Chapter 5 The Federal Reserve The Federal Reserve System Tools of Monetary Policy The Federal Reserve System Tools of Monetary Policy

I. The Federal Reserve System “the Fed” originally a lender of last resort to prevent bank panics today, also conducts monetary policy “the Fed” originally a lender of last resort to prevent bank panics today, also conducts monetary policy

Fed Structure Board of Governors 7 members, 14 yr. nonrenewable terms 1 member is Chair -- Alan Greenspan (1987) Board of Governors 7 members, 14 yr. nonrenewable terms 1 member is Chair -- Alan Greenspan (1987)

Regional Banks 12 districts FRBNY is most important perform bank services Regional Banks 12 districts FRBNY is most important perform bank services

FOMC 12 members -- Board -- FRBNY President -- 4 other district presidents (rotate) meet every 6 weeks to vote on monetary policy (FF rate target) FRBNY implements FOMC votes FOMC 12 members -- Board -- FRBNY President -- 4 other district presidents (rotate) meet every 6 weeks to vote on monetary policy (FF rate target) FRBNY implements FOMC votes

Fed independence How? Fed is self-financing Fed governors serve long-terms Why? economic vs. political goals long-term vs. short-term goals How? Fed is self-financing Fed governors serve long-terms Why? economic vs. political goals long-term vs. short-term goals

Fed is NOT completely independent Fed powers can be limited by Congress Fed is NOT completely independent Fed powers can be limited by Congress

II. Tools of Monetary Policy reserve requirement % deposits banks must hold as cash or Fed deposits changing this will affect MS but this is expensive to change, and is too powerful reserve requirement % deposits banks must hold as cash or Fed deposits changing this will affect MS but this is expensive to change, and is too powerful

discount loans loans from the Fed to banks Fed can change interest rate or availability of loans but most banks do not use them not very effective in controlling MS discount loans loans from the Fed to banks Fed can change interest rate or availability of loans but most banks do not use them not very effective in controlling MS

open market operations main monetary policy tool Fed buys/sells Treasuries through private dealers in 1998 made $35 billion in profit FOMC votes on federal funds rate target FRBNY sells/buys to meet the target open market operations main monetary policy tool Fed buys/sells Treasuries through private dealers in 1998 made $35 billion in profit FOMC votes on federal funds rate target FRBNY sells/buys to meet the target

if Fed BUYS Treasuries banks reserves increase, FF rate decreases immediately other short-term rates fall, MS increases weeks - months economic expansion 1 year banks reserves increase, FF rate decreases immediately other short-term rates fall, MS increases weeks - months economic expansion 1 year

FF rate target, As FF rate falls, other ST rates also fall

Open market repos temporary changes in bank reserves Repo Fed buys Treasuries with seller repurchasing them later temporary increase in reserves temporary changes in bank reserves Repo Fed buys Treasuries with seller repurchasing them later temporary increase in reserves

reverse repo Fed sell Treasuries and agrees to repurchase temporary decrease in reserves reverse repo Fed sell Treasuries and agrees to repurchase temporary decrease in reserves

Chapter 6. Monetary Policy Goals Recent history Goals Recent history

I. Goals price stability/low inflation goal: below 3% 2003: 1.87% (CPI) low unemployment goal: natural rate (4%?) 12/03: 5.7% price stability/low inflation goal: below 3% 2003: 1.87% (CPI) low unemployment goal: natural rate (4%?) 12/03: 5.7%

economic growth % increase in real GDP goal: 3% 4 th Q 2003: 4% annual rate financial market stability calm investors intervene if markets “too high” or “too low” economic growth % increase in real GDP goal: 3% 4 th Q 2003: 4% annual rate financial market stability calm investors intervene if markets “too high” or “too low”

Sometimes goals conflict low inflation vs. economic growth or low inflation vs. financial market stability but in 1990s, enjoyed strong growth, low inflation low inflation vs. economic growth or low inflation vs. financial market stability but in 1990s, enjoyed strong growth, low inflation

II. Monetary policy in 1990s Fed targets FF rate FOMC votes on FF rate target current target: 1% (since 6/2003) Fed targets FF rate FOMC votes on FF rate target current target: 1% (since 6/2003)

recession Fed slow to recognize recession and cut FF rate ‘90-’92 falls from 8% to 3% mild recession, but mild/slow recovery Fed slow to recognize recession and cut FF rate ‘90-’92 falls from 8% to 3% mild recession, but mild/slow recovery

FOMC announces FF rate target after meeting FF rate target raise 8 times (3-6%) prevent inflation surprise to financial markets “soft landing” currency intervention to increase Yen/$ FOMC announces FF rate target after meeting FF rate target raise 8 times (3-6%) prevent inflation surprise to financial markets “soft landing” currency intervention to increase Yen/$

Russian debt default Asian currency crisis Fed cuts FF rate bailout of LTCM to prevent financial panic Russian debt default Asian currency crisis Fed cuts FF rate bailout of LTCM to prevent financial panic

increases in FF rate for another “soft landing” reversed in 2000 after economy slows 3/91 - 3/01 longest U.S. expansion increases in FF rate for another “soft landing” reversed in 2000 after economy slows 3/91 - 3/01 longest U.S. expansion

TodayToday FF rate target cut from 6.5% to 1% Recession 2001 (March-Nov.) slow recovery, esp. job market FOMC has indicated that they will keep FF rate low for now not worried about inflation FF rate target cut from 6.5% to 1% Recession 2001 (March-Nov.) slow recovery, esp. job market FOMC has indicated that they will keep FF rate low for now not worried about inflation