The US Central Bank: The Federal Reserve
By Sandra Ng, Brooklyn Han, Anna Clarey and Pedro Almas
1. The role of the Federal Reserve
A central bank is an institution that manages its country’s banking system. It uses monetary policy to promote financial stability. The US central bank is known as the Federal Reserve, or ‘the Fed’ for short. It was established in the 1913 Federal Reserve Act, after the ‘1907 Bankers’ Panic’, with the dual mandate to stabilise prices and maximise employment.
1.1 Price Stability: A Brief History of Inflation Policy
Price stability, i.e. managing inflation, has been a part of the Fed’s mandate since its founding. Precisely what this goal means has changed over time.
Pre-2012: A private inflation target
Since the late 1990s under Alan Greenspan’s leadership, policymakers have agreed privately to target a 2% inflation rate. The ‘2%’ figure is intended to be low and stable, but not so low as to encourage deflation.
2012: Public announcement of fixed 2% inflation target
Then-Fed chair Ben Bernanke took the historic step of publicly announcing a fixed inflation target of 2%. Explicitly indicating the long-term inflation goal to the public was a major step in influencing daily economic decisions and managing expectations. However, there was much debate about whether setting such a rule was a good idea, which we discuss later in this article.
2020: Average Inflation Targeting
One weakness of a fixed inflation target is that it limits the Fed’s power to address the other part of its dual mandate, stabilising employment. Keeping interest rates lower for longer is a policy that could address unemployment, but could likely cause inflation to breach the 2% target in the nearer term. This was a major concern in April 2020 when unemployment rates reached a record-high 14.7%.
Against this backdrop, in August 2020, the Fed replaced its target fixed inflation rate of 2% with a target average of 2% over time. Inflation rarely reached the target rate between 2012 and 2018, as evident in Figure 1. This new policy of average inflation targeting implies the Fed should now aim for inflation above 2% in the next few years, a goal consistent with boosting employment.
1.2 Regulation of the Banking System
Another role of the Federal Reserve is in regulating US financial institutions and maintaining financial stability. Preventing bank failures is a critical function given the outsized importance of the banking system to the functioning of the economy.
On an individual level, when people and businesses make payments to each other, money moves between different bank accounts, often between different banks. On aggregate, this means banks are constantly transferring money between each other. However, banks do not actually hold most of their customers’ deposits in cash; they profit by making loans and other investments. If they lose too much money on their investments, they may be unable to honour the required payments.
To avoid such a situation, banks (more generally, depository institutions e.g. commercial banks, savings banks, credit unions and savings and loan associations) are required to hold deposits known as reserves with the central bank, and the Fed sets a minimum amount of reserves that each bank must have at any time, the reserve requirement. Each bank essentially has a bank account with the Fed, which is the central bank. The Fed then pays interest on the reserves and can make loans to depository institutions, just like an ordinary bank pays interest on its customers’ deposits.
2. Structure within the Federal Reserve
As illustrated in Figure 2, within the Federal Reserve, there are three key entities: the Board of Governors, a decentralised operating structure of 12 (Federal) Reserve Banks and the Federal Open Market Committee (FOMC).
Central to the Federal Reserve is the Board of Governors, whose members oversee the system. The Reserve Banks are in charge of daily operations coordinated in a not-for-profit organisation acting in the public’s interest. The FOMC determines monetary policy by assigning short-term objectives, often the target level for the federal funds rate.
2.1 The Twelve Independent Reserve Banks
The framers of the Federal Reserve Act geographically divided America into 12 Districts each with a separate incorporated and independent Reserve Bank.
An advantage of this independence is that it makes the Fed ‘immune’ to political pressure. The short-term goals of re-elections favours inflationary policies, but at the expense of longer-term growth. An independent Fed will therefore better address long-term objectives and execute politically unpopular policies.
However, it also has its disadvantages, such as poor coordination between the fiscal policy passed by Congress and the monetary policy enacted by the central bank. If the government cuts taxes (loose fiscal policy), but the Fed raises interest rates (tight monetary policy), the mismatched results would undermine both efforts.
What we have seen as the US economy became more complex is a shift away from complete independence and increased coordination throughout the system.
2.2 Federal Open Market Committee (FOMC)
The FOMC includes 12 members, a combination of members from the Board of Governors and Reserve Banks.
