(FED Board of San Francisco). The official goals of monetary policy are "to promote... maximum employment, stable prices to moderate long term interest rates." Under old statistical measurements, full employment was considered to be a maximum 4% unemployment. Due to changing economic conditions since the 1970's, the full employment rate is now a 6% (some say 6.5%) unemployment rate- hence so much concern by the FED when the rate dropped to 5.8%. An attempt to drop to the 4% rate will invariably lead to higher inflation and, most probably, a recession later and greater unemployment in the end. "Thus, it is important to avoid allowing short run, temporary success in preventing employment losses during recession from leading to longer run failures in maintaining low inflation."
Unfortunately, the FED must try to balance several issues at the same time- employment, interest rates, inflation, etc. and these conflicting goals leads to varying infighting if one areas is supposedly denied for the benefit of another. For example, political pressure on monetary policy is usually criticized for it s tendency to emphasize short run considerations over long run objectives. Though one may indicate otherwise due to past political pressure- probably most notably during Nixon's administration as far as I am concerned, the FED has remained independent from on st of these pressure. "Unless the central bank has sufficient independence from political institutions to resist such pressure, the result is likely to be higher average inflation with no appreciable effect on average inflation or real growth." "In sum, monetary policy is continually faced with a conflict in the short run and what it can permanently achieve in the long run. "
How does the FED achieve some of its primary goals? Through open market operations- the purchase and sales of government securities. "Open market operations influence the level of bank reserves in the economy, which in turn influences the level of interest rates, the provision of money and credit, investment spending, and the pace of economic activity."
Discount Rate: Banks are legally required to hold so much in reserves each night. They keep these reserves in the form of vault cash or deposits with the FED. When the banks need additional reserves in the short term, they can borrow directly from the Federal Reserve Bank of New York. They borrow at the discount rate which is directly set by the FED in response to economic conditions- raising rates to slow borrowing and lowering rates to stimulate the economy.
Federal Funds Rate: While banks can borrow directly from the FED as indicated above, the FED frowns on excessive use of going to the discount window. Therefore many banks, when they need reserves for a short time, can borrow from other member banks who happen to have excess reserves. They borrow at the Federal Funds Rate which is tied indirectly to the Discount and is usually a little higher.
Open Market Operations: If the FED buys government securities from the public, it pays for them by adding reserves to the banking system; this increases the supply of reserves, which lowers the cost of borrowing reserves- the federal funds rate falls. When the FED sells government securities, the reverse happens, the supply of reserve falls and the federal funds rate increases. It could also lower (or raise) the discount rate as well thereby reinforcing the direction of the economy it wishes to stimulate.
The relationships of all these elements are not able to be determined with
a specific degree of accuracy due to the many issues effecting the entire
economy. But the FED tries to analyze the best it can to provide an even
keel to growth.
MONETARY POLICY II: "Monetary policy works by affecting interest rates. Increases in interest rates raise the cost of borrowing and lead to reductions in business investment spending and household purchase of durable goods such as homes and autos. These declines in spending reduce the aggregate demand for the economy's output, leading firms to cut back on production and employment. On the other hand, interest rate declines stimulate aggregate spending and lead to increases in production and employment."
However much it would appear that this change by the FEDS could directly effect and impact the economy essentially the way they wanted, there are four factors that cause problems. First, spending decisions and economic activity depend on real interest rates- that is, market rates corrected for expected rates of inflation. Second, economic activity is likely to be related to both short term and long term interest rates, while the FED most directly controls short term market rates. Third, the FED is interested ultimately in measure of economic performance like inflation, real economic growth and employment. However, statistics on these variables may not be available for days, weeks or even months. Fine tuning without corroborating evidence is difficult, if not futile. Fourth, policy actions taken today will effect the economy only with a significant lag so that policy changes must be made in anticipation of future developments in the economy.
Real Interest Rates: Since it is difficult to measure expected inflation, it is hard to know the current level of real interest rates. And variations in expected inflation can make a big difference. In 1978, the federal funds rate was 7.93%, but inflation was 9.1%- that's a negative 1.17% return. The federal funds rate today is 5.25%. If the market expects a 3% inflation rate, then we have a positive 2.25% projected return. "Further, the FED can only influence the level of real interest rates in the short run. Persistent attempts to keep real rates too low will initially generate an economic expansion that will lead to more rapid inflation. As individuals come to expect higher inflation, real rates will tend to adjust back to the equilibrium level. Further expansionary policy would be needed to keep the real rate down, leading to further increases in inflation."
Long Term Interest Rates: Long term interest rates can be expressed as the sum of an expected real return and an adjustment for expected inflation. Long rates essentially tell us what the market's expectations might be about inflation. If rates rise, then inflation is seen as going up- and vice versa. But. like all economic predictions, its not a perfect indication since it also moves with the expected rate of return.
Intermediate guides: In order to guide the economy properly, you need lots of info on a continuing basis. Unfortunately the statistics are reported sporadically. According to the San Francisco report, the FED does not have a single reliable intermediate target that could be used to guide the economy. (An intermediate target is defined as a variable that, while not directly under the control of the FED, responds fairly quickly to policy actions, is observable frequently and bears a predicable relationship to the ultimate goals of policy.) So the FED uses many variables for indicators of the current and future economy. Such indicators that have been proposed are nominal income growth, real interest rates, commodity prices, exchange rates and the price of gold. But since no one indicator is, again, perfect, it uses them all- though in various percentages. Most recently, rules for monetary base (currency plus bank reserves), M2, nominal GDP and the funds rate have all been studied in an attempt to reduce uncertainty. How's it all worked? Well, while sustained growth did flow nicely for about 10 years, 1994 was most difficult and we still are in the unknowns.
The FED Board of St Louis, in a further statement, noted that the effort to equate changes in interest rates with changes in monetary policy have met with frustration since interest rates can be influenced by so many other factors such as credit demand, expected inflation and the pace of economic activity in other countries. A separate factor is the amount of reserves that a bank is required to have on deposit. The Federal Open Market committee has increased the degree of pressure on reserve position six times in 1994. This also does not necessarily correspond to the movement of interest rates.
But after all said and done, there is direct evidence (which almost all would agree to anyway) that both the increase in short term interest rates and the pressure on reserves indicated a considerable tightening of monetary policy.
DISCOUNT WINDOW: (Financial Update 1998) When a depository institution needs funds to meet liquidity needs, it can go to the FED's discount window and borrow at the prevailing discount rate. "The discount window facilitates the balance sheet adjustments of these institutions that face temporary unforeseen changes in their asset-liability structure. The window also complements open market operations in managing the reserves market day to day and implementing longer term monetary policy goals."
Adjustment credit helps institutions meet short term liquidity goals- for example, unexpectedly large withdrawals of deposits or operational problems
Seasonal credit helps smaller institutions manage liquidity needs that arise from regular, seasonal swings in loans and deposits.
The interest rate that commercial banks and institutions are charged is the discount rate. All discount window loans must have collateral and such includes Treasury and Federal agency securities, state and local government securities and business, consumer and other customer notes.
The discount rate- along with the Fed's open market operations and reserve requirements- is one of the methods the FED uses to set monetary policy. Though the discount lending only accounts for only a small amount of total reserves today, it still has an impact in the implementation of policy.
The discount window serves as a buffer in reserves market against unexpected day to day fluctuations in reserves demand and supply. The avialability of the helps relieve pressures in the reserve market and reduce the extent of unexpected movements in the federal funds rates which is the rate charged by an institution on an overnight sale of excess reserves to another depository."