Jan 13
Fed 101: What is the role of the Federal Reserve in the US economy?
By Patrick Savage, Yunjia Hu, Tim Doherty and Alex Campion
1. The Federal Reserve
1.1 What is the Federal Reserve?
The Federal Reserve (or Fed) is the central bank of the United States. This means it is the financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations. Most importantly, the Fed is responsible for the formulation of monetary policy and the regulation of member banks. The structure of the Fed reflects the federal nature of government in the US. States are represented by the Federal Reserve Banks, the central government is represented in the Board of Governors, and both come together to discuss and agree policy in the Federal Open Market Committee.
1.2 What is the Board of Governors?
The Board consists of seven governors who serve 14-year terms. The Board is headed by the Chairperson– currently Jerome Powell– who is selected by the US President for a 4-year term and acts as a figurehead, conveying Fed policy to the public. Note that both appointments to the Board and the selection of Governor are irreversible, solidifying the Fed’s independence from the legislature.
1.3 What are the objectives of the Federal Reserve?
As outlined in the Federal Reserve Act of 1913, the objectives of the Federal Reserve are to stabilise prices, maximise employment and moderate long-term interest rates [1]. The broad nature of its objectives allows the Fed to evolve its policy as monetary policy consensus evolves. In August 2020, the Fed adjusted their price stability target to one of average inflation targeting; hence policymakers would allow the current inflation rate to run above the target 2% to compensate for the shortfalls in the past [2].
1.4 Why is the Fed independent?
The Fed’s independence from the Treasury is vital to the effective conduct of monetary policy because politicians typically prefer maximum employment in the short term, which is not necessarily conducive to stable prices in the long term. For example, an interest rate rise may be necessary to control inflation but it is politically unpopular given its impact on the economy and on the Treasury’s borrowing costs. The Fed has been officially independent since the Fed-Treasury Accord of 1951, where the Fed agreed with the central government to focus solely on monetary policy rather than guaranteeing inexpensive borrowing for the Treasury [3].
2. Federal Open Market Committee
Increasing complexity and integration across the US economy exposed a lack of coordination between the Reserve Banks and thus limited their effectiveness by the early 1930s. The 1933 Banking Act created the Federal Open Markets Committee (FOMC) and Board of Governors to address this lack of national monetary policy.
2.1 Federal Open Market Committee (FOMC)
The FOMC consists of the Board of Governors, the President of the Federal Reserve Bank of New York and four of the remaining eleven Reserve Bank Presidents serving one-year terms on a rolling basis. The FOMC is chaired by the Chairman of the Board of Governors and vice chaired by the President of the New York Fed — currently Jerome Powell and John C. Williams respectively. The New York Fed executes all Open Market Operations; hence it is seen as first amongst equals justifying its permanent position on the FOMC.
By law, the FOMC meets eight times per year to review the target Federal Funds Rate and as such direct Open Market Operations (OMOs). Members present reports on economic and financial conditions, which inform decisions on the target Federal Funds Rate and OMOs. Policy decisions are held to a vote, which tends to be unanimous — there have been fewer than 500 dissents since 1936. Meetings are private but FOMC Minutes briefly outline topics of discussion and the Chairman appears biannually before Congress to outline the monetary policy activities, objectives and plans of the Board and the FOMC.
3. Monetary Policy Tools
3.1 The Interbank Lending Market
Federal regulation requires banks to hold sufficient reserves to accommodate day-to-day withdrawals of their customers. Banks borrow and lend cash to meet these liquidity requirements amidst their daily transactions in the interbank lending market. The overnight interest rate of these loans is called the Federal Funds Rate.
The Federal Funds Rate is important because it influences long-term interest rates available to business and consumers, which are translated to the real economy through levels of investment and consumption and in the housing market. Consequently, FOMC decisions on Federal Funds Rate can significantly stimulate or cool the economy.
3.2 Pre-2008: The Corridor System
Banks are indifferent between central bank reserves and interbank credit, which has historically set a corridor for the Federal Funds Rate. There is no limit to the Fed’s overnight lending so borrowers will never take interbank loans above the interest rate at the Fed, meaning the discount rate sets an effective upper bound on the Federal Funds Rate. Conversely, lenders will never offer a rate below that of deposits at the Fed so the Interest Rate on Reserve Balances (IORB) rate sets a lower bound for the Federal Funds Rate. The resulting demand curve is illustrated by Figure 1. The Federal Reserve controls the total money supply and thus it is constant and modelled as perfectly inelastic in Figure 1.
3.3 Quantitative easing
In response to the 2008 financial crisis, the Federal Reserve had to take drastic action to revive the economy and ensure financial stability. Despite the Fed lowering the traditional discount rate from 6.25% to 0.5%, the economy was still facing a recession and a credit crunch. The Fed’s main monetary policy tool of the last 50 years had become ineffective due to the effective lower bound on interest rates and a disconnection between official rates and market rates. In response, the Fed adopted a series of extraordinary new monetary policy tools.
