Targeting the Federal Funds Rate - Case Study Example

Targeting the Federal Funds Rate At 2:15 p.m. on September 18, 2007, immediately following a regular meeting, the Federal Open Market Committee (FOMC) announced that it would lower its target for the federal funds rate by one-quarter of a percentage point to 5.0 percent, the first rate reduction in more than four years. In cutting the target rate, the FOMC expressed concern that the fallout from rising mortgage default rates could spread to the wider economy. The fear was that lenders, fearing a meltdown in the housing sector, were becoming overly cautious. This fear of lending was creating a “credit crunch” that could slow investment and economic growth. By lowering the federal funds rate, the Fed hoped this would add liquidity to financial markets and strengthen the economy. As you know by now, the federal funds rate is the interest rate banks charge one another for overnight lending of reserves at the Fed. Because lowering the rate reduces the cost of covering any reserve shortfall, banks are more willing to lend to the public. To execute this monetary policy, the FOMC authorized the New York Fed to make open-market purchases to increase bank reserves until the federal funds rate fell to the target level. For nearly four decades, the Fed has reflected its monetary policy in this interest rate. (For a few years, the Fed targeted money aggregates, but more on that later.) There are many interest rates in the economy—for credit cards, new cars, mortgages, home equity loans, personal loans, business loans, and more. Why focus on such an obscure rate? First, by changing bank reserves through open-market operations, the Fed has a direct lever on the federal funds rate, so the Fed’s grip on this rate is tighter than on any other market rate. Second, the federal funds rate serves as a benchmark for determining other short-term interest rates in the economy. For example, after the Fed announces a rate change, major banks around the country usually change by the same amount their prime interest rate—the interest rate banks charge their best corporate customers. The federal funds rate affect monetary and financial conditions, which in turn affect employment, aggregate output, and the price level. The Fed uses the federal funds rate to pursue its primary goals of price stability and sustainable economic growth. Exhibit 5 shows the federal funds rate since early 1996. As a lesson in monetary policy, let’s walk through the Fed’s rationale. Between early 1996 and late 1998, the economy grew nicely with low inflation, so the FOMC stabilized the rate in a range of 5.25 percent to 5.5 percent. But in late 1998, a Russian default on its bonds and the near collapse of a U.S. financial institution created economic havoc, prompting the FOMC to drop the target rate to 4.75 percent. By the summer of 1999, those fears abated, and instead the FOMC became concerned that robust economic growth would trigger higher inflation. In a series of steps, the federal funds target was raised from 4.75 percent to 6.5 percent. The FOMC announced at the time that the moves “should markedly diminish the risk of rising inflation going forward.” Some critics argued that the Fed’s rate hikes contributed to the 2001 recession. In 2001, concerns about waning consumer confidence, weaker capital spending, and the 9/11 terrorist attacks prompted the FOMC to reverse course. Between the beginning of 2001 and mid-2003, the FOMC cut the rate from 6.5 percent to 1.0 percent, reflecting the most concentrated monetary stimulus ever. The rate remained at 1.0 percent for a year. Some economists criticized the Fed for keeping rates too low too long. They charged that this “easy money” policy overstimulated the housing sector, encouraging some to buy homes they really couldn’t afford. These home purchases, critics argued, sowed the seeds for mortgate defaults that hit years later. Anyway, after leaving the rate at 1.0 percent for a year, the FOMC began worrying again about inflationary pressure. Between June 2004 and June 2006, the target federal funds rate was increased from 1.0 percent to 5.25 percent in 17 steps. The FOMC then hit the pause buttton, leaving the rate at 5.25 percent for more than a year. This takes us up to September 2007, when troubles in the housing sector, a rising mortgage default rate, and a softening economy prompted the first in what was expected to be a series of federal funds rate cuts. Over the years, the Fed has tried to signal its intentions more clearly to financial markets—to become more transparent. In 1995, the FOMC began announcing immediately after each meeting its target for the federal funds rate. Since 2000, the post-meeting statement also included the probable “bias” of policy in the near term—that is, whether or not its current level or direction of interest rate changes would continue. And in 2005, the FOMC began releasing the minutes three weeks after each meeting. By generating such concrete news, FOMC meetings became widely followed media events. If the situation is serious enough, the FOMC may act between regular meetings, and this has a more dramatic impact, particularly on the stock market. Still, in announcing rate changes, the FOMC must be careful not to appear too troubled about the economy, because those fears could harm business and consumer confidence further. Also, the FOMC must avoid overdoing rate cuts. As one member of the Board of Governors warned, the FOMC must not cut the rate so much that it “ends up adding to price pressure as the growth strengthens.” Thus, the FOMC performs a delicate balancing act in pursuing its main goals of price stability and sustainable economic growth. SOURCES: Gregory Ip, “Bernanke Breaks Greenspans Mold,” Wall Street Journal, 30 August 2007; “Tangled Reins: America’s Central