FRBSF Economic Letter
2004-01; January 16, 2004
U.S. Monetary Policy: An Introduction
Part 1: How is the Fed structured and what are its
policy tools?
Since
1999, when the first version
of this Q&A on monetary
policy appeared, several dramatic
developments have had an impact
on the U.S. economy. On the
negative side are the bursting
stock market bubble, the recession,
the terrorist attacks of September
11, 2001, and, more recently,
the emergence of the risk of
deflation. On the positive
side have been continued high
productivity growth and the
resilience of the economy.
In light of these developments
and their implications for
monetary policy, it seemed
appropriate to update and expand
this Q&A on the Federal
Reserve's tasks and how it
carries them out. The revised
text will appear in a pamphlet
soon, and we present it here
in the FRBSF Economic
Letter in four consecutive
issues: (1) "How is the
Federal Reserve structured?" and "What
are the tools of U.S. monetary
policy?" (2) "What
are the goals of U.S. monetary
policy?" (3) "How
does monetary policy affect
the U.S. economy?" and
(4) "How does the Fed
decide the appropriate setting
for the policy instrument?"
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U.S. monetary policy affects all kinds
of economic and financial decisions people make in this country—whether
to get a loan to
buy a new house or car or to start up a company, whether to expand
a business by investing in a new plant or equipment, and whether
to put savings in a bank, in bonds, or in the stock market, for
example. Furthermore, because the U.S. is the largest economy
in the world, its monetary policy also has significant economic
and
financial effects on other countries.
The object of monetary policy is to influence the performance
of the economy as reflected in such factors as inflation, economic
output, and employment. It works by affecting demand across the
economy—that is, people's and firms' willingness to spend on goods
and services.
While most people are familiar with the fiscal policy tools that
affect demand—such as taxes and government spending—many are
less familiar with monetary policy and its tools. Monetary policy
is conducted by the Federal Reserve System, the nation's central
bank, and it influences demand mainly by raising and lowering short-term
interest rates.
How is the Federal Reserve structured?
The Federal Reserve System
(called the Fed, for short) is the nation's central bank. It was
established by an Act of Congress in 1913
and consists of the Board of Governors in Washington, D.C., and
twelve Federal Reserve District Banks (for a discussion of the
Fed's overall responsibilities, see The
Federal Reserve System: Purposes and Functions).
The Congress structured the Fed to be independent within the
government—that is, although the Fed is accountable to the Congress
and its goals
are set by law, its conduct of monetary policy is insulated from
day-to-day political pressures. This reflects the conviction
that the people who control the country's money supply should be
independent
of the people who frame the government's spending decisions.
What makes the Fed independent?
Three structural
features give the Fed independence in its conduct of monetary policy:
the appointment
procedure for Governors, the
appointment procedure for Reserve Bank Presidents, and funding.
Appointment
procedure for Governors. The seven Governors on the Federal Reserve
Board are appointed by the President of the United
States and confirmed by the Senate. Independence derives from a
couple of factors: first, the appointments are staggered to reduce
the chance that a single U.S. President could "load" the
Board with appointees; second, their terms of office are 14 years—much
longer than elected officials' terms.
Appointment procedure for
Reserve Bank Presidents. Each Reserve Bank President is appointed
to a five-year term by that Bank's
Board of Directors, subject to final approval by the Board of Governors.
This procedure adds to independence because the Directors of each
Reserve Bank are not chosen by politicians but are selected to
provide a cross-section of interests within the region, including
those of depository institutions, nonfinancial businesses, labor,
and the public.
Funding. The Fed is structured to be self-sufficient
in the sense that it meets its operating expenses primarily from
the interest
earnings on its portfolio of securities. Therefore, it is independent
of Congressional decisions about appropriations.
How is the Fed "independent
within the government"?
Even though the Fed is independent
of Congressional appropriations and administrative control, it
is ultimately accountable to Congress
and comes under government audit and review. Fed officials report
regularly to the Congress on monetary policy, regulatory policy,
and a variety of other issues, and they meet with senior Administration
officials to discuss the Federal Reserve's and the federal government's
economic programs. The Fed also reports to Congress on its finances.
Who
makes monetary policy?
The Fed's FOMC (Federal Open Market Committee)
has primary responsibility for conducting monetary policy. The
FOMC meets in Washington
eight times a year and has twelve members: the seven members
of the Board
of Governors, the President of the Federal Reserve Bank of
New York, and four of the other Reserve Bank Presidents, who
serve
in rotation. The remaining Reserve Bank Presidents contribute
to the Committee's discussions and deliberations.
In addition,
the Directors of each Reserve Bank contribute to monetary policy
by making recommendations about the appropriate
discount
rate, which are subject to final approval by the Governors.
What are the tools of U.S. monetary policy?
The
Fed can't control inflation or influence output and employment
directly; instead,
it affects them indirectly, mainly by raising
or lowering a short-term interest rate called the "federal
funds" rate. Most often, it does this through open market
operations in the market for bank reserves, known as the federal
funds market. What are bank reserves?
