The Federal Reserve System & You

1. The Federal Reserve System & You What’s its Mission, why did Congress seek to insulate it from political pressure and what can they teach us about the role of quasi-governmental entities in our economy?

2. The Federal Reserve System • The Federal Reserve, the Central Bank of the United States, provides the nation with a safe, flexible and stable monetary and financial system. The Federal Reserve System is made up of the Board of Governors of the Federal Reserve System (the Board) based in Washington D.C. and 12 Reserve Districts each of which is home to its own Federal Reserve Bank. • The Federal Open Market Committee (FOMC), comprised of 7 Governors and 5 Reserve Bank Presidents, meets regularly to set monetary policy. The FOMC is chaired by the Chairman of the Board but the President of the NY Fed is a permanent member of the FOMC and serves as its Vice Chairman.

3. Federal Reserve System (con’t) • The Governors are appointed by the President and confirmed by the U.S. Senate to a 14 year term and they have staggered terms that expire on 1/31 of each even year. • The Chairman and Vice Chairman are appointed to serve in their leadership role for a 4 year term, which is renewable. • The current Governors are Ben Bernanke (Chair), Janet Yellen (Vice Chair), Elizabeth Duke, Dan Tarullo, Sarah Bloom Raskin, Jeremy Stein and Jermone Powell.

4. Various Roles of the Fed • The Federal Reserve Board and the Federal Reserve System have several responsibilities: • First, through the FOMC it sets monetary policy and with the U.S. Treasury it can intervene to protect the U.S. Dollar in the Foreign exchange markets. (more on this later….) • Through the Reserve Banks it issues and delivers coin and paper currency to the U.S. and international banking system. Currently, over half of all US currency is held outside the United States.

5. Various Other Roles of the Fed • The Fed facilitates the auction of U.S. Treasury securities and operates a key interbank payment system (FedWire) and a key government securities settlement system (the Fed Book-Entry System). • Third, it acts as the supervisor of bank holding companies, foreign banks with US offices and so-called Fed member banks. More recently, as a result of the Dodd-Frank Act, it was also given the authority to regulate so-called systemically significant non-bank financial institutions (SSFIs). {Think AIG} • Lastly, it acts as the lender of last resort to stabilize the economy in a severe financial crisis involving “contagion” (Think of a pandemic flu but it impacting only banks) [More on this later….]

6. The Humphrey Hawkins Act (1978) • The current language governing the Federal Reserve's monetary policy objectives, as well as other requirements related to reporting and testimony before the Congress, is contained in the Full Employment and Balanced Growth Act of 1978 (often referred to as the Humphrey-Hawkins Act).

7. Federal Reserve Act: Section 2A. 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. • [12 USC 225a. As added by act of November 16, 1977 (91 Stat. 1387) and amended by acts of October 27, 1978 (92 Stat. 1897); Aug. 23, 1988 (102 Stat. 1375); and Dec. 27, 2000 (114 Stat. 3028).]

8. Are the Objectives Outlined in the FRA Mutually Consistent? • According to FRBSF President John C. Williams in a speech last Spring, “It’s often said that Congress assigned the Federal Reserve a dual mandate: maximum employment and stable prices.” • But, according to Williams that’s not quite accurate. In his view, the Fed has a triple mandate to maintain growth of money and credit consistent . . .“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.”

9. Competing Goals • According to Williams, these are desirable aspirations but Congress clearly failed to provide the Fed with enough specifics. Thus he asks, what does it mean to say “maximum” employment or “stable prices”? Is a 4 percent interest rate moderate? Six percent? Ten percent? Moreover, what do we do if these goals are in conflict with each other? • To answer these questions, he attempts to take a closer at each individual goal in turn.

10. Stable Prices • Taken literally, Congress call for “stable prices” would seem to imply that the Fed’s job is to freeze the costs of all goods and services. But, according to Williams that can’t be right. After all, prices fluctuate all the time in response to shifts in supply and demand. For example, a deep freeze in Florida sends orange juice prices soaring. Flat panel TV prices tumble as production becomes more efficient. These kinds of relative price movements are and should be beyond the control of a central bank like the Fed. The Fed really can’t do anything about the weather or the development of new TV manufacturing technologies. So what did Congress really have in mind?

