MONETARY POLICY

The central agency that conducts monetary policy in the United States is the Federal Reserve System (the Fed). It was founded by the U.S. Congress in 1913 under the Federal Reserve Act. The Fed is a highly independent agency that is insulated from day-to-day political pressures, accountable only to Congress. It is a federal system, consisting of a board of governors, twelve regional Federal Reserve Banks (FRBs) and their twenty-five branches, the Federal Open Market Committee (FOMC), the Federal Advisory Council and other advisory and working committees, and 2,900 member banks, mostly national banks. By law, all federally chartered banks, that is, national banks, are automatic members of the system. State-chartered banks may elect to become members.

The seven-member board of governors, headquartered in Washington, D.C., is the core agency of the Fed, overseeing the entire operation of U.S. monetary policy. The FRBs are the operating arms of the system and are located in twelve major cities, one in each of the twelve Federal Reserve Districts around the nation. The twelve-member FOMC is the most important policy-making entity of the system. The voting members of the committee are the seven members of the board, the president of the FRB of New York, and four of the other eleven FRB presidents, each serving one year on a rotating basis. The other seven nonvoting FRB presidents still attend the meetings and participate fully in policy deliberations.

MONETARY POLICY AND THE ECONOMY

Being one of the most influential government policies, monetary policy aims at affecting the economy through the Fed's management of money and interest rates. The narrowest definition of money is M1, which includes currency, checking account deposits, and traveler's checks. Time deposits, savings deposits, money market deposits, and other financial assets can be added to M1 to define other monetary measures, such as M2 and M3. Interest rates are simply the costs of borrowing. The Fed conducts monetary policy through bank reserves, which are the portion of the deposits that banks and other depository institutions are required to hold either as vault cash or as deposits with their home FRBs. Excess reserves are the reserves in excess of the amount required. These additional funds can be transacted in the reserves market (the federal funds market) to allow overnight borrowing between depository institutions to meet short-term needs in reserves. The rate at which such private borrowings are charged is the federal funds rate.

Monetary policy is closely linked with the reserves market. With its policy tools, the Fed can control the reserves available in the market, affect the federal funds rate, and subsequently trigger a chain of reactions that influence other short-term interest rates, foreign-exchange rates, long-term interest rates, and the amount of money and credit in the economy. These changes will then bring about adjustments in consumption, affect saving and investment decisions, and eventually influence employment, output, and prices.

GOALS OF MONETARY POLICY

The long-term goals of monetary policy are to promote full employment and stable prices and to moderate long-term interest rates. Most economists believe price stability should be the primary objective, since a stable level of prices is key to sustained output and employment, as well as to maintaining moderate long-term interest rates. Relatively speaking, it is easier for central banks to control inflation (i.e., the continual rise in the price level) than to influence employment directly, because the latter is affected by such real factors as technology and consumer tastes. Moreover, historical evidence indicates a strong positive correlation between inflation and the amount of money.

While the financial markets react quickly to changes in monetary policy, it generally takes months or even years for such policy to affect employment and growth, and thus to reach the Fed's long-term goals. The Fed, therefore, needs to be forward-looking and to make timely policy adjustments based on forecasted as well as actual data on such variables as wages and prices, inflation, unemployment, output growth, foreign trade, interest rates, exchange rates, money and credit, and conditions in the markets for bonds and stocks.

IMPLEMENTATION OF MONETARY POLICY

Since the early 1980s, the Fed has been relying on the overnight federal funds rate as the guide to its position in monetary policy. The Fed has at its disposal three major monetary policy tools: reserve requirements, the discount rate, and open-market operations.

Reserve Requirements

Under the Monetary Control Act of 1980, all depository institutions, including commercial banks and savings and loans, are subject to the same reserve requirements, regardless of their Fed member status. As of October 2005, the structure of reserve requirements was 0 percent for all checkable deposits up to $7 million (the exemption), 3 percent for such deposits from above $7 million to $47.6 million (the low-reserve tranche), and 10 percent for the amount above $47.6 million. Both the exemption and the low-reserve tranche are subject to annual adjustment by statute to reflect changes in reservable liabilities at all depository institutions. No reserves are required for nonpersonal time deposits and Eurocurrency liabilities.

Reserve requirements affect the so-called multiple money creation. Suppose, for example, the reserve requirement ratio is 10 percent. A bank that receives a $100 deposit (Bank 1) can lend out $90. Bank 1 can then issue a $90 check to a borrower, who deposits it in Bank 2, which can then lend out $81. As it continues, the process will eventually involve a total of $1,000 ($100 + $90 + $81 + $72.9 + … = $1,000) in deposits. The initial deposit of $100 is thus multiplied ten times. With a lower (higher) ratio, the multiple involved is larger (smaller), and more (fewer) reserves can be created.

Reserve requirements are not used as often as the other policy tools. Since funds grow in multiples, it is difficult to administer small adjustments in reserves with this tool. Also, banks always have the option of entering the federal funds market for reserves, further limiting the role of reserve requirements. Except for the yearly adjustments of the exemption and the low-reserve tranche, the last change in the reserve requirements was in April 1992, when the upper ratio was reduced from 12 to 10 percent.