Banks and other depository
institutions (for convenience, we'll refer to all of these as "banks")
keep a certain amount of funds in reserve to meet unexpected outflows.
Banks can keep
these reserves as cash in their vaults or as deposits with the
Fed. In fact, banks are required to hold a certain amount in reserves.
But, typically, they hold even more than they're required to in
order to clear overnight checks, restock ATMs, and make other payments.
What
is the federal funds market?
From day to day, the amount of reserves
a bank wants to hold may change as its deposits and transactions
change. When a bank needs
additional reserves on a short-term basis, it can borrow them from
other banks that happen to have more reserves than they need. These
loans take place in a private financial market called the federal
funds market.
The interest rate on the overnight borrowing of reserves
is called the federal funds rate or simply the "funds rate." It
adjusts to balance the supply of and demand for reserves. For example,
if the supply of reserves in the fed funds market is greater than
the demand, then the funds rate falls, and if the supply of reserves
is less than the demand, the funds rate rises.
What are open market
operations?
The major tool the Fed uses to
affect the supply of reserves in the banking system is open market
operations—that is, the Fed
buys and sells government securities on the open market. These
operations are conducted by the Federal Reserve Bank of New York. Suppose
the Fed wants the funds rate to fall. To do this, it buys government
securities from a bank. The Fed then pays for the securities
by increasing that bank's reserves. As a result, the bank now
has more reserves than it wants. So the bank can lend these unwanted
reserves to another bank in the federal funds market. Thus, the
Fed's open market purchase increases the supply of reserves to
the banking system, and the federal funds rate falls.
When the
Fed wants the funds rate to rise, it does the reverse, that is,
it sells government securities. The Fed receives payment
in reserves from banks, which lowers the supply of reserves in
the banking system, and the funds rate rises.
What is the discount
rate?
Banks also can borrow reserves directly from
the Federal Reserve Banks at their "discount windows," and
the discount rate is the rate that financially sound banks must pay
for this "primary
credit." The Boards of Directors of the Reserve Banks set
these rates, subject to the review and determination of the Federal
Reserve Board. ("Secondary credit" is offered at higher
interest rates and on more restrictive terms to institutions
that do not qualify for primary credit.) Since January 2003,
the discount
rate has been set 100 basis points above the funds rate target,
though the difference between the two rates could vary in principle.
Setting the discount rate higher than the funds rate is designed
to keep banks from turning to this source before they have exhausted
other less expensive alternatives. At the same time, the (relatively)
easy availability of reserves at this rate effectively places
a ceiling on the funds rate.
What about foreign currency operations?
Purchases and sales of
foreign currency by the Fed are directed by the FOMC, acting in
cooperation with the Treasury, which has
overall responsibility for these operations. The Fed does not
have targets, or desired levels, for the exchange rate. Instead,
the
Fed gets involved to counter disorderly movements in foreign
exchange markets, such as speculative movements that may disrupt
the efficient
functioning of these markets or of financial markets in general.
For example, during some periods of disorderly declines in the
dollar, the Fed has purchased dollars (sold foreign currency)
to absorb some of the selling pressure.
Intervention operations
involving dollars, whether initiated by the Fed, the Treasury,
or by a foreign authority, are not
allowed
to alter the supply of bank reserves or the funds rate. The
process of keeping intervention from affecting reserves and the
funds
rate is called the "sterilization" of exchange market
operations. As such, these operations are not used as a tool
of monetary policy. Suggested reading
For an overview of the Federal Reserve System and its functions,
see:
The Federal
Reserve System: Purposes and Functions, 8th ed. 1994.
Washington, DC: Board of Governors, Federal Reserve System.
http://www.federalreserve.gov/pf/pf.htm
The
Federal Reserve System in Brief. Federal Reserve Bank of San
Francisco.
http://www.frbsf.org/publications/federalreserve/fedinbrief/index.html
For further discussion of the topics in this article, see the following
issues of the FRBSF
Economic Letter:
93-21 "Federal Reserve Independence and the Accord of 1951," by
Carl Walsh.
http://www.frbsf.org/publications/economics/letter/1993/el93-21.pdf
94-05 "Is There a Cost to Having an Independent Central Bank?" by
Carl Walsh.
http://www.frbsf.org/publications/economics/letter/1994/el94-05.pdf
94-27 "A Primer on Monetary Policy, Part I: Goals and Instruments," by
Carl Walsh.
http://www.frbsf.org/publications/economics/letter/1994/el94-27.pdf
95-16 "Central Bank Independence and Inflation," by
Robert T. Parry.
http://www.frbsf.org/publications/economics/letter/1995/el1995-16.pdf
2002-30 "Setting the Interest Rate," by Milton Marquis.
http://www.frbsf.org/publications/economics/letter/2002/el2002-30.html
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