Monetary Policy Strategy

Goals Stability in the price level(CPI). Full employment (low unemployment)

Unemployment rate 4-6% Greater employment greater output Greater unemployment more the employed

must share – food stamps, insurance. Economic growth – increase in economy’s

output of goods and services. Stabilizing interest rates. Stability in foreign currency exchange rates.

Difficulties Measurement difficulties. Policy goals can be competing.

It may be difficult to achieve both full employment and low inflation.

To keep inflation low tight monetary policy which pushes up interest

rates. Fed will typically adopt a compromise policy.

Conflicting goals concerning domestic and international policies.

Employment Act of 1946 Congress declared the federal

government had responsibility to promote the nation’s economic welfare – “promote maximum employment, production, and purchasing power”.

The act contained no specific reference to the related problem of inflation, the promotion of economic growth, or stability in the balance of payments.

Humphrey-Hawkins Full Employment and Balanced Growth Act (1978)

Corrected the Employment Act of 1946.

Set target of 4% unemployment for workers>16 and 3% for >20 by 1983.

Set target of 3% inflation by 1983. Problem: the two goals may conflict

with one another. To achieve one goal you may have to abandon the other at least in the short run.

Evolution of Monetary Policy

WWII – 1979: Keynesian Era Fiscal policy – use of the federal

budget to achieve economic goals. 60s & 70s revealed serious problems

with Keynesian Policy. By 1979 inflation > 13%.

Evolution of Monetary Policy 1979-1982: Target Monetary Growth

July 1979: Carter appointed Paul Volcker chairman of the Fed.

1981: Reagan administration cut taxes with no corresponding cut in spending

Increase in federal deficit Steep rise in interest rates Dollar appreciated

1982: Inflation 4% but unemployment rose to highest level since the Great Depression.

Evolution of Monetary Policy

1982-1990:Target Interest Rate Retain Monetarist goal of price

stability. Rather than target monetary growth,

target the interest rate. Longest peacetime expansion on

record.

Introduction “Federal Open Market Committee (FOMC)

seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output”

Examination of the formulation of policy through the Federal Open Market Committee’s directive

Review the reasons for the particular course of action that is followed

The FOMC Directive The FMOC meets every five or six weeks

Review of recent economic and financial developments

Prices Unemployment Interest rates Money supply Balance of payments Bank credit

Makes projections for the future Based on anticipated economic conditions,

proposes appropriate monetary policy

The FOMC Directive (Cont.) The FOMC directive

In recent years, FOMC directive usually contains a single paragraph that begins with a general qualitative statement of current policy goals

Specifies the immediate prescription for implementing longer-term objectives

In outlining its operating targets, the Committee refers to conditions in the reserve markets, not in terms of money supply growth

The FOMC Directive Although Fed emphasizes monetary and

reserve aggregates, in practice it operates on interest rates (Federal Funds Rate)

After each meeting, the FOMC releases a statement Summarizes the directive Gives some idea of the Fed’s view of future policy

risks Indicates whether policy risks are mainly weighted

toward inflationary pressure, economic weakness, or weighted equally between the two

The Fed’s Strategy Humphrey-Hawkins Act of 1978

Provides policy guidelines to Federal Reserve Maximum employment Price stability Moderate long-term interest rates

Fed has interpreted maximum employment as full employment--economy functions at its potential

Meet these three goals by seeking price stability and sustainable growth since long-term interest rates are low when expected inflation is low

The Fed’s Game Plan Operating and intermediate targets

are more responsive to Fed’s actions These two steps provide timely

feedback so Fed can judge if their actions are on the right tract

Steps in Development of the Fed’s Plan Decide upon GDP growth rate consistent

with inflation and unemployment objectives Set range for monetary growth expected to

generate target GDP growth Set a target for growth in reserves Key to the success of Fed’s

effectiveness is understanding and predicting the linkages between the different steps

Reserves Versus the Federal Funds Rate Different targets selected by Federal Reserve

Before October 1979—favored federal funds rate October 1979 to mid-1982—shifted to reserve

aggregates to get control over inflation After mid-1982—shifted focus back to federal

funds rate It seems that reserves and the federal funds

rate are two sides of the same coin

Reserves Versus the Federal Funds Rate However, there is often an irreconcilable

conflict that prevents the Fed from simultaneously targeting reserves and the fed funds rate

Characteristics of the federal funds market Immediately available funds that are lent between

banks, usually on an overnight basis Transfer of funds through bookkeeping entry on

reserves held by the Fed Interest rate charged is the Federal Funds Rate

Reserves Versus the Federal Funds Rate

The Federal Funds Rate is established in the competitive market (supply and demand of reserves), but is influenced by the Fed (proactive action) Increase reserves—Lower the rate Decrease reserves—Raise the rate

Reserves Versus the Federal Funds Rate

In the real world, demand curves for reserves fluctuates with the pace of economic activity

These shifts in the demand curve will complicate the actions of the Fed (reactive action)

The Fed can target either the level of reserves or the federal funds rate Targeting reserves—the federal funds rate

will vary Targeting federal funds rate—the level of

reserves will vary

Reserves Versus the Federal Funds Rate The Fed cannot set reserve levels and

the federal funds rate independently Which target should the Fed choose?

Select one that produces less variability in GDP Targeting reserves and letting interest rate

change would be best under some conditions Close and predictable relationship between reserves and

spending Private spending is subject to destabilizing variations Resulting interest rate changes would stabilize the

economy

Which Target Should the Fed Choose? Targeting interest rates, with fluctuating

reserves Weak linkage between reserves and spending results

in variation in demand for reserves not related to changes in spending

In this case, automatic changes in interest rates would not allow the Fed to stabilize the economy

Under these conditions, the Fed has concluded it is better to target the federal funds rate

With significant change in economic activity, it might be necessary to alter targeted federal funds rate

Can the Fed Really Control Reserves? Preceding discussion suggests the Fed has

complete control over supply of reserves Banking system has ability to affect reserves

through borrowing at the discount window New discount window system enhances the

Fed’s ability to meet its fed funds rate target Fed funds rate below discount--no borrowing Fed funds rate rising above discount--

Discount borrowing by banks increases reserves thereby lowering fed funds rate

The Taylor Rule and Fed’s Track Record During the Greenspan period at the Fed,

the focus has clearly been on the use of the federal funds rate to influence interest rates

Interest rates then affect the aggregate demand for goods/services, the real GDP and the inflation rate

Although it is difficult to forecast the behavior of the Fed, it appears the general direction of interest rate policy can be explained by the Taylor rule

Taylor Rule Federal funds rate target is a function

of: The difference between actual inflate rate

(INFL) and the target inflation (INFL*) The percentage difference between actual

and potential real GDP (GAP)

Federal funds rate =

2.5 + INFL + 0.5 (INFL - INFL*) + 0.5 GAP

The Actual Fed Funds Rate and the Rate Implied by the Taylor Rule

The fed funds rate seems to have responded quite well to the concerns of the Fed since it moves in the directions suggested by the Taylor rule

However, the actual fed funds rates doesn’t always follow the Taylor rule Impossible to react to certain events such as

September 11 until they influence economic activity

Suggests an argument for giving the Fed some discretion in responding to special circumstances