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Chapter 11 Monetary Policy and the Fed
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- 11.1 Monetary Policy in the United States
- Goals of Monetary Policy
- The Federal Reserve Act
Chapter 11Monetary Policy and the FedStart Up: The Fed’s Extraordinary Challenges in 2008“The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.” So went the statement issued by the Federal Open Market Committee on December 16, 2008, that went on to say that the new target range for the federal funds rate would be between 0% and 0.25%. For the first time in its history, the Fed was targeting a rate below 1%. It was also acknowledging the difficulty of hitting a specific rate target when the target is so low. And, finally, it was experimenting with extraordinary measures based on a section of the Federal Reserve Act that allows it to take such measures when conditions in financial markets are deemed “unusual and exigent.” The Fed was responding to the broad-based weakness of the U.S. economy, the strains in financial markets, and the tightness of credit. Unlike some other moments in U.S. economic history, it did not have to worry about inflation, at least not in the short term. On the same day, consumer prices were reported to have fallen by 1.7% for the month of November. Indeed, commentators were beginning to fret over the possibility of deflation and how the Fed could continue to support the economy when it had already used all of its federal funds rate ammunition. Anticipating this concern, the Fed’s statement went on to discuss other ways it was planning to support the economy over the months to come. These included buying mortgage-backed securities to support the mortgage and housing markets, buying long-term Treasury bills, and creating other new credit facilities to make credit more easily available to households and small businesses. These options recalled a speech that Ben Bernanke had made six years earlier, when he was a member of the Federal Reserve Board of Governors but still nearly four years away from being named its chair, titled “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” In the 2002 speech he laid out how these tools, along with tax cuts, were the equivalent of what Nobel prize winning economist Milton Friedman meant by a “helicopter drop” of money. The speech earned Bernanke the nickname of Helicopter Ben. The Fed’s decisions of mid-December put it in uncharted territory. Japan had tried a similar strategy, though somewhat less comprehensively and more belatedly, in the 1990s when faced with a situation similar to that of the United States in 2008 with only limited success. In his 2002 speech, Bernanke suggested that Japanese authorities had not gone far enough. Only history will tell us whether the Fed will be more successful and how well these new strategies will work. This chapter examines in greater detail monetary policy and the roles of central banks in carrying out that policy. Our primary focus will be on the U.S. Federal Reserve System. The basic tools used by central banks in many countries are similar, but their institutional structure and their roles in their respective countries can differ.
LEARNING OBJECTIVES
In many respects, the Fed is the most powerful maker of economic policy in the United States. Congress can pass laws, but the president must execute them; the president can propose laws, but only Congress can pass them. The Fed, however, both sets and carries out monetary policy. Deliberations about fiscal policy can drag on for months, even years, but the Federal Open Market Committee (FOMC) can, behind closed doors, set monetary policy in a day—and see that policy implemented within hours. The Board of Governors can change the discount rate or reserve requirements at any time. The impact of the Fed’s policies on the economy can be quite dramatic. The Fed can push interest rates up or down. It can promote a recession or an expansion. It can cause the inflation rate to rise or fall. The Fed wields enormous power. But to what ends should all this power be directed? With what tools are the Fed’s policies carried out? And what problems exist in trying to achieve the Fed’s goals? This section reviews the goals of monetary policy, the tools available to the Fed in pursuing those goals, and the way in which monetary policy affects macroeconomic variables. Goals of Monetary PolicyWhen we think of the goals of monetary policy, we naturally think of standards of macroeconomic performance that seem desirable—a low unemployment rate, a stable price level, and economic growth. It thus seems reasonable to conclude that the goals of monetary policy should include the maintenance of full employment, the avoidance of inflation or deflation, and the promotion of economic growth. But these goals, each of which is desirable in itself, may conflict with one another. A monetary policy that helps to close a recessionary gap and thus promotes full employment may accelerate inflation. A monetary policy that seeks to reduce inflation may increase unemployment and weaken economic growth. You might expect that in such cases, monetary authorities would receive guidance from legislation spelling out goals for the Fed to pursue and specifying what to do when achieving one goal means not achieving another. But as we shall see, that kind of guidance does not exist. The Federal Reserve ActWhen Congress established the Federal Reserve System in 1913, it said little about the policy goals the Fed should seek. The closest it came to spelling out the goals of monetary policy was in the first paragraph of the Federal Reserve Act, the legislation that created the Fed: “An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency, [to make loans to banks], to establish a more effective supervision of banking in the United States, and for other purposes.” In short, nothing in the legislation creating the Fed anticipates that the institution will act to close recessionary or inflationary gaps, that it will seek to spur economic growth, or that it will strive to keep the price level steady. There is no guidance as to what the Fed should do when these goals conflict with one another.
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