As we all know, the European Union has recently been under the lime light with their budget deficit problem – causing a lot of anxiety for investors in the U.S. I’m curious if there’s a reason why the even greater deficit in U.S. isn’t being publicized as much?

Crumbling Parthenon

The quick and honest answer is that I don’t have any special insights into the minds and souls of investors – not being one myself. Still, there are some characteristics of the European economic crisis that are different from the United States, but can provide cautionary tales for our own economic policy.

As of today the US national debt stands at $12,988 billion (that’s almost $13 trillion). In 2009 our Gross Domestic Product was $14,256 billion. So our debt is about 91% of GDP.  From news sources Greece has debt of around $368 billion, and a 2009 GDP of $357 billion – a debt load of 103%. So somewhat higher than the US but not by multiples.

So, just to repeat my earlier disclaimer – I don’t know what makes international investors tick. Here, though, are some of my concerns about Greece and Europe, and what distinguishes them from the U.S.

Greece is a member of the Euro community – i.e. they no longer have their own currency, but use the Euro instead. This should provide stability in foreign exchange markets, compared with maintaining their own currency. On the other hand, Greece no longer has sovereign control over its own monetary policy. The Euro central bank can change the supply of euros, and the Euro community in general impacts the value of the euro on the foreign exchange market. In sort Greece is dependent on others to apply some traditional rescue strategies. What Greece has in common with the United States is the need to balance government revenues and government expenses in the long run.

The concern about Greece seems to be bigger than Greece. Policy makers and observers worry about other country members of the euro community, including Spain and Portugal. They see a domino effect that threatens most of Europe. For the U.S. that means worrying about some of our best customers and understanding that the global financial structure is interdependent, with a credit crisis in Europe spreading here quickly.

I also think confidence in the central banking and political system plays a role in investor perception. We’re quick to criticize both the Federal Reserve and Congress for their actions or inactions. The world has a more sanguine view of these institutions, though. The value of the U.S. dollar has been rising in recent weeks, as investors switch to dollar-denominated securities – in particular U.S. treasury bonds. Those investors have more confidence in the U.S. than in Europe – for better or for worse.

None of this means that the U.S. debt situation is nothing to worry about. While I may not be confident in the economic policy process in Congress, I do have faith in the Federal Reserve. And in contrast to the deficit hawks I believe we still need to be spending government money to stimulate our recovery.

Now comes the incredibly difficult climb out of the recession trough. We’ve started climbing, with two successive quarters of positive real GDP growth. The newspapers, cable, talk shows, and blogosphere are filled with opinions, warnings, and predictions. I’m in no position to give a complete prescription for future economic policy, but this is an excellent time for students to be thinking through the issues. They need to separate out the fundamental building blocks of a strong economy and push aside alarmist claims.  Here’s a list of things to think about:

1. Monetary policy and the Federal Reserve: In a mild recession the Fed is our policy instrument of choice. They loosen the money supply, which in turn lowers interests rates a bit, which in turn  helps consumers buy goods and businesses to invest in the future. In the recession that started December 2007, the Fed started with this response but the depth and seriousness of the downturn outstripped the ability of routine monetary policy. They then turned to extraordinary steps to provide stability and liquidity in the financial markets, and have worked to maintain a banking system that will receive deposits from trusting depositors and make loans to worthwhile borrowers. To do this they pumped billions (over a trillion) of dollars into our system.They are now focused on how to retrieve that excess money, so that a more active economy doesn’t use it to spur inflation. They’ve been thinking about this a lot, and Chairman Bernanke insists they will be able to gradually reverse the steps they took, without sending the economy in a tailspin. The Fed also has to decide when to reverse the “normal” monetary policy and started pushing interest rates up. As I see it they are working in kind of a LIFO (last in; first out) order. The most serious and unusual interventions will be corrected first, and then the milder interest rate policies will be corrected as the economy approaches a more normal course.
2. Fiscal Policy and the Congress and Administration: Congress correctly passed a large stimulus spending bill over a year ago. The economy  needed it; routine monetary policy was not going to be sufficient to end the recession; and it would have been political suicide not to take action. The stimulus bill was not perfect. It was probably not large enough. It had some favorite son policy objectives that hindered speedy impact of the spending on the economy, and it had some not very effective tax cuts in order to garner bipartisan support.I’ve learned to appreciate a “prime the pump” analogy for fiscal policy actions like this. If you’ve ever had to use a hand pump you know that sometimes you have to add water in the top in order to get the process working. Government stimulus funds are like priming the pump. They immediately add something to the GDP, since government spending is one component of GDP. The real test of a fiscal stimulus is whether the priming works. In an ideal case, the initial injection of spending prompts a cascading series of new spending decisions in the private sector. This is the essence of what my students learn as the multiplier effect. New spending on roads means more wages for road workers, who hopefully become more likely to spend, and the establishments where those workers spend have the same opportunity. There are plenty of signs that the initial stimulus money started improving GDP. Whether that money has successfully primed the pump is an open question. Some policy experts are calling for more stimulus – a second priming. Others (not including those who object on philosophical grounds to more government spending) worry that another fiscal stimulus would boost the economy just as it is getting better on its own, and could spark an inflationary spiral.There has been a flurry of “job bills” discussed by the administration and Congress. Many of these are responses to a perceived (probably real) concern among the American voter that jobs aren’t coming back quickly enough and something needs to be done about it. I don’t know enough about them to comment thoughtfully. Based on past performance it is easy to guess that some proposals will do little to make a permanent shift in the employment picture, and that some will have serious side effects. One quick example – just about any “Buy American” restrictions will hurt our economy in the long run and have minimal benefits in the short run. The Smoot-Hawley act passed in the early years of the recession is our number one example of the problems of drawing up the bridges and protecting our own workers at the expense of other world markets. On the other hand jobs bills that can reduce structural unemployment through retraining, relocation, and other adaptive strategies are money well spent.
3. Federal Deficit and Debt: This is the trickiest balancing act. It also has the most heat and the least amount of light in media discussions. Here’s what the Congressional Budget Office says about the near term situation:

CBO projects, that if current laws and policies remained unchanged, the federal budget would show a deficit of $1.3 trillion for fiscal year 2010. At 9.2 percent of gross domestic product (GDP), that deficit would be slightly smaller than the shortfall of 9.9 percent of GDP ($1.4 trillion) posted in 2009. Last year’s deficit was the largest as a share of GDP since the end of World War II, and the deficit expected for 2010 would be the second largest.

One way to look at this issue is represented by Paul Krugman:

Contrary to what you often hear, the large deficit the federal government is running right now isn’t the result of runaway spending growth. Instead, well more than half of the deficit was caused by the ongoing economic crisis, which has led to a plunge in tax receipts, required federal bailouts of financial institutions, and been met — appropriately — with temporary measures to stimulate growth and support employment.

Gregory Mankiw is less happy about projected deficits:

The troubling feature of Mr. Obama’s budget is that it fails to return the federal government to manageable budget deficits, even as the wars wind down and the economy recovers from the recession. According to the administration’s own numbers, the budget deficit under the president’s proposed policies will never fall below 3.6 percent of G.D.P. By 2020, the end of the planning horizon, it will be 4.2 percent and rising.

My own take? Closer to Krugman than Mankiw, but I worry that a partial economic recovery or some call for fiscal stimulus will produce not-well-thought-out-spending plans. These won’t help much, in terms of recovery, they are likely to be persistent beyond the current economic problems, and they won’t help re-establish a deficit closer to 4-5% of GDP.

As a quick review for my students – Our most recent and serious recession came about largely because the prices of real estate and houses accelerated dramatically, and out of proportion to other purchases or investments that the average American could make. When that bubble of high prices popped, financial institutions which had been lulled into thinking their real estate-related investments were safe, found their balance sheets decimated. This has happened several times before in our country’s history, including the technology stock bubble in the late 1990s and 2000, and as far back as the 1800s for railroad properties and precious metals. Even in the 17th century speculation in tulip bulbs caused an economic collapse.

There are two main criticisms about Federal Reserve actions in the last 3-4 years:

1. The Federal Reserve kept short term interest rates too low, for too long a time following the mild recession in 2001. Critics argue that this monetary policy encouraged risky borrowing and unnaturally inflated housing prices.
2. The Federal Reserve was lax in its oversight and regulation of the financial services sector – both over institutions, like banks, and over the risky mortgage lending practices. Regulatory faith in the power of market mechanisms was unearned, and institutions made what we now see as irrational moves.