Composition of the FOMC
The FOMC is structured so that it includes the President of the New York Reserve Bank, 7 members from the Board of Governors and 4 of the 11 other Reserve Bank Presidents, where each President has a one-year term and the role is rotated. Traditionally the chairman of FOMC is also the chair of the Board of Governors (currently Jerome Powell) whereas the vice chairman of FOMC is the President of the New York Federal Reserve Bank (currently John C Williams).
Decision making within the FOMC
To reach decisions on monetary policy, the FOMC considers development reports and a vote is taken, with the majority decision implemented. The FOMC members also make decisions on OMOs (Open Market Operations) and discount rates, the interest rate the Fed charges for loans to depository institutions. Within the FOMC, there have been instances when members differed in opinion, evident in the aftermath of the Great Recession. This was between doves who favoured stimulus, hawks with stricter policies and moderates, although it was an extreme case and members have generally had similar preferences.
3. Monetary Policy Tools
The Fed has many tools in its arsenal. With the development of the local and global economy, these tools have waxed and waned in importance.
3.1 Traditional monetary policy: Adjusting the federal funds rate
One of the most closely watched decisions at every FOMC meeting is the target for the federal funds rate.
What is the federal funds rate?
The federal funds rate is the market-clearing interest rate in the overnight interbank market. A chief reason why banks make overnight loans to each other is to comply with the reserve requirement, the minimum amount of reserves they are required to hold with the Fed. On a day-to-day basis, as millions of transactions are carried out, some banks may temporarily fall below this reserve requirement. They take overnight loans from other banks that, on that particular day, have more reserves than they need (‘excess reserves’).
How does the Fed achieve the target federal funds rate?
The channel through which the Federal Reserve influences the federal funds rate has evolved over time, from a ‘corridor system’ to a ‘floor system’. Here we will explain both systems, and why the change was made (Hint: it has to do with the extraordinary monetary easing undertaken by the Federal Reserve in response to the global financial crisis of 2008).
The Corridor System
For decades prior to 2009, the Fed effected changes to the federal funds rate via the corridor system. The demand curve for reserves is for the most part downward-sloping, with a flat upper bound on the left and a flat lower bound on the right (see the following graph). You can think of the flat parts as forming the border of a downward-sloping ‘corridor’ within which the market interest rate can fluctuate.
For now let’s focus on the downward-sloping part. Banks’ demand for reserves is downward sloping because at lower interest rates, it is less costly for banks to borrow excess reserves, hence they are more willing to do so. On the other hand, the supply curve is a vertical line because it can be influenced by the Fed. Within the ‘corridor’, increasing the supply of reserves leads to a lower federal funds rate, and vice-versa.
The Fed interferes with the supply of reserves via open market operations, where it trades short-term treasuries and other securities on the open market. The mechanism for buying and selling is where it gets interesting.
To increase the supply of reserves, the Fed has to buy securities. Suppose it wants to buy $10 billion of treasuries from sellers on the open market. Think of the sellers as banks (even if they’re not, most of the money eventually ends up in a bank account anyway). The Fed adds $10 billion of treasuries to its ‘balance sheet’, and the sellers (banks) are paid $10 billion of new cash that was created out of thin air. They now have extra cash to deposit in their accounts with the Fed, i.e. on an economy-wide level, there would be more excess reserves.
Conversely, the Fed reduces the supply of reserves by selling securities that they already own. These securities are ‘taken off the (Fed’s) balance sheet’, and the cash paid by buyers (again, think of them as banks) for these securities disappears. Banks now hold less cash on aggregate, i.e. less excess reserves.
This is why people say the Fed is ‘printing money’, and this is how they have controlled the US economy for decades.
The Floor System
Following extraordinary monetary easing in response to the crises of the past decade, the US has reached ‘reserve satiation’. The quantity of reserves has risen to the point that we are on the right end of the demand curve for reserves. This segment can be thought of as a ‘floor’; it is the minimum interest rate at which any bank would lend to each other.
