As detailed in the 1978 amendment to the
Federal Reserve Act, the Fed's goals when setting monetary policy
are "to promote maximum sustainable output and employment
and to promote stable prices." Monetary policy has historically
been implemented through three main methods:
- Raising or lowering
the fed funds rate - This is the
Fed's preferred method. The fed funds rate is the interest rate
charged to banks for overnight borrowing from banks with excess
reserves. Lowering this rate makes it less expensive for banks
to borrow money and loan it out, while raising the rate has the
opposite effect. Typically made at Federal Open Market Committee
(FOMC) meetings, changes in the fed funds rate are widely reported
and are viewed as a public signal of the Federal Reserve's monetary
policy. While the fed funds rate applies to a relatively small
volume of borrowed reserves, it has broader implications. Other
interest rates typically change in response to changes in the
fed funds rate.
- Purchasing or selling
U.S. Treasury securities in the open market - If the Fed wants to
increase reserves at member banks so more funds are available
to lend to customers, it purchases government securities in the
open market, paying for the securities with a Federal Reserve
check. Since this check is not issued by a commercial bank, the
entire banking system has more funds available when the check
is deposited in a commercial bank. To reduce the supply of funds,
the Federal Reserve sells government securities.
- Changing reserve requirements - Each bank is required to keep a certain percentage
of deposits on hand that cannot be loaned out. Changing the requirements
allows the Fed to change the amount of money available on a large
scale.
How is the Fed responding
to the current situation?
During the current recession, the Fed has
responded to the large increases in the unemployment rate by aggressively
cutting the fed funds rate, lowering it from 5.25% to essentially
zero. Over the past two decades, the Fed has set the fed funds
rate by lowering it 1.3% when core inflation decreases by 1% and
lowering it by close to 2% when the unemployment rate increases
by 1% (Source: FRBSF Economic Letter, May 22, 2009). During
2007 and 2008, the Fed's reduction of the fed funds rate by 5.25%
was in line with this formula. However, the situation has worsened
in 2009, meaning the Fed would need to reduce the fed funds rate
to negative 5% by the end of 2009 to follow this formula. Obviously,
they can't reduce the rate below zero percent, so they have had
to resort to other methods to stimulate the economy.
Based on economic forecasts of the Fed's
FOMC, the fed funds rate should be near zero for several years.
Due to the severe depth of the recession, it will take several
years of significant growth for the economy to eliminate all slack.
Although it has not said exactly how long it expects the fed funds
rate to be near zero, the Fed has said that it "anticipates
that economic conditions are likely to warrant exceptionally low
levels of the federal funds rate for an extended period."
The Federal Reserve has also implemented
a number of programs designed to support the liquidity of financial
institutions and foster improved conditions in financial markets,
which has significantly increased the assets on the Fed's balance
sheet. As of May 2009, the Fed's balance sheet has doubled in
size to just over $2 trillion, with commitments for further increases
by year-end (Source: FRBSF Economic Letter, May 2009).
The first set of tools, which are closely
tied to the Fed's traditional role as lender of last resort, involves
providing short-term liquidity to banks, other depository institutions,
and other financial institutions. Because of the global nature
of banks, the Fed has also approved bilateral currency swap agreements
with 12 foreign central banks to help them provide dollar liquidity
to banks in their jurisdictions.
A second set of tools provides liquidity
directly to borrowers and investors in key credit markets. The
Commercial Paper Funding Facility, the Asset-Backed Commercial
Paper Money Market Fund Liquidity Facility, the Money Market Investor
Funding Facility, and the Term Asset-Backed Securities Loan Facility
fall in this category.
As a third set of instruments, the Fed has
expanded its traditional tool of open market operations to support
the functioning of the credit markets through the purchase of
longer-term securities for the Federal Reserve's portfolio.
When credit markets and the economy begin
to recover from the current financial crisis, the Fed will need
to wind down some of its various lending programs and eliminate
others. The Fed's balance sheet can be reduced relatively quickly,
since a substantial portion of the assets are short term in nature
and can simply mature. The Federal Reserve also holds significant
quantities of longer-term assets, such as agency debt and mortgage-backed
securities. Although these longer-term securities could be sold,
the Fed will likely not dispose of more than a small portion in
the near future. As the size of its balance sheet and the quantity
of excess reserves in the banking system decline, the Fed should
return to using the fed funds rate as its primary tool to implement
monetary policy.