At a meeting of the American Economic Association in Atlanta this week, Chm. Bernanke rejected the idea that monetary policy caused the housing bubble, but he did acknowledge that weakness in regulatory efforts played a major role.

U of Oregon professor, Mark Thoma, has a nice piece on these issues:

I have been more defensive of the Fed’s actions both before and after the crisis started than most, and I want to talk about why recent criticism of Bernanke and the Fed for their failure to use regulatory intervention to stop the housing bubble is correct, but perhaps directed at the wrong target.

I’ve gotten on this soapbox before – though the Federal Reserve is a human, fallible organization it is staffed and led by thoughtful professionals and should continue to be protected from political second guessing. There is no member of Congress, including Rep. Barney Frank, who can bring more intellectual and effective knowledge to bear on this issue than Bernanke and his staff.

I get asked this question a lot lately. First, despite the inference of the video provided by the Bureau and Engraving and Printing (see below), the Fed has not been running the money printing presses for extra shifts in the past few months. Instead the Fed can buy U.S. Treasury bills on the open market, and can find a number of other ways to pump money into the economy. The way the money gets created is that the Fed credits the account of securities dealers, banks, and other institutions – each of which have accounts at various Fed district banks. So the balance on these accounts is higher, which gives banks in particular the freedom to lend out more more or somehow make use of the cash. And when the Fed and other policy folk measure the amount of money in circulation they count not only hard currency, but also the balances in checking and other demand deposit accounts.

So, now that we know that money isn’t really being printed, we still need to be concerned by the significant increase in money (represented by currency and checking account balances) injected by the Fed. The inflation concern is real and important. It is a concern not lost on Federal Reserve officials. There is no question that in normal times a significant increase in the money supply usually leads to inflation.

This article in today’s Wall Street Journal explains what has been happening, and also describes how the Federal Reserve will be able to bring back much of that money as the economy improves.

‘We are thinking carefully about these issues,’ Mr. Bernanke said in a speech in Atlanta last week. ‘Indeed, they have occupied a significant portion of recent [Federal Open Market Committee] meetings.’

Ideally the Fed will “reel in” the money in a manner that avoids inflation while not prompting another downturn. Reducing the supply of money generally means higher interest rates and a dampening of economic activity. You’ll see in the article that Federal Reserve officials are thinking a lot about this issue right now. You’ll also see some cautionary opinions from others who are skeptical that the Fed will be able to get the timing right. These critics worry that the Fed, for a variety of reasons, will be slow to turn off the money spigot and turn on the money vacuum. If they are slow, inflation can catch on and that is hard to stop or control.

So, when I’m asking about the risks of inflation due to all of this money printing, I agree with the inflation concern, but express my hope and confidence that Fed officials have thought this through and will reduce the money supply at just the right moment.

From Economix in today’s New York Times

Economix: Come With Me to the F.O.M.C.: A Sneak Peak Into Fed Life

By Bob McTeer

Published: October 29, 2008

An economist writes about what it was like to be a member of the Federal Open Market Committee and set monetary policy.

We’re hearing more opinions now that our attention needs to turn to fiscal policy initiatives, which largely deal with the demand side. My colleague, Ric Holt, made this point at a forum last week on the SOU campus.

Paul Krugman wrote about the same thing in his October 16 column.

It’s politically fashionable to rant against government spending and demand fiscal responsibility. But right now, increased government spending is just what the doctor ordered, and concerns about the budget deficit should be put on hold.

In the good old days I would talk about fiscal policy as an imperfect, inefficient economic tool. It suffered from important delays – political, administrative, and implementation – and due to its origins in the legislative and executive branch, fiscal solutions are often not quite right. We prefer (preferred) monetary policy solutions for their relative insulation from political influence, and their relative speed of implementation.

Credit is still not flowing as it should, although there are a few hopeful signs: the London Inter Bank Offered Rate started declining this past week, after rocketing up earlier.

Still, economists and policy makers are starting to look ahead a bit, trying to gauge the depth and length of what seems like a certain recession. We should see the Federal Reserve reducing its Fed Funds target rate – in a traditional monetary policy move, but Krugman and others argue that won’t be enough.

