Monetary Policy: Deliberation and Implementation

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Monetary PolicyDeliberation and Implementation

• Week 12 November 9, 2005

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Roles of Central Banks

• List of central bank roles in Rose (p. 354)
• Market stabilization
• Control of money supply
• Lender of last resort
• Supervisor of the banking system
• Protecting and improveing the flow of payments
• Last two are independent of others, and first
  three all relate to money supply

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Control of money supply

• Promote economic goals
• Full employment
• Price stability
• Economic growth through improvements in
  productivity with investment
• How good must central banks be?
• Theory of optimal currency areas weighs costs of
  multiple currencies versus local control of money
  supply to promote above

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Robert Mundell
Many of the political changes in the century
have been caused by little-understood
perturbations in the international monetary
system, while these in turn have been a
consequence of the rise of the United States and
mistakes of its financial arm, the Federal
Reserve System. The twentieth century began with
a highly efficient international monetary system
that was destroyed in World War I, and its
bungled recreation in the interwar period brought
on the Great Depression, Hitler, and World War
II.
A Reconstruction of the Twentieth Century
(Nobel Prize Lecture, December 10, 2002) in
American Economic Review, June 2002, p. 327
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Roles of Federal Reserve

• Control of money supply - to be discussed
• Market stabilization
• Fed open market operations
• Statements of officials
• Lender of last resort
• Incentive problems
• Maintaining and improvement of payments mechanism
• Private competitors, pre-Fed arrangements
• Supervisor of the banking system
• Performed by other agencies

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Monetary Policy

• Deliberation
• Implementation
• Prediction
• Evaluation
• Criticism

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Deliberation

• Since 1935, monetary policy is the responsibility
  of the Federal Open Market Committee (FOMC)
• FOMC consists of 7 Federal Reserve Governors
  (Washington based) and five voting Federal
  Reserve Bank presidents
• New York FRB president
• Chicago/Cleveland FRB presidents alternate
• Three of remaining nine FRB presidents rotate

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What is Money?

• Fed tracks three money measures
• M1 Currency checkable accounts others
• M2 M1 small savings accounts (including IRAs
  and Keoghs at banks) others
• M3 M2 large CDs Eurodollars others
• Which is relevant to level of economic activity
  -- actively debated issues
• Which can Fed control?

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The Money Multiplier

• Fed controls its balance sheet, including the
  monetary base currency reserves
• Money multiplier derives relation between supply
  of money (whichever definition) and the monetary
  base. Rose (p. 521) has M1 multiplier
• Note factors affecting money supply

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Money Multiplier
Source Federal Reserve Bank of St. Louis FRED II
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Currency Ratio
Source Federal Reserve Bank of St. Louis FRED II
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FOMC meetings

• Eight scheduled meetings per year one today
• Next meeting is December 13, 2005
• Last scheduled meeting was November 1, 2005
• Last meeting for which minutes were released was
  September 20, 2005 (available on Internet)
• Format of meetings routine
• Discuss financial markets and economy
• Adopt formal instructions to the manager of the
  System Open Market Account (directive)

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Input to FOMC Deliberations

• Staff projections
• Green book
• Blue book
• Beige book
• Conceptual framework
• Non-accelerating inflation rate of employment
  (NAIRU)
• Taylors rule
• Econometric models and projections

where i is Fed funds rate and p is inflation and
y is output gap (difference between actual and
potential GDP)
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Implementation

• Fed can only control its own balance sheet, or
  high-powered money consisting of currency and
  bank reserves
• Since 1970, Fed targets growth rates in money
  supply
• Initially two month growth targets
• 1975 started announcing six month target and cone
• Humphrey-Hawkins required annual target

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Fed Balance Sheet Oct. 30, 2003
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Fed Balance Sheet Oct.28, 2004
(U.S. Securities up 7.4, FR Notes up 5.6,
reserves down 6.4)
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Fed Balance Sheet Oct.26, 2005
(U.S. Securities up 4.6, FR Notes up 8.6,
reserves down 13.6)
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FOMC and Board of Governors

