Monetary Policy - An Economist's Perspective (Transcript)

Section 1: Introduction

We think most broadly, what are the goals of the Federal Reserve System? We go back to the Federal Reserve Act, where Congress asks the Fed to provide for a safer, more flexible, more stable financial system. And to do that job, we have three essential components. Number one, there's the supervision and regulation of banks, safety and soundness. Number two, there's the payments function, where we provide a platform for many of the nation's payments to be conducted on. And number three is broadly called monetary policy.

Section 2: Two components of monetary policy

So when we think about monetary policy, I think we can divide it into two components. There's monetary policy, but there's also credit policy. Credit policy was really what the Federal Reserve was founded on top of. Credit policy is about providing liquidity to a financial system that suddenly finds itself short of liquidity. It can happen when a financial system is under great stress, perhaps even a panic sets in and people try to sell assets in huge volumes. When they do this, they'll find that there aren't always enough buyers; liquidity in the system starts to dry up. And its important for a central bank like the Federal Reserve to be able to provide that liquidity, to act as, an economist would say, as the lender of last resort. And so the Federal Reserve has a discount window, where we provide loans to financial institutions and others during periods of these sorts of stresses.

Credit policy is about keeping the conduits of finance open and running efficiently, while monetary policy is really about striking a balance between the amount of money there is in circulation and the trade needs of the economy. Monetary policy as we think about it today is a relatively new function of the Federal Reserve System. It's a function that was added in the mid-1930s.

Section 3: Three basic tools

To conduct monetary policy, the Federal Reserve has three basic tools. The first tool is the management of reserve requirements. The second tool is the interest rate we charge at the discount window, sometimes called the primary credit rate. And the third tool is federal open market operations.

To think about the three tools of monetary policy, we're drawn into a rather complicated governance issue for the Federal Reserve. Each of the tools of monetary policy is really controlled by a different body within the Federal Reserve System. So reserve requirements are controlled exclusively by the governors of the Federal Reserve System. Governors are the seven people that have broad authority over the system in general. Governors are appointed by the president of the United States, confirmed by Congress, to 14-year nonrenewable terms.

The second tool of monetary policy, the primary credit rate—that's controlled by the boards of directors of the individual Federal Reserve banks. So there are 12 boards of directors, one for each the Federal Reserve banks, and they vote on the primary credit rate. The catch is that the primary credit rate has to be approved by the Board of Governors in Washington, D.C.

The third tool of monetary policy, which is really what the Federal Reserve has largely become known for over the years are federal open market operations. And they are controlled by an organization called the Federal Open Market Committee. The goals of the Federal Open Market Committee as established by Congress are more narrow than the goals of the Federal Reserve System as a whole. Congress has given the Federal Open Market Committee what is known as a dual mandate. It expects it to achieve maximum employment and price stability. So the goals of the Federal Open Market Committee are not determined independently by the committee. Congress has given the committee its objectives, but the committee is independent to determine the policies that best achieve these two goals. And so the Federal Open Market Committee meets eight times a year to do just that, to decide what are the monetary policies that best promote price stability and maximum employment.

The Federal Open Market Committee is a committee of 12 people. The seven governors of the Federal Reserve System are always on the committee, as is the president of the Federal Reserve Bank of New York. The four remaining seats on the Federal Open Market Committee are four of the remaining 11 presidents of Federal Reserve banks, who rotate in and out of the committee.

Section 4: How can monetary policy affect the economy?

Traditionally, monetary policy is conducted to the management of the overnight interest rate called the federal funds rate. How does the federal funds rate influence maximum employment and promote price stability? This is a bit of a debate in macroeconomics, and we're not going to resolve it here. The traditional view is that by managing the overnight interest rate, the overnight cost of funds, the Federal Reserve might be able to influence longer-term interest rates, interest rates that are important for investment decisions. And if that's true, the management of short-term interest rates is really the management, within some bounds, of longer-term interest rates, which manage investment, which affect the economy, which affect employment, and, ultimately, which affect inflation.

