The Federal Reserve's monetary policy tools and economic influence

Federal Reserve Bank is the central bank, and therefore plays a critical role in the American economy. The Federal Reserve is charged with developing and implementing monetary policy, while Congress and the White House are charged with developing and implementing fiscal policy. Monetary policy is economic policy that relates to the control of the money supply, and the Fed has a number of tools at its disposal that can allow it to exert influence over the money supply. The main areas where the Fed seeks to exert its influence on the macroeconomic environment are in the inflation rate, the unemployment rate and the GDP growth rate. The Fed also conducts a significant amount of research and publishing, in order to improve the amount and quality of economic research and data available to Americans. This paper will primarily examine the monetary policy of the Federal Reserve in order to examine the contribution that the Fed makes to the overall state of the U.S. economy.

Structure and Role of the Fed

The Federal Reserve system is comprised of twelve district reserve banks, plus a Board of Governors. The presidents of each reserve bank make up the Federal Open Market Committee (FOMC) who provide significant guidance for monetary policy in the United States (Federal Reserve Education.org, 2013). The objectives of monetary policy, as outlined by the Federal Reserve (2013), are "to promote maximum employment, stable prices and moderate long-term interest rates." The view is taken that fostering long-term price stability will lead to long-term economic growth and maximum employment. This implies that the Fed is not as concerned with short-term movements in the unemployment rate or the GDP.

There are three primary instruments of monetary policy. They are via the discount rate, open market operations, and reserve requirements. The FOMC sets the discount rate, which is the rate at which the Federal Reserve lends to banks. This affects the supply of money by affecting the cost of money. Banks will adjust the rates at which they offer credit to their customers, based on the discount rate, because the discount rate is publicly-known. The higher the cost of credit, the less business investment there will be in the economy, as well as less consumer investment in rate-sensitive purchases like housing. The overall effect that this has on the economy can be understood in terms of the accounting identity for the GDP, which is GDP = C + I + G + X -- M. Thus, the sum of consumer spending, business investment, government spending and exports, less imports. When the cost of money is higher, both I and C. will be reduced. When the cost of money is lower, both I and C. should increase, barring extraordinary circumstances such as excess capacity that constrains business investment. The reason for this lies with the relationship between the cost of money and the expected rate of return. Businesses generally make investment decisions using capital budgeting principles -- the expected value of an investment is the value of the future cash flows from that invested. These cash flows are worth less the higher the interest rate is. Thus, the higher the interest rate, the fewer investments will be profitable, therefore the fewer investments will be accepted, and the less business investment there will be. It is roughly the same principle with consumers and housing and the anticipation of a slowdown in housing demand is enough to reduce business investment in real estate projects.

In general, an increasing GDP will correlate with lower unemployment and higher inflation. Thus, the Federal Reserve seeks to strike a balancing act between the two, finding just the right level of discount rate to encourage investment, but not so much that the economy becomes overheated and high inflation results.

Open market operations seek to influence the state of the economy by influencing the amount of the money supply, rather than the cost of money. Because the U.S. dollar is a fiat currency, the precise quantity of dollars in the world at any given point in time is subject to the actions of the central bank. The central bank manages the quantity of dollars in the economy via open market operations. It buys or sells Treasury securities in the open market, and that money either enters or leaves the economy. The cost of money is going to relate to the supply of money under normal circumstances, so open market transactions will tend to affect the decision to invest or not invest, especially on the part of business.

One of the new twists on the open market operation is what has come to be known as quantitative easing, which applies the same technique to longer-term Treasuries. The objective in that case is not necessarily to manage the amount of money in the economy, but to manage the expectations for monetary policy. The objective is to drive down the spread between long-term and short-term Treasuries, to make short-term investing more attractive even at very low rates. As the Economist (2013) points out, this is a riskier strategy than conventional monetary policy, and is normally only undertaken during times when short-term rates are pinned closed to zero, such that conventional open market transactions have no effect. The Fed believes that this strategy worked to improve the economy (Gagnon, Raskin, Remache & Sack, 2010).

