Inside the Fed: Demystifying Monetary Policy
As our nation’s central bank, the Federal Reserve System develops and implements monetary policy. To get the job done, Congress gave the Fed a mission (the dual mandate) and limited oversight. Congress made a trade-off: It would let the Fed make monetary policy decisions without interference with the understanding that the Fed will act in the best interests of the American public.
In normal economic times, the Fed does not face much handwringing over its actions. When the economy is struggling, however, the Fed must sometimes take exceptional steps. During Paul Volcker’s tenure as Chairman in the 1980s, the Federal Funds interest rate rose to an all-time high of almost 20 percent to wring out inflation. During the Great Recession, then-Chairman Ben Bernanke cut interest rates to near zero, orchestrated massive lending programs to keep the financial system from collapsing, and added over $3.5 trillion to the Fed’s balance sheet through quantitative easing.1 These measures were so experimental, extraordinary, and enormous that some have called for more oversight, and even an audit, of the Fed.
This report explains two key aspects of how the Fed works: 1) the dual mandate and 2) the main tools it uses to achieve it.
Mission: The Dual Mandate
Congress gave the Fed its dual mandate of “maximum employment” and “stable prices” in the Federal Reserve Reform Act of 1977.2 When these two numbers are in equipoise, the economy should be in the optimal position to grow enough to create jobs and spur modest real wage increases, but not so much to create a boom-and-bust economic cycle. If the Fed achieves the right balance of employment and inflation, then moderate long-term interest rates should naturally follow—the third and final congressional goal.
Neither target is etched in stone; they can change depending on economic circumstances. Currently, the Fed estimates that the natural rate of unemployment should be 5 to 5.2 percent.3 A rate below the natural rate would be unsustainable and inflationary. A rate above that range shows slack in the labor market and room for the economy to grow faster. The inflation target is two percent.4 Modest inflation gives the Fed some flexibility to adjust monetary policy.
Congress voted to shield the Fed’s monetary policy from GAO oversight in the Federal Banking Agency Audit Act of 1978. In the bill, Congress agreed not to audit monetary policy matters, FOMC transactions, transactions with other central banks, and any related communications.5 Thus, the Fed has enjoyed an extraordinary degree of independence rarely granted by Congress which many (though not all) feel has been of great benefit to the U.S. and world economies.
In normal times, the Fed looks to reach the right balance of inflation and employment by setting a target for the Fed Funds rate—the interest rate at which banks loan excess Federal reserves to each other overnight. The Fed Funds rate influences—but does not set—all other borrowing rates, from mortgage rates to corporate bonds.
Since the recession, the Fed has sought to stimulate the economy by putting cash into the system to keep short- and long-term interest rates as low as possible. But if the Fed Funds rate is only for very short-term interbank loans, how does this affect long-term rates?
Imagine interest rates extending out as far as 30 years as a curved line that arches upward as you look into the future. This is called a yield curve. Lowering the Fed Funds rate at the beginning of that curve should—theoretically—lower interest rates all the way down the yield curve, although the effect diminishes as you go further into the future. Thus, lowering interest rates for an overnight bank loan by 25 basis points should have some small effect on lowering the rate for a 30-year government bond and other longer-term bonds.
In the last six years, however, the crisis has changed economic conditions so much that no textbook on the Fed is quite right anymore. For example, in the past, the Fed had reserves in the tens of billions of dollars; today reserves exceed $4 trillion. In addition, the Fed Funds rate has hovered near zero for so long that there is no more room for adjustment to meet the dual mandate. Because of this, the Fed has had to reach deeper into its toolbox to help the economy.
The Fed: The Federal Reserve System was established by Congress in 1913 in response to recurring banking panics. It is independent from the executive branch.
FOMC: The Federal Open Market Committee is the Fed’s monetary policymaking body. It meets eight times a year to review economic developments and vote on a target for the Federal Funds interest rate. All of the Fed’s Governors have a vote on the FOMC, plus five of the 12 regional bank Presidents, who vote on a rotating basis.
Fed Chairman (or Fed Chair): The Chairman heads both the Fed’s Board of Governors and the FOMC. Janet Yellen, who in 2014 became the first woman to hold this position, uses the title Chair. The Chairman or Chair is nominated by the President and confirmed by the Senate. He or she is required to present a monetary policy report to Congress twice a year.
