The Federal Reserve II. Fed Policy: tools & critique ECO 473 – Money & Banking – Dr. D. Foster

Goals of Monetary Policy Inflation goals: Low/no inflation with limited year-to-year variability. Output goals: High and stable economic (GDP) growth. Employment goals: Stable employment growth with low unemployment.

Federal Reserve Policy Tools Open Market Operations Buy/sell Treasury bonds to affect bank reserves. The major form of monetary policy. What will the Fed do if we run out of Treasury bonds? Discount Window Lend to member banks to affect bank reserves. Purpose is to target the “federal funds rate” – iff This is the rate that banks charge each other for very short term loans. Required Reserve Ratio (rrD) Changing this affects bank excess reserves directly. Used more to reflect structural changes. Was used in 1937 and precipitates more Great Depression. Time to let this go? New policy? – Pay banks i for ER (!!)

Intermediate Targets of Monetary Policy The key rationale for intermediate targeting: The limited long-term information about the economy available to policymakers.

Monetary Policy: Goals & Targets Open Market Operations Discount Window Required Reserve Ratio (rrD) Price stability Low unemployment Sustainable growth Interest Rates Monetary Aggregates

Choosing an Intermediate Target Variable Characteristics: Frequently observable Consistency with ultimate goals Definable and measurable Controllable Potential variables: Monetary aggregates M1, M2, MZM Interest rates (fed’l funds, prime …) Others: Nominal GDP Credit aggregates Exchange rates

Targeting the Federal Funds Rate of Interest Sept. 2017 1.15%

Is Policy the Right Choice? Time lags make effective policy uncertain. Discretionary policy promotes uncertainty. Rules and credible adherence can eliminate bias. Independence is a likely key requirement.

Time Lags in Monetary (& Fiscal) Policy Policy time lags Recognition lag Response lag Transmission lag Real GDP Business cycle time

Monetary Policy may be counterproductive % Real GDP time Ideally, policy would dampen the business cycle… But, dampening the business cycle may lower ave. growth! Or, if policy kicks in at the wrong time, it could worsen recessions and exacerbate inflationary periods.

Discretion versus Rules (Milton Friedman) Discretionary policy is the source of instability. A policy rule can eliminate that instability. Set target for Bank Reserves, Monetary Base, Money Supply to grow in LR sustainable fashion. This is a commitment to a fixed strategy no matter what happens to other economic variables. To be successful, the commitment must be credible. The public believes the Fed will act this way.

Making Monetary Policy Rules Credible Place constitutional limits on monetary policy. Achieve credibility by establishing a reputation. Maintain central bank independence. Establish central banker contracts. Appoint a “conservative” central banker.

Has the Fed maintained stable prices?

Has the Fed maintained the value of the $? 4%

Making Monetary Policy Transparent FOMC Press Release Sept. 20, 2017 Q&A June 22, 2016 Presser Sept. 20, 2017

Quantitative Easing = Credible? QE 1 QE 2 QE 3

Can the Fed undo the QEs? Inflation is a monetary phenomenon. Austrians: the only meaningful definition of inflation is w.r.t. the money supply. What happens if the economy starts growing? Banks will want to lend more, raising the MS and causing inflation. The Fed could try to stop it by raising interest on ER … to 3%? 5%? 10%? Inflationary expectations grow and become rooted in our economy, ala 1979. Fed starts to pull back by selling UST and MBS. Their prices plummet; so Fed can’t buy back all the excess reserves! Interest rates will soar; investment will falter; a recession ensues. But, a recession accompanied by serious inflation, aka “stagflation.” Is it an “insurance policy” against massive sell-off?

The Federal Reserve II. Fed Policy: tools & critique ECO 473 – Money & Banking – Dr. D. Foster