Monetary policy, the FED’s role and activity

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As important as it is to understand economic activity indicators, it would be useless if this knowledge were not used to anticipate monetary policy actions and more particularly the actions of the FED. Very often financial markets interpret data that indicates a change in the economy, but don’t react much because they believe that, whatever changes are made to the economy, they will not lead to a change in monetary policy. In the first section we will examine monetary policy in the United States and in the second part how this policy is implemented.

DEFINITION OF THE FED'S MONETARY POLICY



We will first focus on the objectives of monetary policy, and then on the relative importance of these objectives, ending with one of the essential characteristics of the FED: its independence.

1/ MONETARY POLICY OBJECTIVES



Of course, the FED, like any other issuing institution, has to carry out the traditional tasks of a central bank: organising the clearing and payment system, monitoring money supply developments, maintaining exchange rate stability.
In addition to these traditional objectives, the FED has specific tasks.
The ultimate goals of the American monetary authorities are threefold:
- strong economy (characterized by GDP growth),
- minimum inflation,
- relative full employment.
These three goals are commonly referred to as the "uneasy triangle”.
By altering government spending and taxation, and so influencing aggregate demand, tax policy has a very significant impact on economic activity, employment and the level of inflation. Responsibility for fiscal policy is shared by the White House and Congress. Since 1913, monetary policy has been the responsibility of the FED.

1-1/ Strong economy
GDP growth is now being viewed with a more eclectic attitude than before. The FED has a much more pragmatic approach, not setting itself quantified targets and benchmarks. Before the end of the 1980s, the conduct of monetary policy for growth was based on the growth of the money supply, with the variation of minimum reserve ratios as the main instrument.
Today, the FED's main aim is to stimulate, support or slow down growth while reassuring the markets. It essentially uses interest rates.
It should be noted that, since the FED enjoys the confidence of the financial markets, it does not need to quantify its goals (unlike the ECB).
It is estimated that the ideal net growth target would be around 2% (which would, all other things being equal, prevent recessions and booms.)

1-2/ Minimum inflation
The way in which the FED chooses to achieve its goals varies over time. After having abandoned the control of growth through the money supply, the FED still retains objectives for money supply growth but does not base its formal decisions on variations in M1, M2 or M3.
The FED began to base its monetary policy decisions on assumptions about the relationship between the growth potential of inflation and actual inflation, a practice that it preserves today (we see here the influence of the Chicago monetarist school on the FED)
At the moment, the FED is monitoring the following indexes in particular:
- the price of raw materials in general (the CRB index in particular.)*
- hourly wages and average weekly working time
- the unemployment rate
- available capacity
It can be seen here that the FED seems more concerned with potential cost inflation, than by demand inflation.

1-3/ Relative full employment
Employment and unemployment are highly cyclical indicators. For example in 1985 the unemployment rate was 7.1%, in February 2001 it was 3.9%, in July 2009 it was 9.4% and in August 9.7%. The FED's attitude has therefore changed with this development. The main concern three years ago was the potential for bottlenecks in the labour force, especially for skilled work. Today this problem is no longer relevant.
These three goals are very rarely achieved simultaneously and their relative importance varies according to general economic conditions.

2/ THE RELATIVE IMPORTANCE OF THESE THREE GOALS



The overall economic framework determines these three goals’ order of importance.
For example, in the 1970s, the main concern was inflation.
Although unemployment was rising for most of the decade, the public wanted "something to be done" about inflation. This led to vague, apparently dressing measures, such as freezing prices and wages by the Nixon administration and "supervised” oil prices by the Carter administration.
Of course, the government never considered reducing its spending.
When the crisis reached its peak in the summer of 1979, President Carter was forced to recruit a "falcon" to head the FED in terms of inflation: Paul Volcker.
Acting quickly (with double-digit inflation), on 6 October 1979 he took the following measures:
- raising the discount rate from 11 to 12%
- creating compulsory reserves (8% rate) on additional credits (slowing down money supply expansion)
- massive purchases of $ on the foreign exchange market.

If, on the other hand, we look at the current situation where the main concern is growth, we see that the methods used are totally different: the question is whether or not the recovery will be accompanied by inflation, and therefore for the time being the FED's attitude can be summarized as "wait and see".

