Monetary Policy of the U.S. Federal Reserve - Essay Example

Monetary Policy of the U.S. Federal Reserve The world of today has shrunk beyond belief. News travels across the globe within a matter of seconds, technology has scaled unprecedented heights and the world has become a global village. This has directly resulted in a boom in economic activities where individuals can sell directly to their customer across the world thanks to the marvel of the internet and online banking. In this time and age what has not changed is the primary role of the government. All countries of the world have some sort of government running the country in one way or another. One of the many ways that a government exhibits its control over the economic activities of a country is by means of a monetary policy. This paper discusses the U.S. Federal Reserve’s monetary policy. Most simple put the attempt by the Federal Reserve to establish balanced national income and help spur economic growth by controlling the size of the money supply is termed as monetary policy. It is implemented with the help of policy tools which usually consist of open market operations, discount rates and reserve requirements. Open market operations are the strongest monetary policy tool consisting of the purchase and sale of treasury and federal agency securities. The federal open market committee normally specifies all short-term objectives related to open market operations. These objectives normally identify reserve targets or the desired federal funds rate. It is interesting to note that there have been diverse objectives over the years ranging from federal funds rate targets in the eighties to policy changes in the nineties. No matter what the short term objective the long term objective has always been price stability and sustainable economic growth. Another integral monetary policy tool is the discount rate which most simply put is the interest rate being charged to depository institutions including commercial banks on loans they receive from their regional discount window (Federal Reserve Bank’s lending facility). These loans include primary, secondary and seasonal credit each one with its own respective interest rate. The primary credit program consists of very short term loans to sound financial institutions. Those not eligible for primary credit are allowed to apply for secondary credit whereas seasonal credit is provided to those depository institutions that have fluctuating funding requirements. It should be noted that the discount rates on all three lines of credit vary with the rate on primary credit being the lowest followed by a higher rate on secondary credit whereas the seasonal credit discount rate is an average of selected discount rates. Reserve requirements are another monetary tool that which as the name signifies are the amount of reserve funds that a depository institution must hold as a safeguard against deposit liabilities. These reserves are held in the form of physical cash or deposits with Federal Reserve Banks with the board of governors having lone authority over any changes in the reserve requirements. The reserve requirements are not erratic and are determined using Federal Reserve Board Regulations. All of the above help the government implant its monetary policy and eventually result in a stronger economic power. Proper use of monetary policy can have extremely positive results which were visible during the first half of 2006 when the US economy showed speedy growth. Any change in the federal funds rate triggers a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.( Board of Governors report to the Congress) This expansion did slow down during the year as a result of various factors that included (but were not limited to) federal spending on hurricane relief, increase in energy prices and higher mortgage interest rates. New jobs were created during the initial part of 2006 but from the second quarter new jobs have slowed down yet still managed to keep the unemployment rate steady. Inflation has seen an upward spike in the first half of 2006 as result of the increase in crude oil prices which has resulted in an upward price spiral on a diverse range of goods and services. Even after this spike, inflation did remain within expected parameters. It seems the American economy is undergoing a transition which is visible in the delayed effect of monetary policy. During the end of the year growth in service industries remained strong with the weakest growth in the automobile and housing sector yet housing demand continued to be considerably strong in a limited number of markets. Wages managed to grow moderately with some regional exceptions. The rise in long-term interest rates contributed to an increase in borrowing costs. Inflation has been higher than expected with the increase reflecting in the prices of a range of non-energy goods and services. In addition, increase in housing rents has contributed to higher inflation. This rise in inflation is of more concern to the Federal Reserve then any recession fears because the achievement of price stability is one of the core objectives of Congress's mandate to the Federal Reserve. More important price stability is integral to achieving maximum employment and moderate interest rates (long term) which are also an integral part of the mandate. Inflation is expected to slow down over time as the price of major commodities stabilizes. Monetary policy makers operate work in an uncertain environment with imperfect knowledge of the effect of policy actions as well as of many other factors that help shape economic progress during the forecasted period. It is these uncertainties that have a strong effect on policy decisions because their economic influence becomes prominent after a substantial period of time has passed. It is this lag between policy actions and their effects that the Federal Reserve analyzes and basis its policies upon. As Chairman Ben S. Bernanke said in his testimony to congress (July 19th 2006) “We must take account of the possible future effects of previous policy actions--that is, of policy effects still in the pipeline…..we must consider not only what appears to be the most likely outcome but also the risks to that outlook and the costs that would be incurred should any of those risks be realized.” It is fair to say that legislative, technological and other global developments are having a direct impact on the activities of the Federal Reserve. A simple example is the substantial increase on online banking which has resulted in a reduction in physical cheques leading to reduced check clearing volumes. Nevertheless the Federal Reserve continues to adapt its monetary policy to incorporate the changes that have taken place nationally and internationally and will continue to do to succeed in its objectives. References 1. Board of Governors to the Federal Reserve System. (July 19th 2006). Monetary policy report to the Congress 2. Testimony of Chairman Ben S. Bernanke. (July 19th 2006) Semi-annual Monetary Policy Report to the Congress Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate Read More