Federal Reserve Board of Governors: The Governors, based in D.C., serve as the Fed’s executive council. They also go through the Presidential nomination and Senate confirmation process. There are seven seats on the Federal Reserve Board, but only five are currently filled.
Federal Reserve Bank Presidents: The Presidents of the Federal Reserve Banks are like the Fed’s cabinet of advisors. Unlike the Governors, they are selected by regional boards. Because the Federal Reserve Bank of New York plays the biggest role in executing monetary policy, its President always gets a vote on the FOMC and traditionally serves as the committee’s vice chair—leading to some efforts in Congress to reduce the New York Fed’s influence.
Federal Reserve Banks: There are 12 branches of the Federal Reserve System, located around the country. The regional Reserve Banks hold reserves, offer lending services, conduct bank exams, and perform local economic research. Because the locations were selected when the Fed was created 100 years ago, some have called for a revamp.
The Fed’s Major Tools to Help the Economy
Once the FOMC has formulated interest rate policy, the Fed must execute it. In response to recent economic conditions, the Fed has mainly used four specific tools: 1) open market operations, a tool it uses every day; 2) quantitative easing, an expanded form of open market operations; 3) forward guidance, a standby that has become even more important in a low-interest rate world, and 4) the discount window, to support banks during the financial crisis.
1. Open market operations
Affecting interest rates is one of the key ways the Fed drives monetary policy and guides the economy. The main way the Fed does this is by setting a target for the Fed Funds rate. As noted above, the Fed Funds rate is the interest rate at which banks loan excess federal reserves to each other.The Fed manages this rate through open market operations. Here’s how it works:
Every weekday, the Federal Reserve Bank of New York holds an auction to buy, sell, loan, or borrow government bonds from or to certain large, private banks designated as primary dealers. This daily auction ranges from tens of billions to a few hundred billions worth of government bonds, depending on the Fed’s target level of reserves for that day.6 In the auction, bidders state the amount of bonds they can sell to or buy from the Fed and the interest rate they are willing to accept. At the end of the auction, all of the winning bids go through at the same rate. These open market operations help the Fed maintain the target Fed Funds rate.
How does this impact the economy? Putting more money into the market lowers interest rates, loosens the money supply, and heats up the economy. Thus, when the Fed purchases government bonds from primary dealers in exchange for cash, money enters the system. Likewise, pulling money out of the market raises interest rates, tightens the money supply, and cools the economy. When the Fed sells bonds to primary dealers in exchange for cash from banks, money leaves the system.
2. Quantitative easing
The normal Fed measures to stimulate the economy had only a limited effect, so more extraordinary actions were called upon. One such action was quantitative easing. Quantitative easing is simply a form of open market operations on a larger scale (see our report “Last Call: The End of Quantitative Easing”). The goal of QE was to drive down long-term interest rates further than what traditional open market operations could do to stimulate the economy. Once interest rates hit zero, there was nothing left to “pull” on the short end of the yield curve to bring down interest rates on the long end. To get longer-term rates down, the FOMC directed the New York Fed to purchase outright large quantities of long-term bonds.
Between December 2008 and October 2014, the Fed purchased about $2 trillion in mortgage-backed securities and about $1.7 trillion in Treasury bonds owned by its banking partners.7 Since the Fed already has autonomy over open market operations, it did not need congressional approval to launch QE, even though its sheer size was both controversial and unprecedented.
Supporters of the Fed point to QE as proof that only a truly independent body could have taken such quick and dramatic steps to jumpstart the economic recovery. Opponents see this same action as grossly expanding the central bank’s balance sheet and risking uncontrolled inflation down the road (though no evidence of inflation has yet materialized). The Fed’s bold actions put the U.S. economy on a better path—so much so that the European Central Bank finally instituted QE this year to deal with negative inflation and poor growth in Europe.
