The Monetary Policies and the Federal Reserve - Literature review Example

The Monetary Policies and the Federal Reserve The Monetary Policies and the Federal Reserve The Federal Reserve has undertaken several actions aimed at influencing the availability, as well as the cost of money and credit. These activities have been carried out as a means of aiding to uphold national economic goals (Labonte, 2015). To implement its monetary policies, the Federal Reserve has used three basic tools. These include the discount rate, reserve requirement, and the federal funds rate. With the help of these three tools, the Federal Reserve is able to influence both the demand for, and the supply of balances which are held on deposit by depository institutions at Federal Reserve Banks (Labonte, 2015). Fluctuations in the federal funds rate, prompt a chain of events which affect other long-term interest rates, short-term interest rates, amount of credit and money in the economy, foreign exchange rates, and various economic variables like employment, prices of goods and services, and output. The first monetary policy implementation instrument is the discount rate. This is the interest rate that is charged to commercial banks as well as other depository institutions on the loans that they acquire from their local Federal Reserve lending facility (Federalreserveeducation.org, 2015). The discount rate is established by the Federal Reserve’s board of directors. It is also subject to determination and review by the board of governors. The Federal Reserve has started offering three discount window programs, namely seasonal credit, primary credit, and secondary credit to depository institutions, with each having its interest rates (Engen, Laubach, &Reifschneider, 2014). The Federal Reserve, therefore, sets the discount rate that is usually lower than the federal funds rate despite being closely related. The discount rate set is vital since it serves as a visible message of change in the monetary policy of the Federal Reserve. By so doing, it gives the other markets an insight into the plans of the Federal Reserve. Initially, every reserve bank used to set its discount rate to redirect the credit and banking conditions in its location. Currently, the switch from regional to national credit market has progressively created a national discount rate. Consequently, the Federal Reserve can maintain a homogenous structure of its discount rates across all the reserve banks. At present, the Federal Discount rate is at 0.75, and it was also the same value for the year 2014 (Bankrate.com, 2015). Although this value changes after every two weeks, it has remained the same for this month. The second tool for monetary policy implementation is reserve requirements. These are the sum of funds a depository institution has to hold in standby against listed deposit liabilities (Federalreserveeducation.org, 2015). The board of governors has solitary authority over alterations, within limits that are specified by law, in reserve requirements. These reserve requirements are levied only for the purposes of monetary policy. This implies that depository institutions have to hold funds in the form of deposits or cash with Federal Reserve banks. The Federal Reserve, therefore, sets the amount of physical funds expected to be held in reserve by the depository institutions against their deposits in bank accounts. Through reserve requirements, the Federal Reserve can regulate the amount of money that banks create through investments and loans (Mester, 2015). Presently, the board of governors of the Federal Reserve has set the reserve requirement to be approximately 14.5% (Federalreserve.gov, 2015) Also, excess reserves are held in accounts or as vault cash in the Federal Reserve Bank (Mester, 2015). The Federal Reserve has hence set the reserve requirement so that all depository institutions uphold a minimum amount of funds in their reserves. In order to realize this, the Federal Reserve banks have paid interest on the required reserve balances. This interest rate serves to eliminate successfully the implicit tax, which reserve requirements initially imposed on these depository institutions. The FED has been increasing the Federal Reserve requirements over the past years. For example, the minimum ratios for the years 2011, 2012, and 2014 were 11.5%, 12.4%, and 13.3% respectively (Federalreserve.gov, 2015). The third tool for monetary policy implementation is the federal funds rate. This is the rate that one depository institution charges on an overnight sale of resources that are immediately available, on another depository institution (Federalreserveeducation.org, 2015). This rate