The term monetary policy refers to the actions that the Federal Reserve undertakes to influence the amount of money and credit in the U.S. economy. Changes to the amount of money and credit affect interest rates (the cost of credit) and the performance of the U.S. economy. To state this concept simply, if the cost of credit is reduced, more people and firms will borrow money and the economy will show faster economic growth.
The Fed has three main tools at its disposal to influence monetary policy:
Open-Market Operations – The Fed constantly buys and sells U.S. government securities in the financial markets, which in turn influences the level of reserves in the banking system. These decisions also affect the volume and the price of credit (interest rates). The term open market means that the Fed doesn't independently decide with which securities dealers it will do business with on a particular day. Rather, the choice emerges from an open market where the various primary securities dealers compete. Open market operations are the most frequently employed tool of monetary policy.
Setting the Discount Rate – This is the interest rate that banks pay on short-term loans from a Federal Reserve Bank. The discount rate is usually lower than the federal funds rate (the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis), although they are closely related. The discount rate is important because it is a visible announcement of change in the Fed's monetary policy and it gives the rest of the market insight into the Fed's plans.
Setting Reserve Requirements – This is the amount of physical funds that depository institutions are required to hold in reserve against deposits in bank accounts. It determines how much money banks can create through loans and investments. Set by the Board of Governors, the reserve requirement is currently around 10%. Excess reserves are, therefore, held either as vault cash or in accounts with the district Federal Reserve Bank Therefore, the reserve requirements ensure that depository institutions maintain a minimum amount of physical funds in their reserves.
What is the role of the Federal Open Market Committee (FOMC)?
The FOMC formulates the nation’s monetary policy. The voting members of the FOMC consist of the seven members of the Board of Governors (BOG), the president of the Federal Reserve Bank of New York and presidents of four other Reserve Banks who serve on a one-year rotating basis. All Reserve Bank presidents participate in FOMC policy discussions whether or not they are voting members. The chairman of the Board of Governors chairs the FOMC meeting.
The FOMC typically meets eight times a year in Washington, D.C. At each meeting, the committee discusses the outlook for the U.S. economy and monetary policy options.
What is Quantitative Easing?
The Fed, or any central bank for that matter, enacts quantitative easing by creating money and then buying bonds or other financial assets from banks. The banks then will have more cash available to loan. Higher loan growth, in turn, should make it easier to finance projects – for example, the construction of a new office building. These projects put people to work, thereby helping the economy to grow. In addition, the Fed’s purchases help drive up the prices of bonds by reducing their supply, which causes their yields to fall. Lower yields, in turn, provide the fuel for economic expansion by lowering borrowers’ costs.
This is how the idea works on paper, at least. In practice, banks don’t have to loan excess cash. If banks are tentative and lacking in confidence – as was the case in the years following the financial crisis of 2008 – the higher money supply may not prove to be the engine of growth the Fed had in mind.
QE1” and "QE2”
In the midst of the 2008 financial crisis, slow growth and high unemployment forced the Fed to stimulate the economy through its policy of quantitative easing in the interval from November 25, 2008 through March 2010. The program had little impact initially, so the Fed announced an expansion of the program from $600 billion to $1.25 trillion on March 18, 2009.
Immediately after the program wrapped up, trouble emerged in the form of slower growth, the rise of the European debt crisis, and renewed instability in the financial markets. The Fed moved in with a second round of quantitative easing, which became known as “QE2” and involved the purchase of $600 billion worth of short-term bonds. This program - which Chairman Ben Bernanke first hinted at on August 27, 2010 - ran from November 2010 through June 2011. QE2 sparked a rally in the financial markets but did little to spur sustainable economic growth.
What is Fed Tapering?
“Tapering” is a term that exploded into the financial lexicon on May 22, when U.S. Federal Reserve Chairman Ben Bernanke stated in testimony before Congress that that Fed may taper the bond-buying program known as quantitative easing (QE) in the coming months.
When asked about the timing of a potential end to the Fed’s simulative quantitative easing policy in his May 22 testimony, Bernanke answered, “If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings ... take a step down in our pace of purchases.” This was just one of many statements made by Bernanke that day. However, it was the one that received the most attention because it came at a time that investors were already concerned about the potential market impact of a reduction in a policy that has been so favorable for both stocks and bonds.
That same day, the minutes of the Federal Open Market Committee – or FOMC, the committee that sets monetary policy – revealed that support for QE is by no means unanimous:
Fed to maintain pace of bond-buying programme (18th September 2013)
In surprise move, Fed to keep buying $85 billion in bonds monthly, citing higher mortgage rates, fiscal policy headwinds
“There is no fixed calendar schedule. I really have to emphasize that,” he told a news conference. “If the data confirm our basic outlook, if we gain more confidence in that outlook...then we could move later this year.”
In fresh quarterly projections, the Fed cut its forecast for 2013 economic growth to a 2-2.3% range from a June estimate of 2.3-2.6%. The downgrade for next year was even sharper. It cited strains in the economy from tight fiscal policy and higher mortgage rates as it explained why it decided to maintain asset purchases at the current pace.
“The tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market,” it said in a statement. Nevertheless, the Fed said the economy was still making progress despite tax hikes and budget cuts in Washington.
“Taking into account the extent of federal fiscal retrenchment, the committee sees the improvement in economic activity and labour market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy,” it said.
“The committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases,” the Fed added.
Bernanke had stated in June that officials expected to begin slowing the pace of purchases later this year and end the program by mid-2014, at which point the central bank expected unemployment to be around 7%. We could begin later this year. But even if we do that, the subsequent steps will be dependent on continued progress in the economy,” Bernanke said. “We don’t have a fixed calendar schedule. But we do have the same basic framework that I described in June.”
The Fed has held overnight interest rates near zero since late 2008 and has more than tripled its balanced sheet to more than USD 3.6 trillion through three rounds of bond buying aimed at holding borrowing costs down.
The decision not to taper bond purchases faced a single dissent, from Kansas City Federal Reserve Bank President Esther George, who said she was worried about financial bubbles due to the Fed's low rate policy. George has dissented at every Fed policy meeting this year. Fed Governor Sarah Raskin, who has been nominated to take a top job at the US Treasury, did not participate.
We will explain concepts of Money Supply in the next edition on Mirae Asset Knowledge Academy Tutorials.
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