timing problems is to use targets (variables Fed can influence directly that help achieve monetary policy goals) to meet its goals. Although targets no longer favored approach, they provide insight into difficulties in executing monetary policy. Traditionally, the Fed has relied on two types of targets: • policy instruments or operating targets (variables Fed controls directly, e.g. federal funds % & nonborrowed reserves, that are related to intermediate targets) • intermediate targets (monetary aggregates or interest rates, use intermediate target to achieve goal outside its control better than if focused on goal & feedback)

12. What Happened to the Link between Money and Prices? In US money supply has grown more rapidly when inflation was relatively high. Prior to 1980, strong evidence supports short-run (1-2 yr) link between money & prices. Economists who argued this point most forcefully were known as monetarists. Paul Volcker’s Fed shifted its policy to emphasize nonborrowed reserves as a policy instrument. This episode of “The Great Monetarist Experiment” produced mixed results. Because short-run link between money supply & inflation broke down after 1980, due to changes in nature of M1 & M2, since 1993 Fed no longer announces M1 & M2 targets.

13. Choice between Targeting Reserves and Targeting Federal Funds Rate Fed uses three criteria when evaluating potential variables for policy instruments: 1. Measurable: In short time to overcome information lags. Both easily measurable. 2. Controllable:Open market operations keep both close to Fed’s target. 3. Predictable: Complexity of impact from change in either on econ goals is a problem. The main policy instruments are reserve aggregates (total or nonborrowed reserves) & federal funds rate. Fed can choose one but it cannot choose both. Using one as policy instrument will cause the other to response to changes in the 1st. By 1980s Fed concluded that link between federal funds % & its policy goals is closer. So, the federal funds rate has been the Fed’s policy instrument for the past 30 years

14. Choosing between Policy Instruments Fed chooses reserves as its policy instrument by keeping it constant at R*. If demand for reserves ↑ or shifts right (D1→D2), Fed has to ↑ supply of reserves (S1→S2) to maintain target for federal funds rate at i*ff. If demand for reserves ↑ or shifts right (D1→D2), equilibrium federal funds % ↑ (i*ff1→i*ff2).

15. The Taylor Rule: A Summary Measure of Fed Policy Fed deliberations are complex & incorporate many econ factors summarized in Taylor rule: monetary policy guideline for estimating target for federal funds % (after inflation adjustment) consistent with RGDP = potential RGDP in the long run. Federal Current Equilibrium Inflation gap Output gap funds = inflation + real federal + ---------------- + --------------- target funds % 2 2 Where inflation gap (current – target inflation) & output gap (% difference RGDP – potential RGDP) have the same ½ “weight” or influence on federal funds %. If inflation > Fed’s target rate, FOMC ↑ target federal funds%. If output gap is negative (RGDP < potential RGDP) FOMC ↓ target federal funds %. Historically, Taylor rule explains Fed policy reasonable well only during some periods.

16. Inflation Targeting Significant interest in inflation targeting as monetary policy framework before fin crisis. In 2010, the Fed announced that it would attempt to maintain an average inflation rate of 2% per year. Arguments in favor of an explicit inflation target: 1. It would draw attention to what Fed can actually achieve in practice. 2. It would provide an anchor for inflationary expectations. 3. It would help institutionalize effective U.S. monetary policy. 4. It would promote accountability. Arguments against an inflation target: 1. Rigid numerical targets for inflation diminish flexibility. 2. Reliance on uncertain forecasts of future inflation can create problems. 3. Difficult for elected officials to monitor Fed’s support for overall econ policy. 4. Future output & employment uncertainty impedes decisions in w/ inflation target.

17. International Comparisons of Monetary Policy Industrial countries’ central banks increasingly use short-term interest % as the policy instrument through which goals are pursued. Many central banks focus on ultimate goals (inflation) than intermediate targets. The Bank of Japan Used money growth targets & money growth after 1973 oil shock (inflation > 20%). Promises fulfilment gained public’s trust in commitment to ↓ money growth & inflation. Used short-term interest rate in Japanese interbank market as its operating target. Relied less on M2 aggregate after 1980s deregulation. Does not have formal inflation targets, although emphasizes price stability. Deflationary monetary policy in 1990s & 2000s significantly weakened economy. Began to stimulate both economic growth & inflation in mid-2000s. Intervened to ↓ soaring value ¥ against $, to stimulate exports and econ recovery. The German Central Bank (Bundesbank) Experimented with monetary targets in late 1970s to combat inflation. Used central bank money = weighted ∑ currency, checkable, time & savings deposits. Succeeded in maintaining its target ranges for M3 growth in early 1980s. West & East German currency differences had inflationary pressures after reunification. Used lombard rate (short-term repurchase agreement rate) to achieve its M3 target. Relinquished monetary policy to European Central Bank after 2002 introduction of €.

18. The Bank of Canada Gradually reduced M1 growth in early 1970s as inflation became a concern. Shifted its policy toward an exchange rate target in the late 1970s. Reinstated inflation commitment in 1988 (declining inflation & overnight rate targets). Focused on exchange rates reflecting importance of exports). Helped fin system avoid heavy losses suffered by many banks during 2007-09 crisis. The Bank of England Announced (but not pursued) money supply targets in response to late 1973 inflation. In response to 1970s inflation introduced (unachievable) deceleration of M3 growth. Shifted emphasis toward targeting monetary base growth beginning in 1983. Inflation targets in 1992 & short-term interest % primary instrument of monetary policy. Took several dramatic policy actions during fin crisis, cutting its overnight base rate. Rapidly lowered rate it paid on reserves, and engaged in quantitative easing. The European System of Central Banks (ECB + EU members’ central banks) Operates since 1999, modeled after Bundesbank, with price stability as its primary goal. Secondary objective to support general econ policies of European Union. Attaches significant role to monetary aggregates. Despite emphasis on price stability, not committed monetary or an inflation-targeting. Struggled monetary w/ policy for different needs of member countries during crisis. Received further strains in 2012 by intervening in Greece’s sovereign debt crisis.