FRBSF Economic Letter
2004-03; January 30, 2004
U.S. Monetary Policy: An Introduction
Part 3: How does monetary policy affect the U.S. economy?
This
is the third of four consecutive
issues devoted to our updated
and expanded Q&A on monetary
policy: (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?" The
revised text will appear in a
pamphlet soon.
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The point of implementing policy through raising or lowering interest
rates is to affect people's and firms' demand for goods and services.
This section discusses how policy actions affect real interest
rates, which in turn affect demand and ultimately output, employment,
and inflation.
What are real interest rates and why do they matter?
For the most
part, the demand for goods and services is not related to the market
interest rates quoted in the financial pages of newspapers,
known as nominal rates. Instead, it is related to real interest
rates—that is, nominal interest rates minus the expected rate
of inflation.
For example, a borrower is likely to feel a lot happier
about a car loan at 8% when the inflation rate is close to 10%
(as it was
in the late 1970s) than when the inflation rate is close to 2%
(as it was in the late 1990s). In the first case, the real (or
inflation-adjusted) value of the money that the borrower would
pay back would actually be lower than the real value of the money
when it was borrowed. Borrowers, of course, would love this situation,
while lenders would be disinclined to make any loans.
So why doesn't
the Fed just set the real interest rate on loans?
Remember, the
Fed operates only in the market for bank reserves. Because it is
the sole supplier of reserves, it can set the nominal
funds rate. The Fed can't set real interest rates directly because
it can't set inflation expectations directly, even though expected
inflation is closely tied to what the Fed is expected to do in
the future. Also, in general, the Fed has stayed out of the business
of setting nominal rates for longer-term instruments and instead
allows financial markets to determine longer-term interest rates.
How
can the Fed influence long-term rates then?
Long-term interest rates
reflect, in part, what people in financial markets expect the Fed
to do in the future. For instance, if they
think the Fed isn't focused on containing inflation, they'll be
concerned that inflation might move up over the next few years.
So they'll add a risk premium to long-term rates, which will make
them higher. In other words, the markets' expectations about monetary
policy tomorrow have a substantial impact on long-term interest
rates today. Researchers have pointed out that the Fed could inform
markets about future values of the funds rate in a number of ways.
For example, the Fed could follow a policy of moving gradually
once it starts changing interest rates. Or, the Fed could issue
statements about what kinds of developments the FOMC is likely
to focus on in the foreseeable future; the Fed even could make
more explicit statements about the future stance of policy.
How
do these policy-induced changes in real interest rates affect the
economy?
Changes in real interest rates affect the public's demand
for goods and services mainly by altering borrowing costs, the
availability
of bank loans, the wealth of households, and foreign exchange rates.
For
example, a decrease in real interest rates lowers the cost of borrowing;
that leads businesses to increase investment spending,
and it leads households to buy durable goods, such as autos and
new homes.
In addition, lower real rates and a healthy economy may
increase banks' willingness to lend to businesses and households.
This may
increase spending, especially by smaller borrowers who have few
sources of credit other than banks.
Lower real rates also make
common stocks and other such investments more attractive than bonds
and other debt instruments; as a result,
common stock prices tend to rise. Households with stocks in their
portfolios find that the value of their holdings is higher, and
this increase in wealth makes them willing to spend more. Higher
stock prices also make it more attractive for businesses to invest
in plant and equipment by issuing stock.
In the short run, lower
real interest rates in the U.S. also tend to reduce the foreign
exchange value of the dollar, which lowers
the prices of the U.S.-produced goods we sell abroad and raises
the prices we pay for foreign-produced goods. This leads to higher
aggregate spending on goods and services produced in the U.S.
The
increase in aggregate demand for the economy's output through these
different channels leads firms to raise production and employment,
which in turn increases business spending on capital goods even
further by making greater demands on existing factory capacity.
It also boosts consumption further because of the income gains
that result from the higher level of economic output.
How does
monetary policy affect inflation?
Wages and prices will begin to
rise at faster rates if monetary policy stimulates aggregate demand
enough to push labor and capital
markets beyond their long-run capacities. In fact, a monetary policy
that persistently attempts to keep short-term real rates low will
lead eventually to higher inflation and higher nominal interest
rates, with no permanent increases in the growth of output or decreases
in unemployment. As noted earlier, in the long run, output and
employment cannot be set by monetary policy. In other words, while
there is a trade-off between higher inflation and lower unemployment
in the short run, the trade-off disappears in the long run.
Policy
also affects inflation directly through people's expectations about
future inflation. For example, suppose the Fed eases monetary
policy. If consumers and businesspeople figure that will mean higher
inflation in the future, they'll ask for bigger increases in wages
and prices. That in itself will raise inflation without big changes
in employment and output.