This ‘floor’ exists because instead of lending excess reserves to other banks, a commercial bank can simply keep it in its bank account with the Fed and receive interest from the Fed. The interest paid by the Fed is called the ‘deposit rate’, and is risk-free because the Fed can always create money out of thin air to pay interest. In comparison, lending to other banks carries risks. No sensible bank would take on higher risk for a lower return. The deposit rate is consequently the minimum return, i.e. interest rate, at which a bank is willing to lend to other banks.
Having attained reserves satiation, the Fed can control the federal funds rate simply by announcing and implementing changes to the deposit rate. Market interest rates adjust almost instantly in response.
Why is the federal funds rate so important?
The Fed’s ultimate aim is not to influence overnight interest rates, but to effect changes in the interest rate on longer-term loans. Longer-term loans allow businesses to invest, and consumers to buy big-ticket items like houses and cars.
Suppose the Fed lowers the federal funds rate (‘expansionary monetary policy’). There would very quickly be spillover effects — interest rates on other types of debt would also fall via a no-arbitrage argument. That makes it easier for businesses and consumers to borrow money, allowing them to spend and invest more. This increased spending could lead to higher economic output and inflation.
Post-GFC: Does the federal funds rate still work as a monetary policy tool?
Following the global financial crisis, the FOMC cut its target for the federal funds rate from over 5% in September 2007 to near zero in December 2008. The effective federal funds rate remained around 0.1% well into 2015.
The economy was still in the doldrums, yet the federal funds rate could not go much lower. The Fed’s main monetary policy tool of fifty years had lost its firepower. This motivated the adoption of extraordinary new monetary policy tools which are still in use today.
3.2 Large-Scale Asset Purchases, aka Quantitative Easing (QE)
If the ultimate aim is to influence longer-term interest rates, why not target it directly instead of going a roundabout way via the federal funds rate? Since the global financial crisis, a number of major central banks, including the US Federal Reserve, have expanded open market operations via a non-traditional policy popularly referred to in the media as quantitative easing (QE) .
In contrast with traditional open market operations where short-term assets are traded with the purpose of influencing the federal funds rate, QE entails the purchase of longer dated assets such as ten-year treasuries and mortgage-backed securities. This policy is characterised by the staggering quantity of asset purchases. In April 2020, as part of the response to the COVID-19 pandemic, the Fed was buying $41 billion of assets daily. This artificially generated demand for longer-dated assets increases their prices and directly suppresses longer-term interest rates.
3.3 Forward Guidance
Forward guidance is the practice of making forward-looking statements on monetary policy, chiefly for the purpose of setting expectations. Expectations matter in monetary policy because the economic decisions that the Fed seeks to influence have future implications. It is easier for individuals and firms to make decisions when they have more certainty in what the future would look like.
The Federal Reserve publishes a quarterly ‘Summary of Economic Projections’ which includes projections of the Federal Funds Rate over the next four years and in the long run. On top of that, the ‘FOMC statement’ released after every FOMC meeting typically makes forward-looking statements on monetary policy. For example, after the December 2008 meeting, the FOMC wrote that ‘weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time’, and they followed through with that commitment.
Unexpected announcements can cause huge turmoil in financial markets, and erode public trust in Central Banks. This occurred in 2013, when Federal Reserve Chairman Ben Bernanke announced that the Fed would reduce the future volume of bond purchases; a ‘tapering’ of quantitative easing. Markets, which had operated on the assumption of continued Fed support, panicked. Investors immediately responded by selling off bonds, in an episode referred to as the ‘taper tantrum’.
3.4 Monetary policy tools in action: 2020
On March 15, 2020, the FOMC held an unscheduled emergency meeting. COVID-19 infections were spreading rapidly around the globe, and days earlier, the US stock market had seen its largest single-day crash since 1987. Key markets critical to the functioning of the economy, including credit markets, money markets and even US Treasuries, were experiencing rapid declines in liquidity.
In its press release that day, the Federal Reserve announced a response that included all the monetary policy tools discussed in this article:
- The target range for the Federal Funds Rate was lowered from 1.00–1.25% to 0–0.25%.
- The FOMC signalled that this target range will be maintained until the economy is on track to achieve its employment and inflation goals.
- A $700 billion round of quantitative easing was announced.
Despite these measures, hysteria reigned and asset prices continued to plunge the next day. The Federal Reserve was swift to step up its response, establishing various emergency lending facilities and conducting asset purchases on a scale never seen before. For the first time, even high-yield bonds (more colloquially known as ‘junk bonds’) were included in the Fed’s asset purchase programme.
