6. Federal Reserve Monetary Policy
The Federal Reserve has an information advantage by mastering a large amount of economic data, and is able to make predictions about the future economy and formulate monetary policies. Monetary policy affects market liquidity, thereby affecting consumption, investment demand and economic development. The market predicts the policy direction of the Federal Reserve based on economic data and adjusts asset allocation accordingly. Therefore, the Federal Reserve's monetary policy has a profound impact on the economy and financial markets, and it is crucial to understand its framework and mechanism.
6.1 Federal Reserve Monetary Policy Making
The Federal Reserve is composed of several components responsible for the formulation and implementation of its monetary policy, the most important of which is the Federal Open Market Committee (FOMC). The FOMC is the main monetary policy-making body of the Federal Reserve and is responsible for setting monetary policy goals and implementing policy adjustments. The composition of the FOMC includes
7 members of the Federal Reserve Board of Governors: These include the Fed Chairman and Vice Chairman.
Five of the 12 regional Federal Reserve presidents: the President of the New York Federal Reserve is a permanent member, while the presidents of other regional Federal Reserve banks serve on a rotation basis.
Decisions on the Federal Reserve's monetary policy are usually made at FOMC meetings. The following are meetings that require special attention in the study of the Federal Reserve's monetary policy:
FOMC meetings: 8 times a year, held every 6 to 8 weeks. After each meeting, the Fed releases a policy statement, and at the March, June, September and December meetings each year, it publishes a dot plot of forecasts for economic growth, inflation, unemployment and the federal funds target rate.
Jackson Hole Economic Policy Symposium: A global central bank meeting held in August each year, where the Federal Reserve Chairman usually delivers an important speech to convey future policy direction.
Federal Reserve Minutes: Minutes are typically released three weeks after a meeting and provide more details about policy discussions, helping the market gain a deeper understanding of the views of members within the FOMC.
6.2 Objectives of Monetary Policy
The Federal Reserve has two main monetary policy goals:
Maintain price stability: Maintain inflation (PCE) at 2%. Price stability improves consumer purchasing power and enhances economic predictability.
Promote maximum employment: The Federal Reserve hopes to stimulate economic activity through policies to create more jobs. Full employment not only improves individual living standards, but also promotes overall economic growth.
6.3 Monetary Policy Tools and Transmission Paths
6.3.1 Traditional tools
The four traditional monetary policy tools are the same all over the world, namely open market operations, the reserve system, the discount system and interest rate adjustments.
1. Open market operations (managed by the New York Fed)
Open market operations are one of the core tools of the Federal Reserve to regulate market liquidity. They affect the federal funds rate by adjusting the reserve level of financial institutions. There are mainly the following forms
a. Repo and reverse repo operations
Repo: The Federal Reserve releases liquidity to the market by purchasing securities.
Reverse repurchase (RRP): The Fed recovers liquidity by selling securities. The Fed's reverse repurchase is to withdraw funds, while the positive repurchase is to release funds. It is mainly used to maintain short-term market liquidity stability and control interest rates.
b. Buying and selling securities
The Fed regulates the reserve level of the financial system and thus affects the federal funds rate by buying and selling securities in the secondary market with primary dealers (24 qualified broker-dealers). The securities that the Fed can buy or sell mainly include U.S. Treasury bonds, municipal bonds, and some bonds guaranteed by the U.S. government.
c. Regulation of SOFR (Secured Overnight Financing Rate)
In recent years, the Federal Reserve has promoted SOFR to replace LIBOR as the benchmark interest rate for measuring the financing costs of the U.S. repo market. Through open market operations, especially operations in the repo market, the Federal Reserve keeps short-term market interest rates stable.
2. Reserve System (under the responsibility of the Federal Reserve Board)
IORR: The amount of reserves that the Fed requires banks to keep at the central bank. By adjusting this ratio, the Fed can directly influence banks’ lending capacity and liquidity in the market.
The interest rate on excess reserves (IOER): The Fed began paying interest on excess reserves in 2008, and IOER has become an important tool for regulating the upper limit of the federal funds rate. By raising or lowering IOER, the Fed can adjust the incentives of banks to retain liquidity or lend.
Starting from July 29, 2021, the “Interest Rate on Reserve Requirement (IORR)” and “Interest Rate on Excess Reserve Requirement (IOER)” will no longer be distinguished, but the “Interest Rate on Reserve Balance (IORB)” will be used uniformly.