3/ THE FED’S INDEPENDENCE



In the USA there is a practical distinction between monetary policy and fiscal policy. Taking this fact into account, there is little chance of observing common areas of jurisdiction between the political and monetary authorities.
On the other hand, if we look at the way the members of the Federal Reserve Board (FRB) are appointed (14-year term and 4-year term for the chairman), we can consider its members above politics.
Finally, we note that the FED is the only entity that can risk a recession in order to control inflation.
Once its goals have been defined, we need to look at what means the FED uses to achieve them.

IMPLEMENTATION OF THE FED'S MONETARY POLICY



In this section, we will study the decision-making bodies, then on what basis decisions are taken and finally the tools used to implement the chosen monetary policy.

1/ DECISION MAKING BODIES



Two bodies determine the FED’s policies:
- The Federal Reserve Board (FRB),
- The Federal Open Market Committee (FOMC).

1-1/ The FRB
The FRB is the true monetary authority, although there are some overlaps in monetary policy decisions.
This is made clear by the fact that any member of the FRB is automatically a member of the FOMC. The role of the FRB goes beyond simple monetary policy, it also includes banking regulations and international aspects (the FOMC domain is purely domestic.) The FRB is composed of 7 members appointed by the President of the United States.
The term is 14 years, the chairman and vice-chairman are appointed for 4 years. If a member resigns or dies, their replacement completes the term. The President is supposed to take into consideration the FED Districts. In theory, there cannot be two members from the same district in the FRB. The Senate must approve the appointments.

1-2/ The FOMC
This is composed of 12 members. The 7 members of the FRB and 5 Presidents from the 12 FED Districts. The President of the Federal Reserve Bank of New York is always one of them (among the 5), the remaining 4 seats are rotated among the 11 other Districts.

2/ THE BASIS OF MONETARY POLICY: DATA AND FACTS



There is no real starting point for monetary policy, but it is considered that it starts chronologically with the first presentation by the Chairman of the FED to Congress in the context of the "Humphrey-Hawkins testimony".
This is the time when the FRB and the District Presidents set the growth targets for the money supply and their projections of economic activity and inflation.
The Chairman also gives an overview of the past, present and future performance of the economy. At the Chairman's second appearance in July, the money supply growth targets are revised, and preliminary targets for the following year are set.
Growth and inflation figures are forecasts and not targets.
The FED continues to set growth targets for monetary aggregates, believing that there is a correlation with GDP growth.
The FED tries to regulate monetary expansion in order to achieve non-inflationary economic growth.
There is a relatively pertinent currency-GDP correlation: often the M2 growth rate reaches its lowest level at the same time as GDP growth. On the other hand, M2 seems to precede production by 12 months.
Some economists use this correlation to forecast GDP.

2-1/ Monetary aggregates
*Definition of M1: This is the sum of cash, travellers' cheques, and all current accounts.
*Definition of M2: M1 + money market deposits, savings accounts, time deposits under $100,000
*Definition of M3: M2 + time deposits over $100,000 + Euro deposits + Repurchase agreements

As soon as the growth of these aggregates is defined, it is up to the FED to set itself a growth and inflation target.
The real long-term growth rate apparently desired by the FED is around 2 to 2.5%. If the FED therefore decided that its inflation target is 2%, its nominal growth target would be 4 to 4.5%.
The FED’s second step is to determine the relationship between growth and monetary expansion, this correlation is called the "velocity of circulation of money".
The FED implicitly concluded that over a long period of time, nominal GDP grows at the same rate as M2.
Finally, the FED’s third step is to establish a band of variation around the rate of monetary expansion to set its objectives.
It is assumed that its current objectives are: 2.5% below M2 below 6.5%; and 1% below M3 below 5%.

2-2/ Determination of reserves
Once the growth targets for M2 and M3 have been set, the FED is still not able to directly control the growth of the money supply. All it can do is provide the banking system with sufficient reserves to allow federal funds (and therefore other short-term rates) to move in the desired direction.
The total amount of reserves is defined as the sum of required reserves and excess reserves. Required reserves are the amount of reserves that banks must hold with the FED. The statements of reserves take place every 2 weeks on Wednesdays.
At the moment, the minimum reserves on deposits are around 10%.
Excess reserves are the reserves that banks want to keep. In this case, the banks either expect pressure on federal funds (for technical reasons, for example at the time of tax payments) or they expect an increase in federal funds from the FED. The FED never provides the system with all its needs through the open market system.
It forces some participants to borrow from the "discount window”.
By doing so, the FED establishes control over federal funds.

3/ MONETARY POLICY TOOLS



In addition to its traditional role as an issuing institution and its major objectives, the FED has two other functions:
- lender of last resort,
- defence against severe exchange rate fluctuations.