One such tool was quantitative easing. The Fed massively expanded its balance sheet by buying huge quantities of long-dated securities such as Treasuries and mortgages. This should, in theory, have numerous effects on the economy. First off, the asset purchases increased demand for long-dated securities, hence reducing the term premium of long-dated assets and pushing up their prices. As a result the yield on these assets fell, directly suppressing longer term interest rates. This incentivised households and firms to borrow,consume or invest; hence increasing real economic activity. Further, the QE programme massively increased the supply of central bank reserves and hence the size of banks’ deposits at the central bank. As a result, banks began to lend again, ending the damaging credit crunch that occurred during the global financial crisis of 2008. Finally, households that owned the assets being purchased by the Fed experienced a positive wealth effect via capital gains, which would result in higher demand and GDP.
To date, the Fed has conducted $8.5 trillion of asset purchases, comprising $5.5 trillion of Treasury securities and $3 trillion mortgages.
3.4 Post-2008: The Floor System
Asset purchase programmes since 2008 have significantly increased the supply of money, such that banks are sitting on sufficient cash to meet reserve requirements without interbank lending. Figure 2 shows the dramatic increase in depository reserves held at the Fed since 2008. This translates to a larger quantity of reserves on Figure 1, and an intersection between the supply and demand curves at the Federal Funds Rate floor. The US has therefore reached ‘reserve satiation’, where the Federal Funds Rate moves one-to-one with the deposit rate set by the Federal Reserve. The corridor system has evolved into the floor system shown in Figure 3, where the Fed can directly control the Federal Funds Rate which moves one-for-one with the IORB (Interest on Reserve Balances). At present, the deposit rate is 0.25% and more importantly the IORB is 0.15%.
3.5 Forward Guidance
No arbitrage means that the return on holding a two-year bond is the same as two one-year bonds with the same expected return in each of the two years. In practice, this means that the two-year yield equals the average of the one-year yields so banks can base their long-term interest rates on the average of their expectations for short-term interest rates. Figure 5 illustrates the determination of long-term interest rates, it(2), by the intersection of the downward-sloping demand curve for investment with the interest rate set by the bank based on one-year yields, it and it+1. Of course, banks cannot be certain of future interest rates, so base long-term rates on their expectations for short-term rates, it+1e. Forward Guidance regulates the quantity of medium-term investment by publicly disclosing the Fed’s plans for changing future interest rates to set banks’ expectations for future rates, it+1e. In Figure 5, a commitment to lower or maintain nominal interest rates by the Fed sets lower one-year interest rate expectations, resulting in lower two-year rates and an expansion from A to B along the demand curve reflected in higher levels of long-term investment.
3.6 International tools
Given the international significance of the US dollar, the Federal Reserve has the unique responsibility of overseeing overseas’ dollar markets in times of crisis. The Fed does this because an international dollar liquidity crisis could easily spill over into domestic dollar markets, causing interest rates volatility.
One such tool is the central bank liquidity swap line, which allows select overseas central banks to exchange their currency for USD at market rates. This allows foreign central banks to swap their currency for USD directly with the Fed, bypassing foreign exchange markets which potentially would struggle to handle such large-scale transactions, particularly in times of stress.
3.7 Credit facilities
The final kind of tool in the Fed’s toolbox includes credit facilities. These are individual, one-off policies which “support the flow of credit to employers, consumers and businesses [5].” This is done because private lending markets can become distressed when the economy experiences an adverse shock, causing banks to become more risk averse in their lending decisions. This would in turn cause interest rates to rise for private loans due to the added risk premium, which threatens to undermine growth.
In response to market distress during March 2020, the Fed introduced an individual credit facility for money market funds, auto and student loan lenders, municipal governments, small businesses and for corporate borrowers. This allowed the Fed to mitigate the effects of market volatility in every kind of credit market, preventing mass dysfunction.
4. Policy Rules and Loss Functions
4.1 What is a policy rule?
Monetary policy rules are used for both prescriptive and descriptive purposes depending on context — ultimately these models rest on certain assumptions and it’s up to policy makers to determine their applicability as such. The Taylor Rule was the first monetary policy rule and has inspired many alternatives, which are considered collectively by the Fed when making policy decisions.
4.2 The Taylor Rule
John B. Taylor proposed the Taylor Rule in 1992 as a means of describing how the short-term nominal interest rate is set based on deviation between actual and target inflation and deviation between real and target growth.