The Discount Rate

Banks and other depository institutions may acquire loans through the discount window at their home FRB to meet their short-term needs against, for example, unexpected large withdrawals of deposits. The interest rate charged on such loans is the discount rate. A reduction of the rate encourages more borrowing, and through money creation, bank deposits increase and reserves increase. A rate hike works in the opposite direction. Since it is more efficient, however, to adjust reserves through open-market operations (discussed below), the amount of discount window lending has been unimportant, accounting for only a small fraction of total reserves. Perhaps a more meaningful function served by the discount rate is to signal the Fed's stance on monetary policy, similar to the role of the federal funds rate.

By law, each FRB sets its discount rate every two weeks, subject to the approval of the board of governors. The gradual nationalization of the credit market over the years, however, has resulted in a uniform discount rate. A major revision in the discount window programs took effect in January 2003 to enhance the Fed's lending function. The FRBs began to offer three discount window programs to depository institutions: the primary credit program for financially sound institutions, the secondary credit program for institutions not eligible for primary credit, and the seasonal credit program for small depository institutions that have seasonal fluctuations in funding needs.

Discount-rate adjustments, usually going hand in hand with changes in the federal funds rate, have been dictated by cyclical conditions of the economy, and the frequency of adjustments has varied. For instance, the discount rate moved up from a low of 3 percent in May 1994 to 6 percent in January 2001 to counter possible overheating and inflation from the robust economic growth since the mid-1990s. The rate was then lowered twelve times, to a bare 0.75 percent in two years, to help the economy recover from its 2001 recession. From June 2004 to September 2005, the primary (4.75 percent) and secondary (5.25 percent) credit rates were both raised 11 times to cool off the economy and especially the overheated housing market.

Open-Market Operations

The most important and flexible tool of monetary policy is open-market operations, that is, trading U.S. government securities in the open market. In 2004 the Fed made $7.55 trillion of purchases and $7.51 trillion of sales of Treasury securities (mostly short-term Treasury bills). As of June 2005, the Fed held $721.92 billion of U.S. Treasury securities, roughly 9.2 percent of the total federal debt outstanding.

The FOMC directs open-market operations (and also advises about reserve requirements and discount-rate policies). The day-to-day operations are determined and executed by the Domestic Trading Desk (the Desk) at the FRB of New York. Since 1980 the FOMC has met regularly eight times a year in Washington, D.C. At each of these meetings, it votes on an intermeeting target federal funds rate, based on the current and prospective conditions of the economy. Until the next meeting, the Desk will manage reserve conditions through open-market operations to maintain the federal funds rate around the given target level. When buying securities from a bank, the Fed makes the payment by increasing the bank's reserves at the Fed. More reserves will then be available in the federal funds market and the federal funds rate falls. By selling securities to a bank, the Fed receives payment in reserves from the bank. Supply of reserves falls and the funds rate rises.

The Fed has two basic approaches in running open-market operations. When a shortage or surplus in reserves is likely to persist, the Fed may undertake outright purchases or sales, creating a long-term impact on the supply of reserves. Nevertheless, many reserve movements are temporary. The Fed can then take a defensive position and engage in transactions that impose only temporary effects on the level of reserves. A repurchase agreement (a repo) allows the Fed to purchase securities with the agreement that the seller will buy back them within a short period, sometimes overnight and mostly within seven days. The repo creates a temporary increase in reserves, which vanishes when the term expires. If the Fed wishes to drain reserves temporarily from the banking system, it can adopt a matched sale-purchase transaction (a reverse repo), under which the buyer agrees to sell the securities back to the Fed, usually in fewer than seven days.

see also Federal Reserve System ; International Monetary Fund ; Macroeconomics/Microeconomics

bibliography

Bernanke, Ben S. (2005, March 30). Implementing monetary policy (Federal Reserve Board Member speech). Retrieved January 23, 2006, from http://www.federalreserve.gov/boarddocs/speeches/2005/20050330/default.htm

Bernanke, Ben S. (2004, December 2). The logic of monetary policy (Federal Reserve Board Member speech). Retrieved January 23, 2006, from http://www.federalreserve.gov/boarddocs/speeches/2004/20041202/default.htm

Bies, Susan S. (2004, October 23). The Federal Reserve System and the economy (Federal Reserve Board Member speech). Retrieved January 23, 2006, from http://www.federalreserve.gov/boarddocs/speeches/2004/20041023/default.htm

The Federal Reserve System: Purposes and functions. (2005, June). Washington, DC: Board of Governors of the Federal Reserve System.

Mishkin, Frederic S. (2006). The economics of money, banking, and financial markets (7th ed.). New York: Pearson-Addison-Wesley.

91st Annual Report: 2004. (2005). Washington, DC: Board of Governors of the Federal Reserve System.

Treasury Bulletin. (2005, September). Washington, DC: U.S. Department of Treasury.

Edward Wei-Te Hsieh