We will focus here on the classification of the FED's activities to implement its monetary policy and in the second part we will look at the consequences.

3-1/ Classifications of the FED’s activities
In terms of monetary policy, apart from fixing reserves, the FED's activities can be classified into 3 categories:
- open market operations,
- setting the discount rate,
- influencing short-term rates by fixing the rate on federal funds.

3-1-1/ Open market operations
In terms of monetary policy, open market operations are the most important.
Today Wall Street and the financial world as a whole monitor the FED's purchases and sales of assets.
At the basic level, an asset purchase corresponds to an injection of liquidity in the market, these operations are called "Repurchase Agreements".

* Repos:
They are carried out in two ways:
- customer repos: transactions generally carried out on behalf of third parties, almost no significance in terms of monetary policy,
- system repos: a transaction carried out by the FED on its own account, which tends to indicate to the market that the level of federal funds is too high. The message to the market is clear: either for technical reasons or for deeper reasons, the level of federal funds should decrease.
A sale of assets results in a reduction in market liquidity, these operations are called:

* Matched sales:
When the FED considers that the level of federal funds is too low, it drains market liquidity by selling assets through these matched sales or reverse repo operations.
Through these operations, we can see that the FED regulates short-term rates.

* Coupon passes
The FED is able to have an impact on longer term rates through coupon passes (buybacks of Treasury bills, with a term of between 1 and 3 years), this activity can be interpreted by the bond market as a very strong sign.

3-1-2/ Setting the discount rate
Recently, the discount rate has been adjusted less frequently than the federal funds rate. The fact that changes in discount rates are publicly announced overstates their actual impact. In fact, the Bank Rate is a lagging indicator of monetary policy, with the change in the federal funds rate occurring, most of the time, before the change in the Bank Rate. However, we should note that the discount rate, which was a facility granted to banks in the event of difficult refinancing, has become a penalizing rate since 9 January 2003. It is currently set at 0.50% (1st category) and 1.00% (2nd category) since 16 December 2008.

3-1-3/ By fixing the rate on federal funds, the FED steers short-term rates
Market participants are interested in the federal funds rate because all other short-term rates are derived from it. In fact, the FED’s rate is the marginal borrowing rate for banks. To finance any new loans, banks must obtain resources whose price is derived from the FED’s level. On the banks’ asset side, the “Prime Rate” is also dependent on the FED’s rate.
As a reminder, the FED no longer uses the variation in the rate of minimum reserves.
It remains for us to study the consequences of the FED's activities on the financial markets and on the economy in general.

3-2/ Consequences of the FED's activities



We have just seen how, by setting federal funds, the FED steers short-term rates. Let's try to see how FED activities influence fixed income markets, foreign exchange markets, equity markets and the economy as a whole.

3-2-1/ The FED's activities on interest rate markets: while it steers short-term rates, it cannot accurately control long-term rates
Long-term rates are mainly determined by the following factors: inflation, supply and demand, credit risk affecting the asset concerned, etc.
However, knowing the next direction that the FED will take is of great help in choosing investments.

3-2-2/ FED activities affect the foreign exchange market
Any monetary policy action has repercussions on the foreign exchange market, with the dollar parity partly dependent on the level of short-term rates (See F. Mishkin, interest rate channels.) It should be noted, however, that all other things being equal, the FOMC has always formulated its interest rate guidelines by favouring the domestic aspect over the international aspect.

3-2-3/ The FED's activities affect the equity markets
Equity markets are dependent on management and interest rate levels.
Share prices reflect the net present value of future cash flows. If rates fall, future income is discounted at a lower rate,and so their price rises.
Of course, we must go beyond this simple or even simplistic analysis. In many cases, share prices and interest rates are not inversely correlated. The reality is more often in the comparison of the rate of growth of profits and interest rates. In the worst case scenario (stagflation), non-profits coincide with high interest rates, in this environment stock market indices fall. The best case being when the economy emerges from a recession or a sharp slowdown: shares that have fallen are attractive, interest rates are still low (current situation?).

3-2-4/ The FED's activities affect the economy as a whole
We have noted the correlation between M2 and GDP, so the FED strives, by controlling the expansion of the money supply, to achieve both robust, non-inflationary growth and relative full employment.
While monetary policy is conducted by central banks, fiscal policy is implemented by the political power, with a division of tasks between the executive and legislative powers.
The "technicalities" between the presentation of the budget by the executive and its vote by the legislative power varies from one state to another.

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