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Central Banks and Monetary Policy: The Federal Reserve

In our previous post, we discussed the importance of interest rates in finance. We also introduced central banks by discussing the role it plays in influencing interest rates. We will go deeper into the function of central banks in this article, discussing their mandates and how they carry out their mandates.

Central banks are like normal banks in that they lend money (as the lender of last resort [1]). However, rather than making money for their shareholders, central banks have mandates given to them by the governments of their countries. Although they may differ country to country, the mandates are usually a combination of:

  • Maintaining the target inflation rate
  • Maintaining the target employment rate
  • Maintaining a stable financial system
  • Managing the foreign exchange
  • Acting as the lender of last resort

To fulfill these mandates, central banks have a variety of tools they can use — they are collectively known as monetary policy instruments. These instruments also differ from country to country, but they all act to influence monetary supply and interest rates. These instruments include:

  • Federal Fund Rates
  • Open Market Operations (OMOs)
  • Quantitative Easing (QE)
  • Capital Requirements
  • Reserve Ratio Requirements
  • Forward Guidance

They typically complement fiscal policies (tax policies, spending policies) that the governments use to influence the country’s economy (increase productivity, reduce unemployment, stop deflation etc.). One example of how fiscal and monetary policies work together is the three arrows of Abenomics  a combination of monetary easing, fiscal stimulus and structural reforms was used to tackle persistent deflation in Japan.

Most countries have their own central bank. The notable banks are as follows:

  • Federal Reserve System (The Fed) – United States
  • European Central Bank (ECB) – European Union
  • People’s Bank of China (PBoC) – China
  • Bank of England (BoE) – England
  • Bank of Japan (BoJ) – Japan
  • Bank of Canada (BoC) – Canada

Federal Reserve System

Structure and Mandates

The most important central bank is the Fed, it oversees the world’s largest economy: the United States. The Fed works under its “triple mandate” of maximizing employment, stabilizing prices, and maintain moderate long-term interest rates. To carry out its mandate, it uses monetary policy instruments — namely the discount rate, reserve requirements, and open market operations (OMOs). The Board of Governors is responsible for discount rate and reserve requirements, and the Federal Open Market Committee (FOMC) is responsible for OMOs.

The Chair of the Fed (Chair of the Board of Governors) holds the most important position in the central bank. The chair is usually more influential both inside the FOMC meetings and outside to investors and bankers, even though it does not have any more power on paper. The Chair, along with the Board of Governors are appointed by the POTUS. Past and current Fed Chairs were:

  • Jerome Powell: Considered Neutral-Dovish, current Fed Chair
  • Janet Yellen: Considered Dovish, presided over the Fed taper
  • Ben Bernanke: Considered Dovish, presided over the financial crisis
  • Alan Greenspan: Considered Hawkish, presided over the dotcom bubble

You can try Chairing the Fed yourself, thanks to this game from the Federal Reserve Bank of San Francisco.

The Federal Open Market Committee

The Federal Open Market Committee is one of the most influential forces in the markets. It consists of 12 people, 7 from the Board of Governors (including Fed Chair) and 5 from the Reserve Bank presidents. They meet 8 times a year to assess US economic and financial conditions, and make decisions on monetary policy. The transcript of every meeting is scrutinized by asset managers for hints on where interest rates or asset purchases may trend. One different word might be interpreted as guidance on an earlier than expected rate hike, leading to a sell-off in the stock market. The effects of the communication from the Fed are so pronounced that they themselves are a monetary policy instrument, known as forward guidance.

Monetary Policy

Monetary policies are tools that the central bank uses to influence the economy, in order to fulfill its mandates. If the economic indicators are weak (unemployment high, inflation low or negative), the central bank would aim to stimulate aggregate demand through an easing (or loosening) of monetary policy. Conversely, if the economy is overheating, the central bank would aim to slow down growth through a tightening of monetary policy.

Monetary policies typically affect short-term interest rates, which is linked to long-term rates. Long-term rates then go on to influence corporate decision making through cost of capital (projects may become viable with a lower cost of debt), therefore influencing unemployment rate, wage growth and the economy. Long-term interest rate changes also affect stock prices through the same mechanism  lower rates decreases r in a Discounted Cash Flow. Conceptually, if the payouts from a less risky asset (long-term debt) decrease, the risky asset (stocks) becomes relatively more attractive. The opportunity cost of holding stocks decreases, as you would be paid less if you had sold your stocks for bonds. By influencing stock prices, personal wealth is also affected, which in turn could have an impact on spending patterns (may sell those stocks to buy a house).

