J. K. Dietrich - FBE 524 - Fall, 2005
Monetary Policy:Deliberation and Implementation
Week 12 – November 9, 2005
J. K. Dietrich - FBE 524 - Fall, 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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
Monetary Policy Deliberation Implementation Prediction Evaluation Criticism
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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?
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
Source: Federal Reserve Bank of St. Louis FRED II
J. K. Dietrich - FBE 524 - Fall, 2005
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)
J. K. Dietrich - FBE 524 - Fall, 2005
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)
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
Fed Balance Sheet: Oct.28, 2004
U.S. Government Securities $706.7 Federal Reserve Notes $707.2Gold stock $11.0 Deposits
Depository institutions $24.9 U.S. Treasury $4.6
Total Assets $792.7 Total Liabilities 771.9$ Equity $20.8
Assets Liabilities
(U.S. Securities up 7.4%, FR Notes up 5.6%, reserves down 6.4%)
J. K. Dietrich - FBE 524 - Fall, 2005
Fed Balance Sheet: Oct.26, 2005U.S. Government Securities $739.5 Federal Reserve Notes $767.9Gold stock $11.0 Deposits
Depository institutions $21.5 U.S. Treasury $4.7
Total Assets $821.6 Total Liabilities 794.1$ Equity $27.5
(U.S. Securities up 4.6%, FR Notes up 8.6%, reserves down 13.6%)
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
Source: Federal Reserve Bank of St. Louis FRED II
J. K. Dietrich - FBE 524 - Fall, 2005
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
Source: Federal Reserve Bank of St. Louis FRED II
J. K. Dietrich - FBE 524 - Fall, 2005
“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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
Source: Federal Reserve Bank of St. Louis FRED II
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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?
J. K. Dietrich - FBE 524 - Fall, 2005
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
J. K. Dietrich - FBE 524 - Fall, 2005
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