Bank Attempts to Tame the Beast It Once Let Loose,” Economist, 8 September 2007; and “FOMC Statement on Interest Rates,” “Minutes of the Federal Open Market Committee,” and “Federal Open Market Committee Transcripts” for various meetings. Find the latest FOMC statements, minutes, and transcripts at http://www.federalreserve.gov/monetarypolicy/fomc.htm. 1. (CaseStudy: Targeting the Federal Funds Rate) Why has the Federal Reserve chosen to focus on the federal funds rate rather than some other interest rate as a tool of monetary policy? By 2007, there have been indicators of a housing meltdown as the article mentioned. Therefore, the govt. was trying to arrest a forthcoming problem by focusing on the federal funds rate. Going back to the situation then, it was thought that a credit crunch could slow down the economy which is a valid hypothesis. Thus, the feds resorted to lower the funds rate in the hope financial markets would be liquid. By doing such, borrowing is encouraged so more business can use money for development or capitalization. The article also made mention some reason why Fed focused on the rate such as : it has a bigger effect on the over-all economy through its eefct on the monetary and fiscal conditions. The federal funds rate enables the Fed to promote stabilization of prices which is one of the mandates for a good fiscal policy. Chapter 17 Central Bank Independence and Price Stability Some economists argue that the Fed would do better in the long run if it committed to the single goal of price stability rather than also worry about achieving potential output. But to focus on price stability, a central bank should be insulated from political influence, because price stability may involve some painful remedies. When the Fed was established, several features insulated it from politics, such as the 14-year terms with staggered appointments of Board members. Also, the Fed has its own income source (interest earned from government securities and fees earned from bank services), so it does not rely on Congress for a budget. Does central bank independence affect performance? When central banks for 17 advanced industrial countries were ranked from least independent to most independent, inflation during the 15-year span examined turned out to be the lowest in countries with the most independent central banks and highest in countries with the least independent central banks. The least independent banks at the time were in Spain, New Zealand, Australia, and Italy. The most independent central banks were in Germany and Switzerland..Countries with the least independent central banks experienced inflation that averaged four times higher than countries with the most independent central banks.. The U.S. central bank is considered relatively independent; U.S. inflation was double that of the most independent countries and half that of the least independent countries. The trend around the world is toward greater central bank independence. For example, the Central Bank of New Zealand has adopted a monetary policy of inflation rate targeting, with price stability as the primary goal. Chile, Colombia, and Argentina—developing countries that suffered hyperinflation—have legislated more central bank independence. The Maastricht agreement, which defined the framework for a single European currency, the euro, identified price stability as the main objective of the new European Central Bank. That bank has a policy rule of not reducing the interest rate as long as inflation exceeds 2.0 percent. In fact, the European Central Bank came under criticism recently for not the cutting interest rate even though a recession loomed and unemployment topped 8 percent. The Bank of England and Swiss National Bank also have a inflation target of no higher than 2.0 percent. Many central banks have adopted low inflation targets SOURCES: Alberto Alesina and Lawrence Summers, “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit and Banking 25 (May 1993): 151–162; Ben Bernanke, “A Perspective on Inflation Targeting: Why It Seems to Work,” Business Economics 38 (July 2003): 7–15; and Joellen Perry, “Europe’s Hold on Rates May Persist for Some Time, Wall Street Journal, 7 September 2007 for online links to more than 160 central banks, including all those discussed in this case study, go to http://www.bis.org/cbanks.htm. 2. (CaseStudy: Central Bank Independence and Price Stability) One source of independence for the Fed is the length of term for members of the Board of Governors. In the chapter before last, we learned that the Fed is a “money machine.” Does this suggest another source of Fed independence from Congress? No. I disagree. In fact, the Fed has been printing so much money since November 2008 to help AIG restructure its debts. Apparently, there are powers unseen that directs the actions of Feds since it is very illogical to print trillions of dollars. Fed is not really that independent from Congress since any government institution is not totally free from the workings of politics. There are different political interests that often complicates economic situation and not the other way around. Supposedly, the federal reserve system is an independent central bank. However, independence is not the only issue in this situation. The issue is more of accountability and transparency. So far, the federal reserve is being transparent to the general public which is an indication that it is committed to its goals as an institution. While I’ve said that politics cannot be avoided in making decisions, transparency can be a safeguarding mechanism since the public can criticize any political agenda behind a program. Source: Straka,T. The Fed Money Machine Gears Up to Print Trillions ( 11 Nov 2008).< http://seekingalpha.com/article/105375-the-fed-money-machine-gears-up-to-print-trillions Read More