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Fundamentals of Monetary Policy

Jon Faust Federal Reserve Board Jan. 14, 2014

Note: These slides were prepared for presentation at a Mechanics of Finance Briefing arranged by the Milken Institute and National Press Foundation. These slides are intended only as a primer on the basic topics covered; they reflects the authors views and not necessarily those of the Federal Reserve Board or anyone else associated with the Federal Reserve System.


Never explain, never excuse Montague Norman, Governor, Bank of England, 19211944


FOMC, 2012

The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decisionmaking by households and businesses, reduces economic and nancial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society. (from the statement of longer-run goals and strategy)


Central banks


Almost all nations have a central bank U.S.: Federal Reserve System U.K.: Bank of England Nations that share the euro: European Central Bank
(in conjunction with the central banks of each nation)


Central Bank: Main Responsibilities Monetary policy:

Foster nancial conditions favorable to stable spending, production, and ination.

Financial stability
Traditionally: calm nancial panics by standing ready to provide short-term loans to solvent banks that face runs. This function called lender of last resort to nancial system.


Central Bank: Main Responsibilities Other responsibilities vary a good deal across central banks


Monetary policy


Governance and independence Around the world, monetary policy is often made by a board. Board is often appointed by the government, but. . . . . . government cannot dictate or overrule monetary policy decisions
(or re the policymakers for their policies)

Known as central bank independence


Governance and independence Why independence?

A long historical record worldwide suggests that independence leads to more stable policy and benets citizens in the economy.


Federal Reserve System Established by Congress in 1913

Modied in some important ways through the years


Federal Reserve System Federal Open Market Committee (FOMC) makes monetary policy decisions 19 members 7 members of the Board of Governors of the Federal Reserve System
(the Chair and Vice Chair are governors)

12 Presidents of regional Federal Reserve Banks


Decisionmaking FOMC has 8 regularly scheduled meetings per year FOMC debates and votes on changes to the stance of monetary policy Policy set by a vote of 7 governors and 5 voting presidents
5 of 12 presidents vote on a rotating basis. New York Fed president always votes.


Monetary policy: transparency


Transparency: Explaining policy Modern thinking says policy is more effective when the public understands policy. Policy transparency has come a long way generally in central banks around the world
. . . but transparency is still a work in progress


Federal Reserves Main Communication Tools FOMC statement released at the end of each FOMC meeting. Chairs press conference follows 4 meetings per year Minutes of the FOMC meeting released about 3 weeks after meeting After 5 years, full transcript of meeting.


Federal Reserves Main Communication Tools Summary of Economic Projections of FOMC participants Chair and other ofcials testify regularly in Congress
including a twice yearly Monetary Policy Report

Regular speeches by all policymakers Website lled with mountains material


Goal of all this Explain state of policy Give rationale for policy Explain likely future evolution of policy


The Feds monetary policy mandate


Statutory mandate Promote maximum employment, stable prices, and moderate long-term interest rates
This gives general guidance, but must be lled out


In Jan. 2012, FOMC adopted . . . Consensus statement on longer-run goals and strategy
FOMC reafrms each January


Why longer-run goals? From the statement:

Ination, employment, and long-term interest rates uctuate over time in response to economic and nancial disturbances. Moreover, monetary policy actions tend to inuence economic activity and prices with a lag. Therefore, the Committees policy decisions reect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the nancial system. . .


Stable prices Does this mean zero ination? No. Consensus statement sets a goal of 2 percent ination


Why not zero ination? Long history worldwide suggests that deation very bad for employment and growth
Deation is negative ination; that is, a falling general price level

2 percent ination is judged to be high enough to provide a cushion or buffer against deation But still low enough to avoid undue costs of ination


Maximum employment Does the mean Fed aspires to an unemployment rate of zero? No.


Maximum employment Does the mean Fed aspires to an unemployment rate of zero? No. Consensus statement refers to maximum sustainable employment


Why not zero unemployment? In any dynamic economy there will always be some unemployment
100% employment is not sustainable

The maximum sustainable rate is not known with precision FOMC reports its estimate in the Summary of Economic Projections
current range: 5.26.0 percent unemployment rate


Moderate long-term interest rates FOMC judges that best way to achieve this portion of the mandate is to promote stable prices and maximum employment
Thus, this goal is often not separately emphasized


How do central banks pursue their goals?


