Fundamentals of Monetary Policy with Jon Faust

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Fundamentals of Monetary Policy

Jon Faust

Federal Reserve Board

Jan. 14, 2014

Note: These slides were prepared for presentation at a Mechanics of

Finance Briefing arranged by the Milken Institute and National PressFoundation. These slides are intended only as a primer on the basic

topics covered; they reflects the authors views and not necessarily

those of the Federal Reserve Board or anyone else associated with the

Federal Reserve System.

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Never explain, never excuse

Montague Norman, Governor, Bank of

England, 19211944

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FOMC, 2012

The Committee seeks to explain its monetary

policy decisions to the public as clearly aspossible. Such clarity facilitates well-informed

decisionmaking by households and businesses,

reduces economic and financial uncertainty,increases the effectiveness of monetary policy,

and enhances transparency and accountability,

which are essential in a democratic society.(from the statement of longer-run goals and

strategy)

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Central banks

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Almost all nations have a central bank

U.S.: Federal Reserve System

U.K.: Bank of England

Nations that share the euro: European

Central Bank(in conjunction with the central banks of each

nation)

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Central Bank: Main Responsibilities

Monetary policy:Foster financial conditions favorable to stable

spending, production, and inflation. Financial stability

Traditionally: calm financial panics by standing

ready to provide short-term loans to solvent banksthat face runs. This function called lender of last

resort to financial system.

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Central Bank: Main Responsibilities

Other responsibilities vary a good dealacross central banks

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Monetary policy

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Governance and independence

Around the world, monetary policy is oftenmade by a board.

Board is often appointed by thegovernment, but. . .

. . . government cannot dictate or overrulemonetary policy decisions(or fire the policymakers for their policies)

Known as central bank independence

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Governance and independence

Why independence?A long historical record worldwide suggests that

independence leads to more stable policy andbenefits citizens in the economy.

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Federal Reserve System

Established by Congress in 1913Modified in some important ways through the

years

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Federal Reserve System

Federal Open Market Committee (FOMC)makes monetary policy decisions

19 members 7 members of the Board of Governors

of the Federal Reserve System(the Chair and Vice Chair are governors)

12 Presidents of regional FederalReserve Banks

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Decisionmaking

FOMC has 8 regularly scheduledmeetings per year

FOMC debates and votes on changes tothe stance of monetary policy

Policy set by a vote of 7 governors and 5voting presidents5 of 12 presidents vote on a rotating basis. New

York Fed president always votes.

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Monetary policy: transparency

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Transparency: Explaining policy

Modern thinking says policy is moreeffective when the public understands

policy. Policy transparency has come a long way

generally in central banks around the

world. . . but transparency is still a work in progress

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Federal Reserves Main Communication Tools

FOMC statement released at the end ofeach FOMC meeting.

Chairs press conference follows 4meetings per year

Minutes of the FOMC meeting releasedabout 3 weeks after meeting

After 5 years, full transcript of meeting.

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Federal Reserves Main Communication Tools

Summary of Economic Projections ofFOMC participants

Chair and other officials testify regularly inCongressincluding a twice yearly Monetary Policy Report

Regular speeches by all policymakers

Website filled with mountains material

http://federalreserve.gov

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Goal of all this

Explain state of policy

Give rationale for policy

Explain likely future evolution of policy

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The Feds monetary policy mandate

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Statutory mandate

Promote maximum employment, stableprices, and moderate long-term interest

ratesThis gives general guidance, but must be filled out

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In Jan. 2012, FOMC adopted . . .

Consensus statement on longer-run goalsand strategy

FOMC reaffirms each January

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Why longer-run goals?

From the statement:Inflation, employment, and long-term interest rates

fluctuate over time in response to economic andfinancial disturbances. Moreover, monetary policy

actions tend to influence economic activity and

prices with a lag. Therefore, the Committeespolicy decisions reflect its longer-run goals, its

medium-term outlook, and its assessments of the

balance of risks, including risks to the financialsystem...

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Stable prices

Does this mean zero inflation? No.

Consensus statement sets a goal of 2

percent inflation

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Why not zero inflation?

Long history worldwide suggests thatdeflation very bad for employment and

growthDeflation is negative inflation; that is, a falling

general price level

2 percent inflation is judged to be highenough to provide a cushion or bufferagainst deflation

But still low enough to avoid undue costsof inflation

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Maximum employment

Does the mean Fed aspires to anunemployment rate of zero? No.

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Maximum employment

Does the mean Fed aspires to anunemployment rate of zero? No.

Consensus statement refers to maximumsustainable employment

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Why not zero unemployment?

In any dynamic economy there will alwaysbe some unemployment

100% employment is not sustainable The maximum sustainable rate is not

known with precision

FOMC reports its estimate in theSummary of Economic Projectionscurrent range: 5.26.0 percent unemployment rate

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Moderate long-term interest rates

FOMC judges that best way to achievethis portion of the mandate is to promote

stable prices and maximum employmentThus, this goal is often not separately emphasized

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How do central banks pursue their goals?

