Plain Sense Economics

When economic times are tough, we often look to the government to help steer us into better conditions. When a real recession hits and unemployment grows sufficiently to be a topic of conversation and news articles, government (by which I mean here Congress and the President) can provide some palliative relief – treating the symptoms. Sometimes unemployment insurance benefits can be extended, or extra money appropriated for job training programs. Government can also offer help in the form of more government spending, which is expansionary and can help increase GDP. Government can also offer tax cuts, which provide more disposable income and encourages more consumption, thus also growing GDP.

All of those steps represent fiscal policy – the use of the government purse to affect economic growth.

The purpose of this post is to present the other “lever” by which government can steer the economic ship of state – monetary policy.

There are some sophisticated arguments on whether monetary policy is, or should be, focused on the actual supply of money in circulation, or whether short term interest rates are really the focus of attention. I gravitate to the latter. Here’s a very quick introduction to the topic.

Under the original and subsequently amended laws that established the Federal Reserve System, the monetary policy goals for the Fed are two: to maintain stable prices and to maintain moderate economic growth. Of the two of these, the stable prices goal is the greater among equals. This is in part because inflation is harder to control once it starts, causing policy makers to act almost proactively when they suspect inflationary forces at work. The second reason (or perhaps suspicion on my part) is that the members of the Federal Open Market Committee are overwhelmingly bankers. And bankers, in their role as lenders and in their heart of hearts, do not like inflation.

Let’s remember that one definition of Gross Domestic Product is that it is the sum of Consumption (consumer spending mostly), Investment (by businesses mostly), Government spending, and then the net of exports minus imports. And increase in one or more of these elements would boost economic growth, and vice versa.

The Fed’s main connection to growth is through short term interest rates. If these rates can be influenced downward, consumers will spend more and businesses will invest more. And the reverse is true, too.

To influence short term interest rates in a particular direction, the Fed adjusts the supply of money in the economy. If there is more money in circulation (including funds represented in checking and other demand deposit accounts) interest rates will be lower. If the money in circulation decreases, interest rates increase.

Technically the Fed has three tools to influence the supply of money and the interest rates. Two of them are rarely used: adjusting the reserve requirement for banks will either release or restrict money that banks have available to loan out. This is a sledge-hammer tool, with wide repercussions, and not much subtlety. The other seldom-used tool is changing the discount rate. This is the interest rate that the Federal Reserve charges member banks for short term loans. Banks would rather get a corporate root canal than go to the Fed for a loan, so the discount rate doesn’t have much impact in daily financial operations.

That leaves us with open market operations. The Federal Reserve can buy and sell U.S. treasuries and other securities. When they sell Treasuries, the buyers deposit money with the Fed, and in rough terms, that money disappears from circulation – reducing the money supply. In the other direction, when the Fed buys Treasuries on the open market it pays for them with money that is put into circulation – so the money supply increases.

The decision to raise or lower short term interest rates is made by the Federal Open Market Committee (FOMC). The FOMC is made up of the Governors of the Federal Reserve System, plus the presidents of the twelve Federal Reserve District Banks. Only five of those presidents vote at any one time. These representatives from the different district banks rotate in and out of voting positions, with the exception of the president of the New York district bank – who has permanent voting status.

The FOMC monitors trends in the economy. In reality the legions of staff people there monitor scores of indicators and statistical series. For our purposes here consider that they are primarily looking at changes in growth of real GDP, unemployment, and inflation. When the committee members decide that the economy has gone off the tracks – either heading towards a recession or heading towards accelerating inflation – they take action to help nudge the economy back. They do this by changing the supply of money in circulation, which in turn influences short term interest rates.

Let’s say that the various economic indicators point to a slowing, sluggish economy. If the FOMC feels this trend is strong or persistent enough, they will seek to increase the supply of money, which will lower interest rates. The results of lower interest rates include increasing personal consumption (you and I are more likely to use our credit cards or by a washing machine from Sears) and increased investment spending (businesses buying factories or capital equipment.)

The way the FOMC increases the money supply is by buying U.S. Treasury bonds in the open market. They instruct operators at the New York Federal District Bank to buy bonds from securities dealers. By purchasing those bonds the Fed is injecting money into the economy, making it easier for banks to loan, and lowering the interest rate.

To nudge the economy in the opposite direction the FOMC will direct the NY Federal District Bank to sell US bonds. Banks and investors who buy those bonds pay money that comes to the Fed, goes “inside the gate” and is removed from circulation. This means a reduced money supply and higher interest rates.

The gauge that the FOMC uses to measure their ability to move interest rates is called the Fed Funds Rate. This is a special interest rate that banks charge each other when they loan money to each other. Those loans often take place for very short periods (1 to several days) and help a bank maintain an adequate reserve balance with the Fed.

The FOMC meets about every 6 weeks and decides whether to adjust their target Fed Funds rate up or down or to make no adjustment. When you read in the paper that the Fed decided to lower interest rates by a quarter point, this means the FOMC has decided to lower their target level of the Fed Funds rate by 25 basis points, or one quarter of a percentage point. You can see a recent history of changes in these targets here. Just as a reminder – the Fed doesn’t just determine by fiat that the Fed Funds rate will be higher or lower. They decide to adjust the target level of that rate and then set about buying or selling bonds to bring the Fed Funds rate to that target level.

We’ll stop here, limiting the discussion to the mechanics of monetary policy. See the Macroeconomic Concepts and Macroeconomics Issues labels in the right hand column for posts on similar subjects.