11. Stable Prices • The Fed looks at price stability in an overall, or average, sense. They strive to make sure that the average prices of a comprehensive set of consumer goods and services don’t change much from month to month or year to year. The well-known consumer price index is one measure of average prices. • Next, Williams asks what is the appropriate rate of increase of average prices and whether the Fed should strive for no change at all, that is, zero inflation. He claims a small amount of inflation is good since it can help grease the wheels of the labor market. He cites evidence that nominal wages don’t easily fall even when demand is weak. This is a phenomenon economists call “downward wage rigidity.”

12. Price Stability & the Fed’s Target of 2 Percent Inflation • Williams also makes the case in his speech that a small amount of inflation gives the Fed a little more maneuvering room to respond to negative shocks to the economy. • He correctly points out that the Fed needs to stay away from a zero inflation environment because nominal interest rates can never go below zero. [This is sometimes called leaving yourself some “powder in the keg” i.e. extra gunpowder held in reserve in case the enemy attacks.] • The more the Fed can lower interest rates when appropriate, the more it can stimulate the economy and boost employment when needed. That helps them keep closer to their maximum employment goal. Research on this question has found that an inflation objective of 2 percent or higher generally provides plenty of maneuvering room for the Fed, except in the most severe recessions.

13. Maximum Employment • What about the second component of the Fed’s mandate—maximum employment? The dictionary defines “maximum” as “the greatest quantity possible.” Once again, Williams warns that the words in Section 2A should not be taken too literally. It’s absurd to interpret the law to mean that every man, woman, and child in the nation should be working three full-time jobs, 24 hours a day, 365 days a year! Child labor laws and the human needs for food, rest, and recreation make it plain that maximum employment must mean something far short of nonstop work. Nor does maximum employment suggest we should be aiming for an unemployment rate of zero.

14. Maximum Employment & the Phillips Curve • A more reasonable and practical interpretation is that maximum employment is the level that’s consistent with the other aspects of the mandate. To make this clear, Williams asks his audience to Imagine that the economy was stronger than it is today (say 10 percent growth) and that the rate of unemployment was low. What would happen if the Fed tried to stimulate the economy even further to drive employment even higher? It would be harder for employers to find and keep qualified workers. Employers would have to offer hefty increases in pay and benefits, driving up labor costs rapidly. And since labor costs make up around 60 percent of the cost of producing U.S. goods and services, employers would feel rising pressure to boost prices. And that would run smack into their mandate to promote stable prices.

15. Moderate Long Term Interest Rates • This third part of the Fed’s mandate, the injunction to promote moderate long-term interest rates, has receives the least attention of the Fed’s three mandates. According to Williams this neglect is justifiable because moderate long term rates are a natural byproduct of the price stability goal. To see this, it’s helpful to break down an interest rate into two parts: the inflation-adjusted, or real, rate; plus expected inflation. The Fed cant really influence the former but it sure can impact the latter.

16. The Dual Mandate • If the Fed succeeds in keeping inflation expectations low, then, all else being equal, long-term interest rates should be moderate on average. In this way, the Fed’s mandate to achieve moderate long-term interest rates is simply a reaffirmation of its mandate to keep inflation low and prices stable. And that’s the reason most people speak of the Fed having a dual mandate, rather than a triple mandate. • Speaking of interest rates, time permitting, we will come back to the related topic of Treasury bonds, home mortgages, student loans and long term interest rates at the end of the presentation.

17. Implementing Monetary Policy • The Federal Reserve technically has three principal instruments of monetary policy--the discount rate, reserve requirement ratios, and open market operations. • The discount rate is the interest rate on borrowing by depository institutions from the Federal Reserve. Because banks are highly reluctant to borrow from the Fed due to the stigma attached, this no longer is viewed as a viable tool for implementing monetary policy. Changes in reserve requirements are thus rare. The last change was in 1992. The second tool is the reserve requirements the Fed imposes on member banks. Depository institutions are currently required to hold 10% of their transactions balances in reserves, either in vault cash or in reserve balances held at Federal Reserve Banks. Changes in the required reserve ratios are rare but can be ordered by the Board of Governors. • So today open market operations are the principal instrument of monetary policy.

18. Open Market Operations • The FOMC establishes the target rate for trading in the federal funds market. Open market operations (OMOs) are the tool used. OMOs are conducted by the New York Fed at the direction of the FOMC. The Federal Reserve Banks collectively own well over a trillion dollars in U.S. Treasury securities in an account called SOMA. By trading government securities with the primary dealers, the New York Fed affects the federal funds rate, which is the interest rate at which depository institutions lend balances to each other overnight. http://www.newyorkfed.org/markets/omo/dmm/fedfundsdata.cfm • There are two types of Fed purchases: permanent and temporary. Permanent OMOs involve outright purchases or sales of securities for the SOMA. Temporary OMOs are conducted through either repurchase agreements or reverse repurchase agreements, which are basically a short term loan dressed up as a matched purchase and sale transaction.

