Monetary Policy and the Fed
Read this chapter to understand in more detail the monetary policy tools, process, and impacts on the U.S. economy. Review specific monetary policies and their effects from our recent history.
Problems and Controversies of Monetary Policy
Choosing Targets
In attempting to manage the economy, on what
macroeconomic variables should the Fed base its policies? It must have
some target, or set of targets, that it wants to achieve. The failure of
the economy to achieve one of the Fed's targets would then trigger a
shift in monetary policy. The choice of a target, or set of targets, is a
crucial one for monetary policy. Possible targets include interest
rates, money growth rates, and the price level or expected changes in
the price level.
Interest Rates
Interest rates, particularly
the federal funds rate, played a key role in recent Fed policy. The FOMC
does not decide to increase or decrease the money supply. Rather, it
engages in operations to nudge the federal funds rate up or down.
Up
until August 1997, it had instructed the trading desk at the New York
Federal Reserve Bank to conduct open-market operations in a way that
would either maintain, increase, or ease the current "degree of
pressure" on the reserve positions of banks. That degree of pressure was
reflected by the federal funds rate; if existing reserves were less
than the amount banks wanted to hold, then the bidding for the available
supply would send the federal funds rate up. If reserves were
plentiful, then the federal funds rate would tend to decline. When the
Fed increased the degree of pressure on reserves, it sold bonds, thus
reducing the supply of reserves and increasing the federal funds rate.
The Fed decreased the degree of pressure on reserves by buying bonds,
thus injecting new reserves into the system and reducing the federal
funds rate.
The current operating procedures of the Fed focus
explicitly on interest rates. At each of its eight meetings during the
year, the FOMC sets a specific target or target range for the federal
funds rate. When the Fed lowers the target for the federal funds rate,
it buys bonds. When it raises the target for the federal funds rate, it
sells bonds.
Money Growth Rates
Until 2000, the Fed was
required to announce to Congress at the beginning of each year its
target for money growth that year and each report dutifully did so. At
the same time, the Fed report would mention that its money growth
targets were benchmarks based on historical relationships rather than
guides for policy. As soon as the legal requirement to report targets
for money growth ended, the Fed stopped doing so. Since in recent years
the Fed has placed more importance on the federal funds rate, it must
adjust the money supply in order to move the federal funds rate to the
level it desires. As a result, the money growth targets tended to fall
by the wayside, even over the last decade in which they were being
reported. Instead, as data on economic conditions unfolded, the Fed
made, and continues to make, adjustments in order to affect the federal
funds interest rate.
Price Level or Expected Changes in the Price Level
Some
economists argue that the Fed's primary goal should be price stability.
If so, an obvious possible target is the price level itself. The Fed
could target a particular price level or a particular rate of change in
the price level and adjust its policies accordingly. If, for example,
the Fed sought an inflation rate of 2%, then it could shift to a
contractionary policy whenever the rate rose above 2%. One difficulty
with such a policy, of course, is that the Fed would be responding to
past economic conditions with policies that are not likely to affect the
economy for a year or more. Another difficulty is that inflation could
be rising when the economy is experiencing a recessionary gap. An
example of this, mentioned earlier, occurred in 1990 when inflation
increased due to the seemingly temporary increase in oil prices
following Iraq's invasion of Kuwait. The Fed faced a similar situation
in the first half of 2008 when oil prices were again rising. If the Fed
undertakes contractionary monetary policy at such times, then its
efforts to reduce the inflation rate could worsen the recessionary gap.
The
solution proposed by Chairman Bernanke, who is an advocate of inflation
rate targeting, is to focus not on the past rate of inflation or even
the current rate of inflation, but on the expected rate of inflation, as
revealed by various indicators, over the next year.
By 2010, the
central banks of about 30 developed or developing countries had adopted
specific inflation targeting. Inflation targeters include Australia,
Brazil, Canada, Great Britain, New Zealand, South Korea, and, most
recently, Turkey and Indonesia. A study by economist Carl Walsh found
that inflationary experiences among developed countries have been
similar, regardless of whether their central banks had explicit or more
flexible inflation targets. For developing countries, however, he found
that inflation targeting enhanced macroeconomic performance, in terms of
both lower inflation and greater overall stability.