Has this created a moral hazard where companies neglect to carry out adequate risk management as they expect to be propped up by the Fed when in need? Only time will tell.
3.5 The dangers of excessive monetary easing
In a free market, weak companies are eventually bankrupted and are replaced by more innovative, efficient ones. Artificially low interest rates allow ‘zombie companies’ to continue surviving by accessing cheap debt. This stifles innovation and efficiency improvements, and could in fact be a threat to long-run growth.
Moreover, excessive stimulus might cause the Fed to overshoot its target inflation rate (at least, in theory). Excessive inflation like that seen in the 1960s-1980s is hugely damaging to the economy. QE in particular was controversial because it has not only suppressed interest rates, but caused the US money supply to explode.
According to the monetarist theory of inflation, if the money supply grows too quickly, there will be inflation. Money becomes worthless when there is too much of it, just like your favourite flavoured Haribos become pleasingly cheap when there’s so much of them! (Except it’s not a good thing for money to become ‘cheap’.)
However, despite four massive rounds of QE, inflation rates have remained stubbornly low. Does that mean this theory doesn’t work? One way to look at it is that while there has been little inflation in the real economy, prices of financial assets such as bonds and stocks have soared. Another reason is that the Fed is a lot more serious than in past decades keeping the inflation rate low and stable.
4. Monetary Policy Rules
The Fed can’t just use their tools without restraint, and so with tools comes the ‘rools’ (rules) that govern the ways in which central banks make monetary policy decisions.
4.1 Taylor Rule
The Taylor Rule, devised by American economist John Taylor (what a surprise!), is the most well known monetary policy rule. It gives a ‘formula’ for deciding the Federal Funds Rate, as a function of economic variables chosen at the economists’ discretion based on what they care about. This could be anything, but most commonly: the equilibrium real interest rate, the target inflation rate, the inflation gap, and the output gap.
For alternative rules, see: https://www.federalreserve.gov/monetarypolicy/policy-rules-and-how-policymakers-use-them.htm
For example, if inflation (πₜ) is above target (2%), the Fed raises the Federal Funds Rate — often more than how much inflation is above target. Similarly, if output (yₜ) is above target (yₜ,FE), the Fed raises the Federal Funds Rate in order to stabilise fluctuations in the economy. However, they do not simply adjust the Federal Funds Rate by the extent of the increase in inflation. Rather, following the Taylor Principle, the Federal Funds Rate should be adjusted by even more than that (the coefficient on the inflation deviation from target is greater than 1).
The chaos of the macroeconomy between 1970 to 1990 can be seen by comparing outcomes when the Federal Reserve did, and did not, follow the Taylor Rule. Between 1970 and 1978, Arthur Burns was the chairman of the Federal Reserve. In contradiction to the Taylor principle, his setting of monetary policy was not aggressive enough. Burns’ ‘soft’ approach was criticised for not being able to re-align rife inflation due to oil shocks in the mid-1970s back on target.
From 1979 to 1987, Paul Volcker became the Chairman. Consistent with the Taylor Principle, he raised interest rates even more than the increase in inflation. His aggressive action has been credited with finally ending the prolonged hyperinflation in the US.
The contrasting outcomes of the two Chairmen in this episode supports the use of the Taylor Rule as a framework for using monetary policy to stabilise the economy.
4.2 The Central Bank’s Loss Function
In addition to following the Taylor Rule or its variants, Central Banks use a number of frameworks within which they make their policy decisions. A key framework for balancing both halves of the dual mandate is the loss function.
Before explaining the loss function, it is necessary to motivate it by understanding the Phillips Curve.
The Phillips Curve
The Phillips Curve outlines an inverse relationship between the inflation rate and the unemployment rate. Mathematically, this is expressed as a relationship between the inflation rate and unemployment gap (which is the difference between actual unemployment and the natural rate of unemployment). The idea is that with economic growth implies higher inflation, which is in turn associated with lower unemployment.
Many believed that this relationship broke down in the 1970s due to a period of ‘stagflation’ where both inflation and unemployment was prohibitively high. However, this was merely a shift of the Phillips Curve outwards; the inverse relationship remained unaltered. Volcker, as outlined above, restored the Phillips Curve close to its original position with his aggressive monetary policies.
Since the 21st century, there has been an observed flattening of the Phillips Curve in the US — changes in the inflation rate are now associated with larger changes in the unemployment rate. The primary explanation was that the Fed has been much more mindful of inflation targeting; consequently, inflation has remained stable over the past two decades or so, despite fluctuations in the unemployment rate. However, whether the Phillips Curve is accurately estimated or not is contentious, as the natural rate of unemployment — the level of unemployment without any business cycles — is difficult to forecast.
Although this does imply an altering of the strength of the inflation-unemployment relationship, there is still a clear trade-off between inflation and unemployment. Thus, the Phillips Curve remains an important concept in Central Bank decision-making.
Back to the Loss Function
Having outlined the trade-off between inflation and unemployment with the Phillips Curve, the loss function is meant to be a simplistic representation of society welfare if the only two plagues of society are inflation and unemployment.
The loss function, which the Fed tries to minimise, is increasing in deviations from the inflation target and deviations from the natural rate of unemployment.
Without imposing any further structure to the Fed’s decision-making, we encounter a problem which makes it difficult for the central bank to minimise the society’s loss function. Imagine someone who hates unemployment (i.e. most central bankers) and wishes to aim for a rate lower than the natural rate. Also imagine that people in the economy are magicians and can anticipate future inflation, unless the Fed ‘surprises’ them. If the Fed promises on-target inflation (assuming this target is not enforced as a rule) but wishes to ‘surprise’ the economy by creating a little more inflation above target, it can lower unemployment below the natural rate. However, the people expect the higher inflation (because they are magicians), and will thus make decisions accordingly; for example, workers may negotiate higher wages if they think inflation is going to erode away their purchasing power. Thus, unemployment returns to the natural level and inflation is above target. This is known as the time inconsistency problem; the Central Bank’s temptation to lower unemployment below the natural rate leads to an inflation bias above the inflation target. This makes it difficult for the central bank to minimise society’s loss function. A key solution, which the Fed previously adopted, was to instate an explicit inflation targeting rule (2%).
4.3 Rules vs. Discretion
Setting a commitment device, a rule (different from the ‘rule’ in the sense of the Taylor Rule above), helps Central Banks maintain their credibility and reduce inflation bias, but it raises further questions about its trade-offs. Is it better to enforce a draconian rule that keeps inflation on target all the time — and reduces the Fed’s ability to respond to economic shocks — or should inflation be allowed to vary and respond to shocks, at the cost of being highly variable and unpredictable? This illustrates none other than the topical debate about rules versus discretion in central banking.
In 2012, Federal Reserve Chairman Ben Bernanke set a 2% inflation target. Only then did the US join many of the world’s central banks in adopting inflation targeting. Whether the adoption was a good idea was widely debated both before its implementation and after. One major concern was that a greater emphasis on keeping inflation in line would result in the loss of freedom to pursue more discretionary objectives. This was a view shared by Alan Greenspan, Bernanke’s predecessor, and other members of the FOMC including Alan Blinder.
Prior to 2012, inflation had been consistently running below 2%. The Fed’s rationale was to increase long-run expected inflation.
By the Fisher equation, which outlines a relationship between the nominal interest rate, real interest rate, and inflation, this increases nominal interest rates, which leaves more room for it to be cut in recessions. Specifically, why the Fed aimed for a 2% inflation target was that, while higher prices would add to the burdens of families needing essential goods such as food and shelter, low inflation can weaken the economy as households and businesses will expect low inflation in the future. In response to low inflation, the Federal Funds Rate will be cut, but, as the Great Financial Crisis has shown, there is a lower bound at which the Federal Funds Rate can no longer be cut. Thus, by aiming for and committing to a slightly higher inflation rate in normal times, the Fed leaves a little more scope for the Federal Funds Rate to be cut in times in need of a little more stimulus.
This article is written by: Sandra Ng (Head of US Monetary Policy Research), Brooklyn Han (Research Associate, US Monetary Policy Research), Anna Clarey (Research Associate, US Monetary Policy Research) and Pedro Almas (Research Associate, US Monetary Policy Research). This article is reviewed by Jason Jia (VP, Monetary Policy Research).