19. Treasuries & OMO • U.S. Treasury Securities • The New York Fed purchases and sells U.S. Treasury securities in its implementation of monetary policy, as directed by the FOMC. Prior to the financial crisis, the Federal Reserve's outright holdings of Treasury securities accounted for the bulk of the SOMA's holdings of securities and generally grew with the amount of currency in circulation. Since the financial crisis, as changes in the size and composition of the SOMA portfolio have become important tools of monetary policy, holdings of Treasury securities have increased significantly. See http://www.newyorkfed.org/markets/pomo/display/index.cfm

20. OMO & GSE MBS Securities • Agency Mortgage-backed Securities. These are securities issued by Fannie Mae, Freddie Mac and GinnieMae that are back by pools of residential home mortgages. • Since 2008, the FOMC has directed the New York Fed from time to time to purchase mortgage-backed securities (MBS). Purchases have included agency MBS issued or guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. See http://www.newyorkfed.org/markets/ambs/ • Query: Should the Fed be buying Agency MBS given all of the problems we know about at the GSEs and in the securitization process? Does the Fed own any subprime loans? Should it?

21. Milton Friedman: The Role of Monetary Policy, March 1968 • http://www.aeaweb.org/aer/top20/58.1.1-17.pdf • Tough reading no? • What can we learn from Friedman’s Article? • What was his main argument? • What would he think of Obama and Romney Tax Plans and the merits of their plans to stimulate the economy? What about their efforts to address the US Deficit? Would he be worried about inflation rekindling?

22. Milton Friedman: The Potency of Monetary Policy • Clearly sides with those that blame the Fed for the Great Depression. Claims they failed to expand the monetary base as was needed during the crisis. This remains the consensus view even today. • Rejects the Keynesian viewpoint that expansionary fiscal policies (deficit spending) or “cheap money” policies are a panacea for any sluggish economy. • Emphasizes the significance of the Federal Reserve-Treasury Accord in 1951 as it makes clear that central banks cant artificially fix the interest rates at which a particular government bond will trade.

23. Friedman • Friedman makes clear that monetary policy is a potent tool but that it can only cajole the free market. It cant fix the price of a bond for very long. Nor can it enforce or peg the economy to a specific unemployment rate. The force of free markets will always prevail. • He claims monetary policy can contribute to offsetting major disturbances in the economic system. If there is an independent secular exhilaration, like the postwar expansion, monetary policy can in principle help to hold it in check by a slower rate of monetary growth. Ifan explosive federal budget threatens unprecedented deficits, monetary policy can hold any inflationary dangers in check.

24. Monetary Policy & Fiscal Policy • What can we learn from Friedman’s Article? Well, in addition to the Fed’s awesome powers under the FRA, both Congress and the President have enormous tools at their disposal to try and stimulate an economy. • What was his main argument? Monetary policy is not a string. The Fed can slow an overheated economy but its can also recessitate a sluggish economy given enough time. The Fed should avoid sharp swings in policy. • What would he think of Obama and Romney Tax Plans and Plans to Address the US Deficit?

25. The Keynesian Model: Using Fiscal Policy to Stimulate Economic Growth • Should the U.S. Federal Government ever operate with a deficit? • When federal revenue is less than federal outlays, how is the annual federal budget deficit funded? • Who buys U.S. Treasury Bonds, Notes and Bills? How are they sold and priced? Can individuals participate directly? • Can a country ever have too much debt? What are the risks if they do? [Hint think about Greece or Spain today] • What is the national debt ceiling? What would happen if Congress did not increase the debt ceiling?

26. Raising the Federal Debt Ceiling: A Game of Chicken • The statutory imposed ceiling on the Federal debt currently stands is $16.394 Trillion Dollars. The government is currently running an average monthly deficit of $100 billion and is likely to hit the debt ceiling sometime in late December. The behavior of Treasury during the many previous debt ceiling crises suggests that Treasury can and will, if necessary, take emergency steps for several months in advance to prevent the government from missing any payments it owes on its securities, including shutting down federal offices.