As per the Fed’s average 2% inflation target, πₜ*=2. The target growth rate ȳₜ is less clear, but conventional wisdom suggests it is also around 2% — Taylor calculated it to be 2.2% from 1984 to 1992 [6]. The equilibrium interest rate rₜ* is a more complicated ‘natural rate of interest’, which keeps the economy at full employment and inflation constant. In 1993 Taylor suggested rₜ*=2 but, following the abrupt decline in interest rates after 2008, consensus has arisen that rt* has similarly fallen [7]. Coefficients aπ and ay reflect the nominal interest rate’s sensitivity to changes in inflation and output. They have since been recalculated on numerous occasions but Taylor’s 1993 paper also proposed that aπ=ay=0.5, which gives:
In simpler terms, the Taylor Rule expresses the target Federal Funds Rate as inflation plus a weighted average of deviation between actual and target inflation and deviation between real and potential growth.
The Taylor Rule gives two intuitive results in line with pre-existing monetary policy decision-making.
- Inflation rising above its 2% target means the ‘inflation gap’ is positive, which results in higher short-term interest rates
- Growth falling below its target (i.e., falling below its trend) means the ‘growth gap’ is negative and short-term interest rates fall
4.3 The Taylor Principle
The Taylor Principle observes that as the coefficient of πₜ>1, the target Federal Funds Rate must move more than one-to-one with inflation. Note that this principle is independent of the true value of rₜ* and is true for all aπ>0, which can equally be interpreted as the Taylor Principle. Therefore as inflation rises, the target Federal Funds Rate rises by a larger margin. Intuitively, this is important because it controls animal spirits and market inflation expectations — the target Federal Funds Rate rising by more than inflation communicates that the Fed is taking serious action against inflation and sets an expectation that inflation will not continue to rise.
4.4 Criticism and limitations
There are a number of issues with the Taylor Rule, many of which are acknowledged by Taylor.
- Interest rates need to quickly respond to economic shocks. The Taylor Rule waits for the economic shock to feed into inflation or unemployment before changing the nominal interest rate, but monetary policy can be a pre-emptive measure to prevent the shock’s undesirable outcomes. For example, the Fed cut interest rates in March 2020 in anticipation of the economic shock resulting from the COVID-19 pandemic.
- The Taylor Rule gives unclear results when inflation is high and growth is poor. A positive inflation gap and negative output gap seemingly cancel one another out, so under stagflation (for instance the 1973–75 recession) the Taylor Rule offers little guidance.
- The Taylor Rule includes no parameters on other economic variables. Interest rates significantly affect financial stability through exchange rates, asset prices, credit or leverage, and credit spreads [8]. Without these considerations, a nominal interest rate based exclusively on the Taylor Rule could have unintended consequences in the financial sector.
Ultimately, the Taylor Rule is one of many monetary policy rules utilised by the Fed. To follow the Taylor Rule alone would be nonsensical,but equally, to ignore it would neglect some of the most fundamental insights in monetary policy. With the Fed’s current emphasis on bolstering the recovery of the US economy following COVID-19 despite high inflation, the Taylor Rule offers less guidance. However the Taylor Rule is sure to continue to guide policy through the 2020s as the US economy recovers and will present a ‘normal’ context for monetary policy once again.
4.5 Loss functions
The tradeoff being employment and price stability poses a challenge for central banks in determining the optimal interest rate for the economy. This is especially true for the Federal Reserve and its dual mandate. Mathematically, a loss function serves to represent the costs felt by a central bank when it deviates from its target inflation rate and unemployment rate taking into account its preferences between the two.
One example of a loss function is: 0.5(𝛑-π ̅)²+0.5𝜆(U-Uᵀ)² where π ̅ is the inflation target and Uᵀ is the unemployment target. If a certain country’s central bank was more concerned with unemployment than inflation, it would tolerate more deviation from its inflation target compared to its unemployment target. That is, they would set 𝜆>1. When setting monetary policy, the Federal Reserve tries to minimise its loss function.
This article was written by: Patrick Savage (Head of Federal Reserve Monetary Policy Research), Yunjia Hu (Research Associate, Federal Reserve Monetary Policy Research), Tim Doherty (Research Associate, Federal Reserve Monetary Policy Research) and Alex Campion (Research Associate, Federal Reserve Monetary Policy Research). This article was reviewed by Roberto Patiño (Head of Monetary Policy Research).
References
[1] US Code, Title 12, Chapter 3, Subchapter I, Line 225A — cornell.edu
[2] Fed’s New Inflation Targeting Policy Seeks to Maintain Well-Anchored Expectations — Dallasfed.org
[3] The Evolution of Fed Independence — richmondfed.org
[4] Board of Governors of the Federal Reserve System (US), Monetary Base; Total [BOGMBASE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BOGMBASE, November 2, 2021.
[5] Federal Reserve announces extensive new measures to support the economy — federalreserve.gov
[6] Taylor (1993) calculated the 2.2% as a simple trend line on US GDP over these years.
[7] Mian et. al. (2021) observes a lower rt* value following Launch and Williams (2003)
[8] Käfer (2014) analyses ‘various kinds of stability measures in the Taylor Rule’