The final monetary policy tool that the Federal Reserve uses is the reserve requirements. Like open market operations, these affect the amount of money in the economy, by changing the amount of money in the banking system. The way it works is this. Every bank takes in deposits so that they have capital to lend out. In order to preserve the integrity of the banking system, the banks cannot lend out all of the deposits they take in. The amount that they are not allowed to lend out is known as the reserve requirement. The Federal Reserve has the capability of changing the reserve requirements. If the Fed tightens the reserve requirements, this will take money out of the economy, because banks will need to reduce the amount of money that they are lending out; conversely if the Fed loosens the reserve requirements, this will put money into the economy because banks will be allowed to lend out more of their deposits out.

Changing the reserve requirements is an inelegant solution, so it is not used much. The process by which the banks will call in loans, or stop lending outright, can have a significant negative effect on particular individuals and businesses that simply have the misfortune of seeking a loan right after the change in Fed policy. Furthermore, the banks cannot execute a change in reserve requirements very quickly, and this time lag is a little bit more clumsy than other major monetary policy instruments, which work more quickly.

Recent Performance

The recent economic conditions and Fed action highlights the challenges that the Fed faces in trying to manage the economy. When the economy began to slide badly in 2008, it was accompanied by a credit crunch, so banks were not lending. This stifled business investment. Consumer spending was already off from 2006 levels because investment in real estate -- or spending fueled by borrowing against real estate assets -- was also down. The Federal Reserve responded with fast, aggressive monetary policy, dropping the discount rates to near zero, and engaging in expansionary open market transactions.

These monetary policy tools, which are normally effective for handling slight declines in economic performance, were inadequate for the depth of the slump that was faced. Banks had surplus capital, but were reluctant to lend it, and business investment remained suppressed in response to the sluggish consumer spending. Thus, unemployment not only rose quickly but with slow responses to this expansionary polices, unemployment has only fallen slowly. Moreover, because business investment and consumer spending remain at relatively low levels for this intensity of expansionary monetary policy, inflation has remained low as well.

The recent experience highlights the overall effect that the Federal Reserve can have on the economy. Monetary policy tools in general have an impact mainly under normal conditions. The economy responds to changes in monetary policy strategy and the Fed in that way is capable of effectively managing the economy. However, when the economic shock is strong, the Fed may not have sufficient tools to address it. Runaway growth can be addressed by raising interest rates very high, but a deep slump puts the Fed against the zero bound for interest rates, such that the Fed cannot alone bring about recovery. The Fed has done all it can -- even undertaking risky actions -- in the past few years, but without adequate fiscal policy or trade policy, the Fed under these circumstances can only have a limited effect on the economy, at best stabilizing it but not being able to spur strong economic recovery.

Works Cited:

Bernanke, B. & Kuttner, K. (2005). What explains the stock market's reaction to Federal Reserve policy? The Journal of Finance. Vol. 60 (3) 1221-1257.

Federal Reserve. (2013). Statement on longer-run goals and monetary policy strategy. Federal Reserve.gov. Retrieved April 19, 2013 from http://www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf

Federal Reserve Education.org. (2013). Monetary policy basics Federal Reserve. Retrieved April 19, 2013 from http://www.federalreserveeducation.org/about-the-fed/structure-and-functions/monetary-policy/

Federal Reserve Education.org. (2013). The structure of the Federal Reserve system. Federal Reserve. Retrieved April 19, 2013 from http://www.federalreserveeducation.org/about-the-fed/structure-and-functions/

Gagnon, J., Raskin, M., Remache, J. & Sack, B. (2010). Large scale asset purchases by the Federal Reserve: Did they work? Federal Reserve Bank of New York. Staff Report No. 441.

Romer, C. & Romer, D. (1996) Federal Reserve private information and the behavior of interest rates. NBER Working Paper 5692.

The Economist. (2013). The other side of QE. The Economist. Retrieved April 19, 2013 from http://www.economist.com/news/finance-and-economics/21570753-what-happens-when-fed-starts-losing-money-other-side-qe