Reserve Requirements

Reserve requirements are a percentage of deposits that a commercial bank must hold as reserves. The percentage depends on the size of the institution — specifically the dollar value of the deposits in the institution. By changing the reserve requirements (occurs infrequently), the Board of Governors can affect the ability of banks to lend out money (increasing the reserve requirements means banks have less money to loan out). By reducing the supply of money (lenders) and keeping demand of money constant (borrowers), interest rates typically increase.

  • Easing Monetary Policy: Decreasing Reserve Requirements
  • Tightening Monetary Policy: Increasing Reserve Requirements
Federal Funds Rate

If commercial banks do not meet these reserve requirements, they can borrow money from those banks who exceeded the requirements. The average rate at which they borrow the money at is known as the effective federal funds rate.

Typically, the relationship between the federal funds rate and economic growth is inverse. To try to improve growth or reduce unemployment, the Fed would lower the target rate. To slow down growth in an overheated economy (tech bubble for example), the Fed would increase the target rate.

The Fed sets a target for that federal funds rate, and may use OMOs or other instruments to make sure the effective rate stays on target. Any changes in the federal funds rate will affect short-term interest rates, and to a lesser degree long-term interest rates.

  • Easing Monetary Policy: Decreasing Target Federal Funds Rate
  • Tightening Monetary Policy: Increasing Target Federal Funds Rate
Open Market Operations

Open Market Operations involve the purchase (or sale) of securities from the open market. Essentially, buying securities expands monetary base and depresses interest rates in order to stimulate the economy (selling securities induces the opposite effect). Traditionally, OMOs were used to keep effective federal funds rate on target. Since the financial crisis, OMOs have been extended to the large scale purchases of longer-term securities on the open market. This variant is also known as Quantitative Easing

  • Easing Monetary Policy: Purchasing Securities from the Open Market
  • Tightening Monetary Policy: Selling Securities to the Open Market
Quantitative Easing

After the 2008 financial crisis, the Fed exhausted its main monetary policy tool the federal funds rate was lowered to near zero. In late 2008, the Fed began a large scale purchase of longer-term securities in order to directly influence the long-term interest rates. By increasing demand for these securities, prices go up and rates go down. This led to multiple round of QE by both the Fed and the ECB, purchasing billions of dollars of debt, MBSs (Mortgage Backed Securities), and long-term treasuries.

  • Easing Monetary Policy: Starting QE
  • Tightening Monetary Policy: Tapering QE
Forward Guidance

Forward Guidance is another non-traditional monetary policy that emerged from the financial crisis, it was also necessitated by the exhaustion of traditional monetary policy. To exert further influence on the long-term interest rates, the Fed communicated their intention to keep the interest rate low for the foreseeable future. Specifically, the language the Fed used was that they will keep the federal funds rate “exceptionally low” for “an extended period”. It was effective, every word from the Fed became data on future interest rates and moved both the yield curve and the stock market.

[1] The Lender of Last Resort provides liquidity to financial institutions during liquidity shocks. In plain terms, they lend money to banks when inter-bank lending stops, to prevent the propagation of bankruptcies that follows a financial panic.

Finance 101Value Capture Model · Understanding Porter’s Five Forces · Modern Portfolio Theory and the Capital Allocation Line · M&A Deal Case Study · Introduction to Enterprise Value and Valuation · Option Contracts and Put Call Parity · Fama French and Multi Factor Models · Understanding the Yield Curve · Bond Valuation and Arbitrage · CAPM – Capital Asset Pricing Model · Inflation and Interest · Annuities and Perpetuities · Net Present Value ·
Accounting 101Accounting Estimates: Managing Earnings · Accounting Estimates: Recognizing Assets · Accounting Estimates: Recognizing Expenses · Accounting Estimates: Recognizing Revenue · Analyzing Financial Statements and Ratios · Understanding the Three Financial Statements ·
Economics 101Understanding Market Structure — Perfect Competition, Monopoly and Monopolistic Competition · Marginal Costs and Marginal Revenue · Central Banks and Monetary Policy: The Federal Reserve · Understanding Supply and Demand ·
Statistics 101Statistical Inference and Hypothesis Testing · Multivariate Regression and Interpreting Regression Results · Correlation, Covariance and Linear Regression ·

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