3. Discount system (managed by the 12 Federal Reserve Banks)
The discount system is an important tool for the Federal Reserve to provide short-term liquidity support. Banks can borrow from the Federal Reserve's discount window. The discount window is divided into the following three categories according to the credit status of different banks:
Primary Credit Discount Window: Provides preferential lending conditions to financial institutions with good credit standing.
Secondary Credit Discount Window: Provides higher lending rates to financial institutions with weaker credit standing and experiencing liquidity difficulties.
Seasonal Credit Discount Window: Targeted at small and medium-sized financial institutions that are affected by seasonal fluctuations in funding demand.
The discount window offers an interest rate that is typically higher than the federal funds rate and serves as a source of emergency financing.
4. Interest rate policy (responsible for by the Federal Reserve Board)
The federal funds rate is the core target rate for the Federal Reserve to regulate market liquidity. By adjusting this rate, the Federal Reserve influences the overall interest rate level of the financial system.
The Federal Reserve affects overnight borrowing costs in the market by adjusting the target interest rate range (currently the upper limit of the interest rate channel is the deposit reserve balance interest rate IORB, and the lower limit is the reverse repurchase operation interest rate ON RRP, usually at an interval of 25bp). This interest rate has a direct impact on the cost of funds for interbank lending, which is then transmitted to corporate and consumer loan interest rates, affecting economic activities.
6.3.2 How is monetary policy transmitted?
a. Interest rate channel
After the Federal Reserve adjusts the federal funds rate, the cost of borrowing between banks changes, which in turn affects loan rates and deposit rates. Lower interest rates reduce borrowing costs for consumers and businesses, encourage consumption and investment, and promote economic growth. On the contrary, rising interest rates reduce consumption and investment, and curb inflation.
b. Asset price channel
Monetary policy also affects the economy by affecting asset prices (such as stocks and bonds). Loose policies usually drive up stock and bond markets, increase the wealth effect of investors, and stimulate consumption and investment.
c. Credit channels
The Fed affects the supply of credit by affecting the liquidity of the banking system. Loose policies (such as lowering interest rates or reducing reserve requirements) increase banks' lending capacity and promote credit expansion.
d. Exchange rate channel
Monetary policy also affects exchange rates, which in turn affects international trade. Lowering interest rates will lead to a depreciation of the US dollar, increasing export competitiveness, while raising interest rates may cause the US dollar to appreciate and weaken exports.
6.3.3 Unconventional Monetary Policy Tools
When dealing with extreme economic situations, the transmission process of conventional monetary policy tools is blocked, and unconventional monetary policy tools need to be used. For example, in the 2008 financial crisis and the 2020 epidemic crisis, a large number of unconventional tools were innovated to directly inject liquidity into the real economy. There are many types of unconventional monetary policy tools, and there is no need to remember them. The essence is to directly inject liquidity into the relevant parts according to which link is blocked in the transmission process of conventional monetary policy in the previous chapter.
For example
During the 2007-2008 financial crisis, the financial system was in trouble and the Fed introduced 10 innovative monetary policy tools, which were essentially an expansion of the policy application of quantitative easing (QE) to provide much-needed liquidity to financial institutions and prevent the collapse of the financial system while providing financial support to the real economy. As the crisis ended, some of the tools were withdrawn from use, while open market operations and reverse repurchase mechanisms were retained and evolved into regular tools.
In the 2020 COVID-19 crisis, the real economy ran into problems, and the Federal Reserve once again introduced a variety of unconventional monetary policy tools, some of which were inherited from the 2008 financial crisis and some of which were newly created. These tools helped the Federal Reserve break through traditional financial institutions and directly support businesses, consumers, and local governments.
6.4 Summary
The Fed's monetary policy achieves the goals of controlling inflation and promoting employment by adjusting interest rates and regulating liquidity. Its decision-making process is based on a detailed analysis of economic data, and the tools used include traditional interest rate adjustments, open market operations, and unconventional quantitative easing. The transmission mechanism of monetary policy ultimately achieves its policy goals by influencing interest rates, asset prices, credit supply, and exchange rates. Paying attention to the Fed's FOMC meetings, policy statements, and minutes is the key to studying the Fed's monetary policy. 6. Fed Monetary Policy