can vary depending on the depository institution. Presently, the Federal Open Market Committee (FOMC) sets the target federal funds. Through setting of a target federal funds rate, the Federal Reserve has managed actually to promote the goals of stable prices, maximum employment, and relatively long-term interest rates, as stated in the Federal Reserve Act. Each and every bank is subject to reserve requirements. However, these banks often fall under the conditions in running their daily businesses (Carpenter, Demiralp & Eisenschmidt, 2014). In order to meet these requirements, banks must borrow from the reserves of each other. This helps to create a market in the reserve funds, enabling banks to borrow and lend as required at the federal funds rate. The federal funds rate is hence useful since by decreasing or increasing it over time; the Federal Reserve can practically impact every other rate of interest charged by United States banks. Since the primary aim of monetary policy is to ensure a sustainable economic growth, stable prices and full employment, the Federal Reserve through monetary policy, strives to tweak the economy towards the right levels (Labonte, 2015). At every meeting, the FOMC studies a number of pointers to current and future economic developments. After these observations, cognizant that its activities affect economic activities considerably, it has to decide whether to change its target for the rate of federal funds. The FED has maintained a low level of the federal funds rate in the year 2015. The rate for 2015 is 0.12 percent while the rate for 2014 was 0.09 percent (Federalreserve.gov, 2015). This was a decrease from 0.14 % in 2012. However, the rate is expected to increase for the 2016 fiscal year, which is attributed to the expected reduction in the rate of unemployment. A drastic decline in the rate kindles economic growth, though an extremely high level of economic activity may cause inflation pressures to increase to a point that eventually destabilizes the sustainability of the economic expansion (Engen, Laubach & Reifschneider, 2015). A severe rise in the rate limits economic growth, thereby helping contain inflation pressures. This can in turn stimulate the sustainability of an economic expansion. However, a greater increase can extremely hinder economic growth (Engen, Laubach & Reifschneider, 2015). Therefore, the FOMCs decisions on the target rate of federal funds are carried out to attain the maximum rate of economic growth that is consistent with reasonable long- term interest rates and price stability. The roles of the Federal Reserve in supervising banks, conducting monetary policy, and offering payment services to various depository institutions is significant in ensuring that it keeps the solidity of the financial system (Carpenter, Demiralp & Eisenschmidt, 2014). With the help of the monetary policy tools, the Federal Reserve has promoted an atmosphere of price stability and rationally damped fluctuations in the whole economic activity that helps nurture the health and stability of markets and financial institutions. Also, the Federal Reserve has assisted in fostering economic stability by supervising and regulating numerous types of banking institutions to ensure they are safe and reliable. In addition, the Federal Reserve controls certain fundamental payment mechanisms and directs the operation of these payment systems to strengthen and stabilize the system (Labonte, 2015). All these activities, of the Federal Reserve, are made possible by the various actions the Federal Reserve has taken on the monetary policy implementation tools. In these cases, the Federal Reserve supports financial system stability by offering ample liquidity through vast open market acquisitions of securities and by spreading discount window loans to various depository institutions. Similarly, in unusual and pressing circumstances, the Federal Reserve has the power to lend funds to individuals, corporations, and partnerships. The Federal Reserve has an impact on the money stock mainly by its influence on interest rates (Engen, Laubach, &Reifschneider, 2014). When the Federal Open Market Committee reduces the target federal funds rate, the ratio at which depository organizations sell and purchase immediate funds to each other in the market as well as other short-term rates fall. Lesser short-term market interest rates upsurge the attraction of the rates paid on deposits at commercial banks as well as other depository organizations, since fluctuations in these rates are likely to delay changes in market rates (Engen, Laubach, &Reifschneider, 2014). As a result, the public is likely to buy the assets incorporated in