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Conventional policy

Central bank can control the interest rateat which banks lend to each other for 1

day.generally called an overnight interest rate

In U.S., called the federal funds rate

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Promoting the goals

Raising or lowering the federal funds ratetarget indirectly affects all other interest

rates . . . . . . and stock prices, home prices, the

exchange value of the dollar against other

currencies, and all other financialconditions

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Promoting the goals

Raising the federal funds rate target tendsto make financial conditions less favorable

to borrowing and spending.Called less accommodative

Lowering the target makes conditions

more accommodative

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In terms of the mandate

More accommodative policies tend to . . . promote higher employment

promote higher inflation Less accommodative policies do the

opposite

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Simple facts about this interest rate tool

It can be powerful

It is blunt and indirect

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Note also

This interest rate policy moves bothemployment and inflation in the same

directione.g. tending to raise both employment and inflationor lower them

Dont have an interest rate tool to pushone up and the other down

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Note also

Right now the two sides of the mandateboth call for accommodative policy

Inflation below 2 percent, employment belowmaximum sustainable level

Very often the two goals call for the same

policy

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When the goals call for different policy

Statement of goals and strategy:When the goals conflict, FOMC takes a balanced

approach to promoting a return to the desiredlevels over time.

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Monetary policy mechanics and what is

different at present

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Mechanics

In conventional policy, the FOMC strivesto hit the federal funds rate target by

buying and/or selling governmentsecurities

For example, buying securities increases

bank reserves and tends to push downthe federal funds rate.

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What is different right now?

U.S. had a financial crisis and deeprecession

led to high unemployment, downward pressure oninflation

Normal response: lower the federal funds

rate target

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But you can only go so far

Cannot push the federal funds rate belowzero

A negative interest rate means the lender pays theborrower to borrow. Lenders would rather just

keep the funds.

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Thus,

Once the conventional policy interest ratehits zero the conventional approach

cannot be pursued further Must use unconventional tools to create

the needed accommodation

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2 main tools

Forward guidance

Large scale purchases of longer-term

securities

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Forward guidance

Forward guidance is clear communicationabout the conditions under which the

federal funds rate target will remain highlyaccommodative.

Loosely, speaking, FOMC seeks to make

clear that it will promote highlyaccommodative conditions until the job isdone.

The expectation of continuedaccommodation should put downwardpressure on longer-term interest rates.Which tends to stimulate the economy

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Forward guidance: December FOMC statement

The Committee also reaffirmed its expectation that

the current exceptionally low target range for the

federal funds rate of 0 to 1/4 percent will be

appropriate at least as long as the unemployment

rate remains above 6-1/2 percent, inflation

between one and two years ahead is projected to

be no more than a half percentage point above the

Committees 2 percent longer-run goal, and

longer-term inflation expectations continue to be

well anchored.

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Forward guidance: December FOMC statement

At least as long, but maybe longer?The Committee now anticipates, based on its

assessment of these factors, that it likely will beappropriate to maintain the current target range for

the federal funds rate well past the time that the

unemployment rate declines below 6-1/2 percent,especially if projected inflation continues to run

below the Committees 2 percent longer-run goal.

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Large scale purchases of longer term securities

FOMC policies usually affect longer-terminterest rates indirectly through a affecting

an overnight interest rateor through communications about the futurecourse of the overnight interest rate

Instead, the FOMC could purchase alarge amount of longer-term securitiesFOMC is empowered to by Treasury securities and

agency and agency mortgage-backed securities

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Large scale purchases of longer term securities

Large scale purchases of longer-termsecurities tend to push down the interest

rate on these securitiesputting downward pressure on longer-term interestrates more generally, which should stimulate the

economy

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December FOMC statement

FOMC had been purchasing $85 permonth in longer-term securities

In December, FOMC reduced rate ofpurchases to $75 billion per monthKnown popularly as a taper

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December statement: future path of purchases

If incoming information broadly supports the

Committees expectation of ongoing improvement

in labor market conditions and inflation moving

back toward its longer-run objective, the

Committee will likely reduce the pace of asset

purchases in further measured steps at future

meetings.

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December statement: future path of purchases

Asset purchases are not on a preset course, and

the Committees decisions about their pace will

remain contingent on the Committees outlook for

the labor market and inflation as well as its

assessment of the likely efficacy and costs of such

purchases.

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Overall

Fed is maintaining a highlyaccommodative policy

To promote return to maximum sustainableemployment and return of inflation to 2 percent

Because federal funds rate target is near

zero, using unconventional tools

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Overall

Over time, as conditions warrant, Fed willreturn to more conventional policy

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With this broad sketch. . .

. . . the other speakers will now talk in greater

detail about the effects of unconventionalpolicy in the U.S. and abroad. . .

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References for some specifics

Basic Federal Reserve structure:http://federalreserve.gov/aboutthefed/

The consensus statement on longer-rungoals and strategy:http://federalreserve.gov/monetarypolicy/

FOMC statements:http://federalreserve.gov/monetarypolicy/fomccalendars.htm

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Fundamentals of Monetary Policy with Jon Faust

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