The Federal Reserve System Origins & structure of the Fed. ECO 473 – Money & Banking – Dr. D. Foster

The Federal Reserve Banking System Purpose: Develop, supervise & control the nation’s money. Serve as a national check-clearing system. Serve as depository for federal gov’t. funds. Board of Governors of the FRS 7 members, equal standing . . . but, includes Secretary of the Treasury and Comptroller of the Currency. Problems: Only using discount window, Each District Bank sets its own policy.

The Federal Reserve Banking System

The Early Fed, 1913–1935 Accommodates the Treasury Dept. during WWI. Buys Treasury bonds to finance G spending (aka “monetizing the debt”). From 1916 to 1918, this increases MS by 70%. Huge risk of inflation. The Great Depression - Failure of the Fed Initially increased liquidity, but pulled back. By 1933, 33% of banks fail, MS fallen 33%.

The Fed - version 2.0, 1935 Serves as a “lender of last resort.” Board of Governors reconstituted: All 7 member selected by President/Senate confirms. Can’t include Treasury Sec. nor Comptroller of Currency. Members serve 14 yr. terms on staggered basis. Geographic diversity. Office of Chairman and Vice Chairman created. Has authority over district banks. Federal Open Market Committee (FOMC) 12 members; primary policy-making body.

The Evolution of the Modern Fed WWII - working “for” the U.S. Treasury Federal Reserve–Treasury Accord (1951) “Leaning Against The Wind” Martin (1953-1970) The technocratic Fed Burns (1970-1978) . . . the “political business cycle” Coping with inflation Volcker (1979-1987) Keeping the economy stable? Greenspan (1987-2006) Coping with recession Bernanke (2006-2014) Yellen (2014-?)

The Fed’s Balance Sheet – 12/2007 In millions of dollars.

The Fed – 2014 Treasury Securities ……… $2.6 trillion Holdings of MBS …………. $1.8 trillion Total Assets ………………… $4.5 trillion

The Fed – Q2 2017 Treasury Securities ……… $2.56 trillion Holdings of MBS ……… $1.8 trillion Total Assets ….… $4.47 trillion

FRS – Total Assets; 2007-2017 Sept. 2017: $4.46 t. $2.46 t. $1.77 t.

The Fed – 2014 FR Notes outstanding ….. $1.3 trillion Bank reserve deposits …. $2.4 trillion Total Liabilities ……….…… $4.5 trillion

The Fed – Q2 2017 FR Notes outstanding ….. $1.49 trillion Bank deposits …. $2.15 trillion Total Liabilities ……… $4.47 trillion

FRS – Total Liabilities; 2007-2017 Sept. 2017: $4.46 t. $2.31 t. $1.58 t. $0.41 t.

The Federal Reserve System Origins, structure, policies. ECO 473 – Money & Banking – Dr. D. Foster

Goals of Monetary Policy Inflation goals: Low/no inflation with limited year-to-year variability. Output goals: High and stable economic (GDP) growth. Employment goals: Stable employment growth with low unemployment.

Federal Reserve Policy Tools Open Market Operations Buy/sell Treasury bonds to affect bank reserves. The major form of monetary policy. Since 2009, also buying MBS! Discount Window Lend to member banks to affect bank reserves. Purpose is to target the “federal funds rate” – iff This is the rate that banks charge each other for very short term loans. Required Reserve Ratio (rrD) Changing this affects bank excess reserves directly. Was used in 1937 and precipitates more Great Depression. New policy? – Pay banks interest on their Excess Reserves!

Monetary Policy: Goals & Targets Open Market Operations Discount Window Required Reserve Ratio (rrD) Price stability Low unemployment Sustainable growth Interest Rates Monetary Aggregates

Choosing an Intermediate Target Variable Characteristics: Frequently observable Consistency with ultimate goals Definable and measurable Controllable Potential variables: Monetary aggregates M1, M2, MZM Interest rates (fed’l funds, prime …) Others: Nominal GDP Credit aggregates Exchange rates

Making Monetary Policy Transparent FOMC Press Release May 2, 2018 Q&A June 22, 2016 Con. Test. Feb. 27, 2018

Targeting the Federal Funds Rate of Interest Jan. 2018 1.41%

Is Policy the Right Choice? Time lags make effective policy uncertain. Recognition/Response/Transmission lags Discretionary policy promotes uncertainty. It may promote more volatility! Can Rules and credible eliminate bias? Milton Friedman promoted this.

Time Lags in Monetary (& Fiscal) Policy Policy time lags Recognition lag Response lag Transmission lag Real GDP Business cycle time

Monetary Policy may be counterproductive % Real GDP time Ideally, policy would dampen the business cycle… But, dampening the business cycle may lower ave. growth! Or, if policy kicks in at the wrong time, it could worsen recessions and exacerbate inflationary periods.

Discretion versus Rules (Milton Friedman) Discretionary policy is the source of instability. A policy rule can eliminate that instability. Set target for Bank Reserves, Monetary Base, Money Supply to grow in LR sustainable fashion. This is a commitment to a fixed strategy no matter what happens to other economic variables. To be successful, the commitment must be credible. The public believes the Fed will act this way.

Making Monetary Policy Rules Credible Place constitutional limits on monetary policy. Achieve credibility by establishing a reputation. Maintain central bank independence. Establish central banker contracts. Appoint a “conservative” central banker.

Has the Fed maintained stable prices?

Has the Fed maintained the value of the $? 4%

Quantitative Easing = Credible? QE 1 QE 2 QE 3

Can the Fed undo the QEs? Inflation is a monetary phenomenon. Austrians: the only meaningful definition of inflation is w.r.t. the money supply. What happens if the economy starts growing? Banks will want to lend more, raising the MS and causing inflation. The Fed could try to stop it by raising interest on ER … to 3%? 5%? 10%? Inflationary expectations grow and become rooted in our economy, ala 1979. Fed starts to pull back by selling UST and MBS. Their prices plummet; so Fed can’t buy back all the excess reserves! Interest rates will soar; investment will falter; a recession ensues. But, a recession accompanied by serious inflation, aka “stagflation.” Is it an “insurance policy” against massive sell-off?

The Federal Reserve System Origins & structure of the Fed. ECO 473 – Money & Banking – Dr. D. Foster