Doesn't U.S. inflation depend on worldwide
capacity, not just U.S. capacity?
In this era of intense global
competition, it might seem parochial to focus on U.S. capacity
as a determinant of U.S. inflation, rather
than on world capacity. For example, some argue that even if unemployment
in the U.S. drops to very low levels, U.S. workers wouldn't be
able to push for higher wages because they're competing for jobs
with workers abroad, who are willing to accept much lower wages.
The implication is that inflation is unlikely to rise even if the
Fed adopts an easier monetary policy.
This reasoning doesn't hold
up too well, however, for a couple of reasons. First, a large proportion
of what we consume in the
U.S. isn't affected very much by foreign trade. One example is
health care, which isn't traded internationally and which amounts
to nearly 15% of U.S. GDP.
More important, perhaps, is the fact
that such arguments ignore the role of flexible exchange rates.
If the Fed were to adopt an
easier policy, it would tend to increase the supply of U.S. dollars
in the market. Ultimately, this would tend to drive down the value
of the dollar relative to other countries, as U.S. consumers and
firms used some of this increased money supply to buy foreign goods
and foreigners got rid of the additional U.S. currency they did
not want. Thus, the price of foreign goods in terms of U.S. dollars
would go up—even though they would not in terms of the foreign
currency. The higher prices of imported goods would, in turn, tend
to raise the prices of U.S. goods.
How long does it take a policy
action to affect the economy and inflation?
It can take a fairly
long time for a monetary policy action to affect the economy and
inflation. And the lags can vary a lot,
too. For example, the major effects on output can take anywhere
from three months to two years. And the effects on inflation tend
to involve even longer lags, perhaps one to three years, or more.
Why
are the lags so hard to predict?
So far, we've described a complex
chain of events that links a change in the funds rate with subsequent
changes in output and
inflation. Developments anywhere along this chain can alter how
much a policy action will affect the economy and when.
For example,
one link in the chain is long-term interest rates, and they can
respond differently to a policy action, depending
on the market's expectations about future Fed policy. If markets
expect a change in the funds rate to be the beginning of a series
of moves in the same direction, they'll factor in those future
changes right away, and long-term rates will react by more than
if markets had expected the Fed to take no further action. In contrast,
if markets had anticipated the policy action, long-term rates may
not move much at all because they would have factored it into the
rates already. As a result, the same policy move can appear to
have different effects on financial markets and, through them,
on output and inflation.
Similarly, the effect of a policy action
on the economy also depends on what people and firms outside the
financial sector think the
Fed action means for inflation in the future. If people believe
that a tightening of policy means the Fed is determined to keep
inflation under control, they'll immediately expect low inflation
in the future, so they're likely to ask for smaller wage and price
increases, and this will help achieve low inflation. But if people
aren't convinced that the Fed is going to contain inflation, they're
likely to ask for bigger wage and price increases, and that means
that inflation is likely to rise. In this case, the only way to
bring inflation down is to tighten so much and for so long that
there are significant losses in employment and output.
What problems
do lags cause?
The Fed's job would be much easier if monetary policy
had swift and sure effects. Policymakers could set policy, see
its effects,
and then adjust the settings until they eliminated any discrepancy
between economic developments and the goals.
But with the long
lags associated with monetary policy actions, the Fed must try
to anticipate the effects of its policy actions
into the distant future. To see why, suppose the Fed waits to shift
its policy stance until it actually sees an increase in inflation.
That would mean that inflationary momentum already had developed,
so the task of reducing inflation would be that much harder and
more costly in terms of job losses. Not surprisingly, anticipating
policy effects in the future is one of the more difficult parts
of conducting monetary policy, and it's a key issue in the next
and final Economic Letter in this series, "How does
the Fed decide the appropriate setting for the policy instrument?"
Suggested reading
For further discussion of the topics in this article, see the following
issues of the FRBSF Economic Letter.
93-38 "Real Interest Rates," by
Bharat Trehan. http://www.frbsf.org/publications/economics/letter/1993/el93-38.pdf
95-05 "What Are the Lags in Monetary Policy?" by
Glenn Rudebusch. http://www.frbsf.org/publications/economics/letter/1995/el1995-05.pdf
95-23 "Federal Reserve Policy and the Predictability of Interest
Rates," by Glenn Rudebusch. http://www.frbsf.org/publications/economics/letter/1995/el1995-23.pdf
97-18 "Interest Rates and Monetary Policy," by
Glenn Rudebusch. http://www.frbsf.org/econrsrch/wklyltr/el97-18.html
2002-30 "Setting the Interest Rate," by
Milton Marquis. http://www.frbsf.org/publications/economics/letter/2002/el2002-30.html
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