27. The Federal Debt Ceiling: Games People Play • Once the government hits the debt ceiling, it can no longer borrow money in excess of the statutory limit, and it would most likely have to postpone interest payments and the return of principal to investors in its securities if the ceiling is not lifted by Congress in a timely manner. See http://www.treasury.gov/initiatives/Documents/Debt%20Limit%20Myth%20v%20Fact%20FINAL.pdf • Like bonds issued by other sovereigns, Treasuries are assigned a credit rating by the leading rating agencies and on August 5, 2011 S & P downgraded US Treasuries for the first time to below AAA. The nation had previously maintained a AAA rating for over 70 years. Is anyone in your generation worried?

28. Fiscal Policy: The Other Lever • Each January, CBO prepares “baseline” budget projections spanning the next 10 years. Those projections are not a forecast of future events; rather, they are intended to provide a benchmark against which potential policy changes can be measured. In other words, CBOs projections generally incorporate the assumption that current laws are implemented. (i.e. the Bush era tax cuts will be allowed to expire). • But substantial changes to tax and spending policies are slated to take effect within the next year under current law. So CBO has also prepared projections under an “alternative fiscal scenario,” in which some current or recent policies are assumed to continue in effect, even though, by law, they are scheduled to change. The decisions made by lawmakers as they confront those policy choices will have a significant impact on budget outcomes in the coming years.

29. CBO & The President’s Budget • CBO estimates that the President's proposals would have the following consequences for the budget: • The deficit in 2012 would equal $1.3 trillion (or 8.1 percent of gross domestic product), $82 billion more than the 2012 deficit projected in CBO's baseline. In 2013, the deficit would decline to $977 billion (or 6.1 percent of GDP), $365 billion more than the shortfall projected for 2013 in CBO’s baseline. The deficit would decline further relative to GDP in subsequent years, reaching 2.5 percent by 2017, but then would increase again, reaching 3.0 percent of GDP in 2022. The deficits after 2013 would exceed those in CBO's baseline by between 1.4 percent and 1.9 percent of GDP each year. • Federal debt held by the public would increase from $10.1 trillion (68 percent of GDP) at the end of 2011 to $15.2 trillion (77 percent of GDP) at the end of 2017 and then to $18.8 trillion (76 percent of GDP) at the end of 2022. Under the assumptions of CBO's current-law baseline, debt held by the public would increase more slowly, ending 2022 at $15.1 trillion; as a percentage of GDP, however, such debt would decline to 61 percent by the end of 2022.

30. Federal Reserve Independence? • Despite Congress’ intent, it is clear that the Federal Reserve’s has not always been able to remain fully independent from political pressure. • One example of our Central Bank’s struggle to remain independent was a long-standing dispute between President Johnson’s Treasury Secretary Snyder and Fed Chairman McCabe regarding the Fed’s obligation to prevent the price of the U.S. Treasury 2 1/2 Percent Notes from falling during the Korean War. An excellent chronology of this fight and the cold war context in which it occurred, can be found at http://www.richmondfed.org/publications/research/economic_quarterly/2001/winter/pdf/hetzel.pdf

31. Federal Reserve Independence Con’t • One interesting item in the article is that President Johnson forced the members of the FOMC to meet with him at the Oval Office on January 31, 1951 and then tried to force them to publically support a price floor on U.S. Treasury bonds being used to fund the Korean War. • Do you think President Obama would have the legal right under the Constitution to demand a similar meeting today? What if the country was at War with China or Russia? Would it depend if we were being invaded?

32. Fed as Lender of Last Resort • Section 13(3) of the FRA states: “In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, to discount for any participant in any program or facility with broad-based eligibility, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank.” • 13(3) was used by the Fed, to lend to AIG at the height of the 2008 financial crisis. These actions were roundly criticized and resulted in Congress amending 13(3).

33. Fed as Lender of Last Resort: Gone? • In the Dodd Frank Act, Congress insisted on limiting the Fed’s emergency lending powers by requiring that the Board “establish in consultation with the Treasury Secretary, certain policies and procedures governing its emergency lending activities that ensure that any program or facility is for the purpose of providing liquidity to the financial system, and not to aid a failing financial company, and that the security for emergency loans is sufficient to protect taxpayers from losses. • They also provided that: The Board may not establish any program or facility under this paragraph without the prior approval of the Secretary of the Treasury. [ouch]

34. Thanks • Questions? • Other Topics?