Monetary Policy Federal Reserve

Monetary Policy and the Federal Reserve

The Federal Reserve ("the Fed") is responsible for formulating and implementing the nation's monetary policy. Monetary policy is government actions to increase or decrease the money supply and change banking requirements and interest rates in order to influence spending by altering banker's willingness to make loans. An expansionary monetary policy increases the money supply in an effort to cut the cost of borrowing, which encourages business decision makers to make new investments, in turn stimulating employment and economic growth. A restrictive monetary policy reduces the money supply to curb rising prices, over expansion, and concerns about overly rapid growth (Kurtz).

The Federal Open Market Committee (FOMC) is the Fed's main agency for monetary policy making. All national banks must be members of this system and keep some percentage of their checking and savings funds on deposit at the Fed. In order to regulate the economy the Fed's governing board uses a number of tools. By changing the required percentage of checking and savings accounts that banks must deposit with the Fed, the governors can expand or shrink funds available to lend. The Fed also lends money to member banks, which in turn can make loans to at higher interest rates to business and individual borrowers. By changing the interest rates charged to commercial banks, the Fed affects the interest rates charged to barrowers and consequently their willingness to borrow. These rate changes can sometimes help jump-start an economy that may be sliding into a recession (Kurtz).

Discussion

The current financial situation began with unusual monetary policy moves by the Federal Reserve System and novel federal regulatory interventions. These public policies distorted interest rates and asset prices, diverted loan funds into the unsecured investments, and forced normally solid financial institutions into unsustainable positions. Private miscalculation and imprudence have made matters worse for more than a few institutions.

The Federal Reserve's expansionary monetary policy supplied the means for unsustainable housing prices and unsustainable mortgage financing. Growth in regulatory mandates and subsidies exaggerated the demand for riskier mortgages, most importantly the implicit guarantees to Fannie Mae and Freddie Mac that combined with HUDs imposition of "affordable housing" mandates on Fannie and Freddie to accelerate the creation of a market for securitized subprime mortgages (White).

The financial crisis that began in 2007 significantly affected the way the Federal Reserve implemented monetary policy. In September of that year the FOMC began dropping its target for Federal Reserve funds to zero. In ten steps the target rate was taken from 5.25% to a band of 0 to 0.25% as of December 2008. When the federal funds rate reached almost zero traditional open market operations were no longer able to ease monetary policy further to deal with the crisis (Hill and Wood).

In the summer of 2007 the Fed initiated a number of temporary liquidity measures aimed at improving credit conditions and economic conditions nationwide. Initially the governors enabled additional borrowing at the discount rate. Specifically, the Board extended the availability of discount window leading beyond the usual overnight basis and up to 30 days with possible renewal. This measure was put into place to provide greater assurances to depository institutions that they could borrow from regional Reserve Banks (Hill and Wood).

As the crisis worsened the Feds implemented new monetary policy tools. Some of these tools required the Fed to invoke a special provision of the Federal Reserve Act that gives the Fed the authority to lend any individual, partnership or corporation in " Unusual and exigent circumstances." The Term Auction Facility program (TAF), the Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF) were implemented to improve liquidity in the financial system. As the financial crisis expanded further in 2008 it became apparent that additional liquidity measures were needed. The measures involved providing liquidity directly to borrowers and investors. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF), the Money Market Investor Funding Facility (MMIFF) and the Term Asset-Backed Securities Loan Facility (TALF) measures were aimed at reducing key instabilities and providing liquidly directly to borrowers and investors (Hill and Wood).