But of course things aren't always so easy. Changes in the overnight interest rate do not necessarily directly translate into longer-term interest rates, and it takes some time for those longer-term interest rates to affect the real economy, and it takes some time for any real effects to be felt in inflation. The lags between a policy action and a policy effect are long and variable. Policymakers have to be very forward-looking when they establish their policies. The policies established today might not affect the rate of inflation for six months out to perhaps as long as three years from now. And so economic forecasts of how the economy is going to unfold are going to be crucial in how the FOMC discharges its responsibilities.

In the implementation of monetary policy and how it affects the economy, there are some economists, many economists, who think that the dual mandate represents something of a trade-off. That is, in the short run, policy can affect the real economy, but that has an offsetting effect on the rate of inflation—the stronger the economy, the faster the rate of inflation [and] the weaker the economy, the slower the rate of inflation.

There are other economists who take a longer-term perspective and say that the only sure way to provide for maximum employment is to first make sure that you've stabilized the rate of inflation. Provide price stability, and you provide a platform that gives the economy the best chance of growing and to provide maximum employment. This conflict between the short-run potential trade-off between growth and inflation and the longer-term reinforcing relationship between inflation and growth is an important part of the monetary policy deliberation.

So why can't I be more precise about how it is that a particular federal funds rate will affect the economy, and over what time horizon? The answer to that is, is that every time a policy is set, it's introducing itself to an economy that's very different than the economy before. History isn't always a perfect guide about how these policies will play themselves out. And important in that is the expectations of the public. These are constantly evolving. It's very dynamic, and that dynamism causes changes in the way in which a change in monetary policy through the federal funds rate can be felt in the economy down the road.

Section 5: Why monetary policy is important for everybody

In some sense, in a very real sense, many of the topics that we're talking about are topics that only a macroeconomist can love. It's about interest rates and policies, and in effect broad economic aggregates like inflation and real GDP growth and the unemployment rate. But therein lies why monetary policy is so crucial for everybody.

The Federal Open Market Committee is asked to do two things, two very important things. The first thing is to provide for maximum employment. Jobs are important to everybody. High unemployment and the loss of productivity that accompanies high unemployment affect every American. We all have a stake in the outcome of Federal Open Market Committee decisions.

Likewise, the rate of inflation that the committee ultimately sets is going to be important for all sorts of decisions, short-term and, more importantly, long-term decisions. It's going to affect investment, it's going to affect the cost of your mortgage, it's going to affect how you plan for retirement, it's going to affect all sorts of things that affect your long-term well-being. To the extent that the FOMC gets this right—that is, that it's able to achieve its mandate, its congressional mandate of maximum employment and price stability—a lot of good things happen for the economy.

So when might the Federal Open Market Committee want to tighten monetary policy or, conversely, ease monetary policy? That's really up for the committee to decide. And you have a committee environment such that all the various perspectives on the problem can be brought to consideration.

The traditional view is the following. When the economy is underperforming, when the economy could produce a lot more goods than people are buying, you want to stimulate more buying. You do that by lowering interest rates. The lower the interest rates, the more spending. The more spending, the faster the growth rate of the economy. At least that's the traditional view. Conversely, the traditional view would say that when prices are starting to rise at a pace that isn't consistent with price stability, when they go above 2 percent by a measurable amount, then it might be time for the committee to think about tightening monetary policy, to raise interest rates, to slow the rate of spending in the economy so that the amount of demand in the economy is consistent with the economy's longer-term potential.

Section 6: Lender of last resort

Monetary policy isn't something that was just important at the founding of the Federal Reserve System. Although I think it is true that financial crises are less frequent today than they were in the early part of our history, they can still occur. During 9/11, for example, when much of the financial infrastructure of the nation was impaired by the events of that day, the Federal Reserve was there to act as the lender of last resort and make sure that there was ample liquidity so that businesses could stay open and financial institutions could work through the problem that they confronted. During the financial crisis of 2008, many of the policies conducted by the Federal Reserve were credit policies, policies conducted to provide liquidity to a variety of institutions in a variety of markets, so the conduits of finance stayed open.

The goals of the Federal Reserve System more broadly are to provide for a more safe, more flexible, more stable financial system. And that requires that we have safety and soundness of our financial institutions. And it also requires that we have a strong infrastructure in which payments can be made. These are also important responsibilities of the Federal Reserve.