Conventional policy Central bank can control the interest rate at which banks lend to each other for 1 day.
generally called an overnight interest rate

In U.S., called the federal funds rate


Promoting the goals Raising or lowering the federal funds rate target indirectly affects all other interest rates . . . . . . and stock prices, home prices, the exchange value of the dollar against other currencies, and all other nancial conditions


Promoting the goals Raising the federal funds rate target tends to make nancial conditions less favorable to borrowing and spending.
Called less accommodative

Lowering the target makes conditions more accommodative


In terms of the mandate More accommodative policies tend to . . . promote higher employment promote higher ination Less accommodative policies do the opposite


Simple facts about this interest rate tool It can be powerful It is blunt and indirect


Note also This interest rate policy moves both employment and ination in the same direction
e.g. tending to raise both employment and ination or lower them

Dont have an interest rate tool to push one up and the other down


Note also Right now the two sides of the mandate both call for accommodative policy
Ination below 2 percent, employment below maximum sustainable level

Very often the two goals call for the same policy


When the goals call for different policy Statement of goals and strategy:
When the goals conict, FOMC takes a balanced approach to promoting a return to the desired levels over time.


Monetary policy mechanics and what is different at present


Mechanics In conventional policy, the FOMC strives to hit the federal funds rate target by buying and/or selling government securities For example, buying securities increases bank reserves and tends to push down the federal funds rate.


What is different right now? U.S. had a nancial crisis and deep recession
led to high unemployment, downward pressure on ination

Normal response: lower the federal funds rate target


But you can only go so far Cannot push the federal funds rate below zero
A negative interest rate means the lender pays the borrower to borrow. Lenders would rather just keep the funds.


Thus, Once the conventional policy interest rate hits zero the conventional approach cannot be pursued further Must use unconventional tools to create the needed accommodation


2 main tools Forward guidance Large scale purchases of longer-term securities


Forward guidance Forward guidance is clear communication about the conditions under which the federal funds rate target will remain highly accommodative. Loosely, speaking, FOMC seeks to make clear that it will promote highly accommodative conditions until the job is done. The expectation of continued accommodation should put downward pressure on longer-term interest rates.
Which tends to stimulate the economy

Forward guidance: December FOMC statement

The Committee also reafrmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, ination between one and two years ahead is projected to be no more than a half percentage point above the Committees 2 percent longer-run goal, and longer-term ination expectations continue to be well anchored.


Forward guidance: December FOMC statement At least as long, but maybe longer?
The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected ination continues to run below the Committees 2 percent longer-run goal.


Large scale purchases of longer term securities FOMC policies usually affect longer-term interest rates indirectly through a affecting an overnight interest rate
or through communications about the future course of the overnight interest rate

Instead, the FOMC could purchase a large amount of longer-term securities

FOMC is empowered to by Treasury securities and agency and agency mortgage-backed securities


Large scale purchases of longer term securities Large scale purchases of longer-term securities tend to push down the interest rate on these securities
putting downward pressure on longer-term interest rates more generally, which should stimulate the economy


December FOMC statement FOMC had been purchasing $85 per month in longer-term securities In December, FOMC reduced rate of purchases to $75 billion per month
Known popularly as a taper


December statement: future path of purchases

If incoming information broadly supports the Committees expectation of ongoing improvement in labor market conditions and ination moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings.


December statement: future path of purchases

Asset purchases are not on a preset course, and the Committees decisions about their pace will remain contingent on the Committees outlook for the labor market and ination as well as its assessment of the likely efcacy and costs of such purchases.


Overall Fed is maintaining a highly accommodative policy

To promote return to maximum sustainable employment and return of ination to 2 percent

Because federal funds rate target is near zero, using unconventional tools


Overall Over time, as conditions warrant, Fed will return to more conventional policy


With this broad sketch. . .

. . . the other speakers will now talk in greater detail about the effects of unconventional policy in the U.S. and abroad. . .


References for some specics Basic Federal Reserve structure:

The consensus statement on longer-run goals and strategy:

FOMC statements: