monetary policy: deliberation and implementation

J. K. Dietrich - FBE 524 - Fall, 2005

Monetary Policy:Deliberation and Implementation

Week 12 – November 9, 2005


Roles of Central Banks List of central bank roles in Rose (p. 354)

– Market stabilization– Control of money supply– Lender of last resort– Supervisor of the banking system– Protecting and improveing the flow of

payments Last two are independent of others, and first

three all relate to money supply


Control of money supply Promote economic goals

– Full employment– Price stability– Economic growth through improvements in

productivity with investment How good must central banks be? Theory of optimal currency areas weighs costs of

multiple currencies versus local control of money supply to promote above


Robert Mundell“…Many of the political changes in the century have been caused by little-understood perturbations in the international monetary system, while these in turn have been a consequence of the rise of the United States and mistakes of its financial arm, the Federal Reserve System. The twentieth century began with a highly efficient international monetary system that was destroyed in World War I, and its bungled recreation in the interwar period brought on the Great Depression, Hitler, and World War II.”

”A Reconstruction of the Twentieth Century” (Nobel Prize Lecture, December 10, 2002) in American Economic Review, June 2002, p. 327


Roles of Federal Reserve Control of money supply - to be discussed Market stabilization

– Fed open market operations– Statements of officials

Lender of last resort– Incentive problems

Maintaining and improvement of payments mechanism– Private competitors, pre-Fed arrangements

Supervisor of the banking system– Performed by other agencies


Monetary Policy Deliberation Implementation Prediction Evaluation Criticism


Deliberation Since 1935, monetary policy is the responsibility

of the Federal Open Market Committee (FOMC) FOMC consists of 7 Federal Reserve Governors

(Washington based) and five voting Federal Reserve Bank presidents– New York FRB president– Chicago/Cleveland FRB presidents alternate– Three of remaining nine FRB presidents rotate


What is Money? Fed tracks three money measures

– M1 = Currency + checkable accounts + others– M2 = M1 + small savings accounts (including

IRAs and Keoghs at banks) + others– M3 = M2 + large CDs + Eurodollars + others

Which is relevant to level of economic activity -- actively debated issues

Which can Fed control?


The Money Multiplier Fed controls its balance sheet, including the

monetary base = currency + reserves Money multiplier derives relation between

supply of money (whichever definition) and the monetary base. Rose (p. 521) has M1 multiplier:

Note factors affecting money supply )TIMERR(EXRCASHRRCASH1Multiplier1M

TD


Money Multiplier

1.6

2.0

2.4

2.8

3.2

3.6

4.0

60 65 70 75 80 85 90 95 00

M1MULTIPLIER

M1 Multiplier 1959 to Present

Source: Federal Reserve Bank of St. Louis FRED II


Currency Ratio

.20

.25

.30

.35

.40

.45

.50

.55

.60

60 65 70 75 80 85 90 95 00

CRATIO

Currency Ratio 1959 to Present



FOMC meetings Eight scheduled meetings per year: one today Next meeting is December 13, 2005 Last scheduled meeting was November 1, 2005 Last meeting for which minutes were released was

September 20, 2005 (available on Internet) Format of meetings routine

– Discuss financial markets and economy– Adopt formal instructions to the manager of the

System Open Market Account (directive)


Input to FOMC Deliberations Staff projections

– Green book– Blue book– Beige book

Conceptual framework– Non-accelerating inflation rate of employment (NAIRU)– Taylor’s rule

– Econometric models and projections

tttt yi 5.5. * where i is Fed funds rate and π is inflation and y is output gap (difference between actual and potential GDP)


Implementation Fed can only control its own balance sheet, or

high-powered money consisting of currency and bank reserves

Since 1970, Fed targets growth rates in money supply– Initially two month growth targets– 1975 started announcing six month target and cone

Humphrey-Hawkins required annual target


Fed Balance Sheet: Oct. 30, 2003

U.S. Government Securities $658.0 Federal Reserve Notes $669.4Gold stock $11.0 Deposits

Depository institutions $26.6 U.S. Treasury $5.7

Total Assets $748.2 Total Liabilities 730.4$ Equity $17.8

Assets Liabilities


Fed Balance Sheet: Oct.28, 2004

U.S. Government Securities $706.7 Federal Reserve Notes $707.2Gold stock $11.0 Deposits



Assets Liabilities

(U.S. Securities up 7.4%, FR Notes up 5.6%, reserves down 6.4%)


Fed Balance Sheet: Oct.26, 2005U.S. Government Securities $739.5 Federal Reserve Notes $767.9Gold stock $11.0 Deposits



(U.S. Securities up 4.6%, FR Notes up 8.6%, reserves down 13.6%)


FOMC and Board of Governors FOMC sets monetary policy Board of Governors rules on issues

concerning regulatory changes, acquisitions under Gramm-Leach-Bliley Act of 1999

Board reports twice annually to Congress under requirements of Full Employment and Balanced Growth Act of 1978 (Humphrey-Hawkins)

Testimony to Congress


Problems in Implementation Monetary statistics reported late and are

subject to revision (described as driving by looking in rear-view mirror)

Market rates are instantaneously observable and Fed Funds rate immediately impacted by changes in high-powered money (reserves)

Fed traditionally focussed on rates or credit market conditions


Fed Targets and Base Growth

Demand for Reserves and Funds

f=Fe

d Fu

nds r

ate

ReservesNon-Borrowed Reserves Borrowed Reserves

= Discounts at Fed

} }Wide

range

Narrowrange


Required reserves Reserve requirements depend on which banks (3%

for smaller banks) and level of transactions versus other accounts

Calculation period runs 14 days from a Tuesday to Monday

Maintenance period is 14 days, ending on Wednesday 16 days after calculation period

Vault cash based on previous maintenance period applied to required reserves


Lagged Reserves

Reserve calculated on a dollar days basis Penalties for shortfalls, limited advantage (carry-forward) for excess Clearing balances affected by Fed wire and Treasury transactions

Tuesday Monday Monday

Wednesday17 days

WednesdayCalculation

PeriodMaintenance

Period

Wednesday Wednesday

Monday Monday

Thursday


Growth Monthly and Smoothed

-4

-2

0

2

4

6

60 65 70 75 80 85 90 95 00

BASEGROWTH BGROWSMOOTH

Monthly Base Growth and 12-Month Moving Average



Monetary Base and Money

0

200

400

600

800

1000

1200

1400

60 65 70 75 80 85 90 95 00

BASE CURRENCY M1

Monetary Growth: Base, Currency, and M1



“Base Drift”

260

280

300

320

340

360

1974 1975 1976 1977 1978

M1M1HIGHGM1HIGHG2

M1LOWGM1LOWG2

M1 Growth Cones at 2% and 4% Annual Growth

Base Drift 1/1974 to 1/1976


Fed Funds and M1 Growth in ‘70s

2

4

6

8

10

12

14

-10

-5

0

5

10

15

20

70 71 72 73 74 75 76 77 78 79

FEDFUNDSRATE M1GROWTH

Fed Funds and Base Growth in the 1970's


Volcker - October 6, 1979 Focus on growth of aggregates Widen Fed Funds trading range to 400 basis

points Focus on non-borrowed reserves Experience

– Interest rates– Monetary growth


The Early ‘80s under Volcker

4

6

8

10

12

14

16

18

20

-20

-10

0

10

20

30

40

80 81 82 83 84 85 86

FEDFUNDSRATE M1GROWTH

M1 Growth and Fed Funds Rate 1979-1982


Fed Funds and M1 Growth Now

-4

-2

0

2

4

6

8

10

88 90 92 94 96 98 00 02 04

M1GROWSMOOTH M1GROWTH FEDFUNDS

Fed Funds Rate and Base Growth



Prediction (“Fed Watching”) Importance of Fed actions is less than in 1970’s,

but still matter to market observers Fed watching is still common on the street Fed watching consists of

– Observing what they say they are doing» Speeches, testimony, interviews, remarks

– Assessing what they have done» Statistical releases

– Tracking the market’s reaction


Evaluation Humphrey-Hawkins specifies monetary

policy objectives to be low inflation and economic growth

Last eight years have been a period of low inflation and rapid growth

Basic evaluation is that Greenspan has been a great chairman and his re-appointment by Clinton de-politicized the Fed


Criticism Theoretical argument by monetarists

– “Inflation is always and everywhere a monetary phenomenon” - Milton Friedman

Fed is a giant player and its actions have an immense effect on markets, producing uncertainty

A base growth rule, gold standard, or comprehensible price rule would eliminate uncertainty about Fed policy


Theoretical/Philosophical Issues The econometric models used for policy are

fundamentally flawed (the Lucas critique)– Participants in efficient markets try to anticipate

changes and alter behavior accordingly– Parameters of estimated response functions will

change constantly, hence are unstable– Data too limited to assess changes on models

Unanticipated changes in policy are risks


Greenspan revisited What are his (or the FOMC’s under his

leadership) guiding principles, or rules? How do asset prices, representing future

value of cash flows, and goods inflation relate to each other and monetary policy?

Fed has increased its transparency with post-FOMC meeting announcements, but what else is being discussed?


Central Banks European monetary system

– The Euro - January, 1999, and beyond– Brief history of European monetary union– Challenges facing the European Central Bank

Bank of Japan People’s Bank of China Central banks elsewhere - independence or

political domination are the issues


Next Week: November 16 Read Chapter 18 in text concerning

government and consumer debt markets Bring a Wall Street Journal for next

Tuesday to class Plan team meeting and consultation with

me concerning group semester project

monetary policy: deliberation and implementation

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