3. Forward guidance
Longer-term interest rates are affected not just by what the Fed does today but by what investors expect the Fed to do tomorrow. Therefore, the Fed communicates its plans through forward guidance. Forward guidance has been used to guide markets for a long time. For example, in 2003, when the Fed lowered rates to one percent to stimulate the economy, the FOMC issued forward guidance to ensure the markets that rates would stay low “for a considerable period.”8 During the recent financial crisis, guidance became even more important. Rattled markets needed clarity and certainty about how long near-zero interest rates would last to feel comfortable making longer-term loans, like mortgages, at very low rates. From 2009 to 2011, Chairman Bernanke used the term “extended period” to describe Fed intentions of keeping interest rates near zero.
Recently, the FOMC has used a threshold-based form of forward guidance, announcing the specific employment and inflation targets that will signal to the FOMC that it is appropriate to consider changing interest rate policy. As we have reached the latter stages of recovery and the economic crisis has abated, Chair Yellen has issued forward guidance that more resembles guidance during normal times—that is, economic conditions will ultimately determine when interest rates “lift off.”
4. The discount window
One of the Fed’s statutory roles is to serve as the lender of last resort. This is an authority Congress gave to the Fed to stabilize financial institutions and protect the economy. To maintain financial stability, the Fed offers credit to banks when no one else will lend to them. Banks can access short-term loans, usually overnight, through a program at their regional Federal Reserve Banks called the discount window. These loans are not without cost. Banks must repay the loans at a penalty rate and put up collateral. Further, there is a stigma attached when banks need to borrow from the discount window, so they do not want to do it unless they absolutely have to. When that happens, they want to protect their identities to prevent a run.
The interest rate on discount window loans is called the discount rate. The discount rate is a little higher than the rate banks offer each other in the Fed Funds market, so banks have to pay a premium when they must borrow from the government instead of the private sector.
During the financial crisis, the discount window was not sufficient to support the extraordinary strain on the banking system. The Fed created a series of emergency lending programs to manage a cascade of urgent liquidity meltdowns. All told, the Fed lent an aggregated, non-term adjusted total of $16 trillion through seven lending programs called facilities, with $1 trillion in loans outstanding at the peak in 2008. All have been repaid, or are scheduled to be repaid, with interest.9 The Fed launched these programs under the “unusual and exigent circumstances” clause, so it did not need to seek congressional approval.
“Unusual and Exigent Circumstances” and Dodd-Frank
Section 13(3) of the Federal Reserve Act allows for the Fed to go into MacGyver-mode during “unusual and exigent circumstances.”10 Under this provision, Congress essentially said: “When everyone runs for cover, do whatever is necessary to save the economy.” The Fed used this power on a grand scale during the crisis. Some felt the Fed went too far, leading Congress to include some Fed reforms in the Dodd-Frank Act.
First, Dodd-Frank required an immediate GAO audit of the Fed’s emergency lending programs, plus an audit of the Fed’s governance system. It amended the Federal Reserve Act to require a higher burden for establishing emergency lending programs in the future, and the GAO now has authority to audit these in the future. Loans cannot be designed to benefit one single and specific company, like the “Maiden Lane” programs created to prop up AIG, and the identity of banks that borrow from the discount window must be revealed after a two-year lag. As former Chairman Bernanke recently explained, the Fed accepted these changes because the creation of Orderly Liquidation Authority relieved the Fed of being in the unpleasant position of deciding what to do for banks on their last gasp.11
Although Dodd-Frank created some new restrictions on the Fed, it stopped short of prescriptively telling the Fed what it can and cannot do. Time will tell whether these reforms protect against taxpayer-funded bailouts (as hoped) or tie the Fed’s hands in the next crisis (as feared).
The rationale for limited oversight is that it allows the Fed to respond to market developments in real time without the threat of congressional, executive branch, or electoral pressure. To many, this independence is an indispensable ingredient in America’s economic success, protecting the economy from manipulation for political gain. To others, its opacity puts U.S. economic progress at the whims of a handful of unelected, unaccountable shamans.
Some in Congress want to overhaul how the Fed operates, but even some of the Fed’s harshest critics have admitted they do not want to take on the job of making monetary policy. As policymakers look into potential changes at the Fed, they should take special care to ensure that any further reforms do not inhibit the Fed’s ability to manage monetary policy, whether on a day-to-day basis or in another emergency.