the money stock, hence increasing the money growth. On the other hand, when the FOMC increases the target federal funds rate, the actual federal funds rate rises together with other short-term interest rates. By so doing, the rates paid on assets that were included in the money stock turn out to be less attractive, hence lowering the money growth. The Federal Reserve policy of sustaining low interest rates all through the early 2000s that led to cheaper mortgages has been mentioned by several economists as the most important aspect of the housing fizz, even though some economists dispute the notion (Labonte, 2015). Post-crisis, the Federal Reserve has experienced scrutiny due to its extraordinary large-scale involvement in the bond markets, counting three rounds of the famous quantitative easing, which helps in maintaining the recovery, but changed the federal recovery into a vehicle of investment that has an open-ended directive to create money. Though partisan congestion in Washington compelled the Federal Reserve to assume an important policy role in sustaining a delicate economic recovery, the Dodd-Frank Wall Street Reform of 2010, as well as the Consumer Protection Act, extended the responsibility of the central bank for assessing the health of the United States financial system (Labonte, 2015). By late 2014, the United States growth rates as well as the wanting unemployment impelled the Federal Reserve to indicate an end to its program of bond buying and a looming return to a relatively more standardized monetary policy. The contemporary scale by which majority of the economists analyze Federal Reserve policy is called Taylor rule (Franscisco, 2015). This rule states that interest rates ought to be raised when the rates of employment or inflation are high but lowered under the conflicting conditions. According to Taylor, the federal reserves’ loose financial policy of the early 2000s, possibly worsened housing price inflation, thereby stimulating the ensuing collapse of the sub-prime mortgage market. The regulatory purview of the Federal Reserve also progressively expanded when the United States banking dramatically changed when the merger of securities, banking institutions, and insurance, were legalized (Engen, Laubach, &Reifschneider, 2014). This legalization gave room for the amalgamation of investment and retail banking operations, which had been divided under the glass-seagall banking act. This law also gives the Federal Reserve authority the power to establish suitable financial activities in member banks and bank holding corporations. Figure 1: Graph of Federal Discount rates for the last 12 months (http://www.federalreserve.gov/releases/h15/data.htm) Figure 2: Graph of Federal funds rate for the last 12 months (http://newyorkfed.org/charts/ff/) References Bankrate.com,. (2015). Federal Discount Rate | Federal Reserve Rates. Retrieved from http://www.bankrate.com/rates/interest-rates/federal-discount-rate.aspx Carpenter, S., Demiralp, S., & Eisenschmidt, J. (2014). The effectiveness of non-standard monetary policy in addressing liquidity risk during the financial crisis: The experiences of the Federal Reserve and the European Central Bank.Journal of Economic Dynamics and Control, 43, 107-129. Retrieved from http://isiarticles.com/bundles/Article/pre/pdf/27638.pdf Engen, E., Laubach, T., & Reifschneider, D. (2014). The Macroeconomic Effects of the Federal Reserve’s Unconventional Monetary Policies. Retrieved from http://www.federalreserve.gov/econresdata/feds/2015/files/2015005pap.pdf Federalreserve.gov,. (2015). FRB: Monetary Policy Report. Retrieved from http://www.federalreserve.gov/monetarypolicy/files/20150224_mprfullreport.pdf Federalreserve.gov,. (2015). FRB: Reserve Requirements. Retrieved from http://www.federalreserve.gov/monetarypolicy/reservereq.htm Federalreserveeducation.org,. (2015). Monetary Policy Basics - Federal Reserve Education. Retrieved from https://www.federalreserveeducation.org/about-the-fed/structure-and-functions/monetary-policy Francisco, F. (2015). What is Taylor’s rule?. Federal Reserve Bank of San Francisco. Retrieved from http://www.frbsf.org/education/publications/doctor-econ/1998/march/taylor-rule-monetary-policy Labonte, M. (2014). Monetary Policy and the Federal Reserve: Current Policy and Conditions. Retrieved from https://www.fas.org/sgp/crs/misc/RL30354.pdf Mester, L. (2015). Recent Developments in U.S. Monetary Policy: From Extraordinary Back to Ordinary. clevelandfed. Retrieved 12 May 2015, from https://www.clevelandfed.org/Newsroom%20and%20Events/Speeches/03-23-2015%20Recent%20Developments%20in%20US%20Monetary%20Policy%20From%20Extraordinary%20Back%20to%20Ordinary Read More