I. The Federal Reserve  ("The Fed")

• Background
• central bank, created in 1913 in response to 1907 panic
• originally a lender of last resort to prevent bank panics
• today also decides monetary policy
• Fed Structure
• Board of Governors
• 7 members, including Chair (4 yrs.), 14 yr nonrenewable terms
• Alan Greenspan chair since 1987
• Regional Banks
• 12 regions
• FRBNY is most important regional bank
•  FOMC--Federal Open Market Committee
• Board of Governors
• President, FRBNY
• 4 other Presidents of regional banks, rotating
• meet every 6 weeks to vote on target for the federal funds rate
• FRBNY implements FOMC decisions
• by buying and selling Treasury securities in the open market
• Fed independence
• Fed is self-financing through open market operations and bank services
• Long terms of Governors also insulate the Fed from political pressure
• Independence allows Fed to focus on long-term economic goals instead of short-term political goals
• For example, high interest rates (to slow down economy, fight inflation) may be unpopular in the short run, even though price stability is in the long-run best interest of the economy.  This would be especially true in an election year
• The Fed is not completely independent: Fed powers can be limited by Congress through new law

•  Reserve Requirement
• % of deposits banks must hold as cash or on deposit with Fed
• changing requirement affects the money supply BUT
• the RR is expensive to change, and has a powerful effect, so it is rarely changed.
• Discount Loans
• Loans from the Fed to banks
• Fed can change rate or availability to affect the money supply BUT
• most banks do not take out discount loans so this tool is not very effective
• Open market operations
• main tool used for monetary policy
• Fed buys/sells Treasury securities in the bond market
• 1998, 12% of debt outstanding ($465 billion), $35 billion profit
• FOMC votes on a federal funds rate target
• FRBNY sell/buys Treasuries to shift the supply curve for reserves and meet the FF rate target
• If the Fed BUYS treasuries
• immediate decrease in FF rate, increase bank reserves
• other short-term rates decrease (weeks)
• MS increases (months)
• economic expansion (GDP growth, lower unemployment)
• can take at least 6 mos., more likely a year
• potentially may cause inflation
• If the Fed SELLS treasuries
• variables move in opposite direction
• economy slows, inflation decreases or is kept from increasing
• Open Market Repos
• for temporary changes in reserves
• Repurchase Agreement (Repo)
• Fed buys treasuries and seller agrees to buy them back at a later date at a slightly higher price
• seller gets a short-term loan from Fed
• temporary increase in reserves
• counteract other factors affecting reserves
• holidays, Y2K, crash of 1987
• Reverse Repo
• Fed sells treasuries and then buys them back
• temporary decrease in reserves
• glut of reserves due to tax refunds or SS checks

Monetary policy = using changes in the money supply and interest rates to achieve economic goals

I. Goals of Monetary Policy

• Price stability or low inflation
• primary goal of the Fed since the 1980s
• goal: below 3%
• CPI inflation below 4% annually since 1991
• 2003:  1.87%
• inflation is caused by excessive money supply growth
• Low unemployment
• what is low?  natural rate of unemployment (4-5%?)
• December 1999 4.1%; December 2003 5.7%
• Fed influences employment indirectly and slowly; unemployment is a lagging indicator, meaning that unemployment does not improve until well into an economic recovery
• Economic growth
• % increase in real GDP
• Fed wants "sustainable growth"
• highest growth without triggering inflationary pressures--about 3% on average
• 4th quarter 2003:  4% annual rate
• Financial market stability
• interest rates, exchange rates, asset prices, derivatives markets
• calm investors after crashes
• intervene if $ is "too low" or "too high" relative to other currencies
• Fed does not regularly intervene in financial markets

II. Recent Monetary Policy (1990s)

• Fed has effectively targeted the FF rate since 1983; current target is 1% (since June 2003)
• Fed criticized for being slow to recognize 1990 recession, dramatically cuts rate to stimulate economy in 1991,
• 90-92, the FF rate falls from 8% to 3%
• but recovery is slow:  mild recessions often mean a mild recovery

• Since 1995, FOMC announces new FF rate target right after their meeting.
• In an effort to prevent inflation, Fed raises FF rate target 8 times in 1994-95 (from 3% to 6.0%)
• surprising financial markets (derivatives losses)
• "soft-landing" --slowing down economy without a recession
• 1994 currency intervention in increase value of $ against the yen
• Decreases in FF rate target in 1998 with Russian debt/Asian currency crisis and collapse of Long Term Capital Management
• goals of both economic growth and financial stability
• Increases in target in 1999 as Fed attempts another "soft-landing"
• reversed at the end of 2000 as economy slowed down; FF rate target has fallen from 6.5% to 1% from 2000-2003
• 1990s:  longest economic expansion in U.S. history  (March 1991 - March 2001, 120 months)
• Recession of 2001 (March-Nov.)
• slow recovery, especially in the job market
• FOMC has indicated that they will keep FF rate low for now
• not worried about inflation right now