• FOMC sets monetary policy
• Board of Governors rules on issues concerning
  regulatory changes, acquisitions under
  Gramm-Leach-Bliley Act of 1999
• Board reports twice annually to Congress under
  requirements of Full Employment and Balanced
  Growth Act of 1978 (Humphrey-Hawkins)
• Testimony to Congress

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Problems in Implementation

• Monetary statistics reported late and are subject
  to revision (described as driving by looking in
  rear-view mirror)
• Market rates are instantaneously observable and
  Fed Funds rate immediately impacted by changes in
  high-powered money (reserves)
• Fed traditionally focussed on rates or credit
  market conditions

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Fed Targets and Base Growth
Demand for Reserves and Funds

Wide
Narrow

fFed Funds rate
range
range
Reserves
Non-Borrowed Reserves
Borrowed Reserves Discounts at Fed
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Required reserves

• Reserve requirements depend on which banks (3
  for smaller banks) and level of transactions
  versus other accounts
• Calculation period runs 14 days from a Tuesday to
  Monday
• Maintenance period is 14 days, ending on
  Wednesday 16 days after calculation period
• Vault cash based on previous maintenance period
  applied to required reserves

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Lagged Reserves
Tuesday
Monday
Monday
Monday
Monday
17 days
Wednesday
Wednesday
Wednesday
Wednesday
Thursday
Calculation Period
Maintenance Period

• Reserve calculated on a dollar days basis
• Penalties for shortfalls, limited advantage
  (carry-forward) for excess
• Clearing balances affected by Fed wire and
  Treasury transactions

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Growth Monthly and Smoothed
Source Federal Reserve Bank of St. Louis FRED II
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Monetary Base and Money
Source Federal Reserve Bank of St. Louis FRED II
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Base Drift
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Fed Funds and M1 Growth in 70s
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Volcker - October 6, 1979

• Focus on growth of aggregates
• Widen Fed Funds trading range to 400 basis points
• Focus on non-borrowed reserves
• Experience
• Interest rates
• Monetary growth

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The Early 80s under Volcker
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Fed Funds and M1 Growth Now
Source Federal Reserve Bank of St. Louis FRED II
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Prediction (Fed Watching)

• Importance of Fed actions is less than in 1970s,
  but still matter to market observers
• Fed watching is still common on the street
• Fed watching consists of
• Observing what they say they are doing
• Speeches, testimony, interviews, remarks
• Assessing what they have done
• Statistical releases
• Tracking the markets reaction

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Evaluation

• Humphrey-Hawkins specifies monetary policy
  objectives to be low inflation and economic
  growth
• Last eight years have been a period of low
  inflation and rapid growth
• Basic evaluation is that Greenspan has been a
  great chairman and his re-appointment by Clinton
  de-politicized the Fed

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Criticism

• Theoretical argument by monetarists
• Inflation is always and everywhere a monetary
  phenomenon - Milton Friedman
• Fed is a giant player and its actions have an
  immense effect on markets, producing uncertainty
• A base growth rule, gold standard, or
  comprehensible price rule would eliminate
  uncertainty about Fed policy

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Theoretical/Philosophical Issues

• The econometric models used for policy are
  fundamentally flawed (the Lucas critique)
• Participants in efficient markets try to
  anticipate changes and alter behavior accordingly
• Parameters of estimated response functions will
  change constantly, hence are unstable
• Data too limited to assess changes on models
• Unanticipated changes in policy are risks

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Greenspan revisited

• What are his (or the FOMCs under his leadership)
  guiding principles, or rules?
• How do asset prices, representing future value of
  cash flows, and goods inflation relate to each
  other and monetary policy?
• Fed has increased its transparency with post-FOMC
  meeting announcements, but what else is being
  discussed?

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Central Banks

• European monetary system
• The Euro - January, 1999, and beyond
• Brief history of European monetary union
• Challenges facing the European Central Bank
• Bank of Japan
• Peoples Bank of China
• Central banks elsewhere - independence or
  political domination are the issues

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Next Week November 16

• Read Chapter 18 in text concerning government and
  consumer debt markets
• Bring a Wall Street Journal for next Tuesday to
  class
• Plan team meeting and consultation with me
  concerning group semester project