Despite Krugman’s wish that we put concerns about the Federal budget deficit aside, the financial bailout and one or more fiscal stimuli to be passed by Congress will surely strain it.

Liquidity / Credit Crisis: The main cloud hanging over our economy at the moment is the inability, or more accurately, the unwillingness of banks and other financial institutions to loan money – hence the label “credit crisis”. This has happened for a number of reasons. I’ll mention a couple.

1. Banks and other financial companies saw their assets disappear in rapid, unexpected fashion. As we’ve learned throughout the year, many financial institutions had been buying, for investment purposes, securities made up of mortgages on people’s homes. A couple of years ago these packages of 1000s of mortgages were judged to be quite safe. Even if a percentage of those mortgages went into foreclosure, the rest would be fine and the whole package would be fine. However, when the housing price bubble burst and when some loans with very low interest rates and monthly payments reverted to more normal levels, the rate of foreclosures escalated. Now those packages of mortgages started looking less safe, and banks and others started trying to sell them and bail out. Those packages were recorded on the banks’ books with a certain value, but that value started plummeting, as it got harder to find buyers for these packages. Banks started seeing their net worth disappear overnight, and that in turn put many of them in jeopardy of default. There is a side issue here about how forthcoming companies should be in reporting the drop in value of these assets. It is called “mark to market.” Here’s a little write up about it.

2. Lenders, taking a peek in the mirror, started losing trust in their borrowers. Many of the same banks that were suffering problems were less likely to loan out money – not just because they were in trouble themselves, but also because they worried about the credit worthiness of the banks, businesses, and other institutions who were looking for loans. Vikas Bajaj wrote about this in today’s New York Times – about how fear seems to be overtaking logic and normal market forces right now.
3. We’re being reminded of how much our economic system, and day-to-day business relies on easy credit. None of this is new, but this crisis has brought out into the open the traditional practice of businesses (large and small), banks, and other financial organizations to borrow money to cover short term demands for cash, and then repaying that loan shortly. They do it to buy inventory, meet a payroll day, take advantage of low prices, or to just make other investments with someone else’s money.

What is the U.S. government doing? Lots of things, many of which I don’t really understand or can keep track of. There are a couple of major activities that I can try to comment on:

1. “The bailout.” The final bill passed by Congress was larded with all sorts of things to buy the necessary votes, but the essential piece was giving the Treasury Department authority to buy some of those hard-to-value mortgage packages. This should have two beneficial effects. First, banks and institutions that sell these to Treasury get cash, which helps their own balance sheet. Second, this starts establishing a market price or value on these packages. The lack of a commonly agreed upon price or value has made it impossible to establish a market and to get these securities moving again.

2. Flinging open the discount window. Traditionally the Federal Reserve Bank, acting as the “banks’ bank” has had a lending facility for banks called the discount window. Banks experiencing temporary hard times could borrow money from the Fed at fairly reasonable rates, for short periods of time. In normal circumstances this is not used much, because the loan from the Fed also raises eyebrows from the Fed’s own bank regulators. I describe it like going to Dad to ask for an advance on your allowance – you can get the money, but you open yourself up to disapproving questions. This year the Fed has taken a number of steps to encourage banks to use this borrowing option, and has allowed financial institutions other than commercial banks to make use of it. This provides more credit and liquidity in a market where there is a shortage of both.
3. Reducing short term interest rates. The Fed announced today that it was lowering the Federal Funds target interest rate by one-half a percentage point – from 2.0 to 1.5. They announced this in concert with a number of other large countries and their central banks. This is a classic exercise of monetary policy, with the Federal Open Market Committee releasing funds into the market in order to drive short term interest rates lower. This doesn’t have a direct impact on mortgage interest rates, but is designed to help stimulate the economy, encourage more borrowing, and more consumption.

So will all these steps work? We hope so, but it is hard to tell. We’re in uncharted waters. When people ask I tell them that I’m comforted by having a Federal Reserve Chairman, Ben Bernanke, whose academic specialty as an economist was the study of the Great Depression. He’s done some of the most important work on understanding how we got into the Depression, the actions the government took (for better or for worse), and how various countries emerged from the Depression years later. Still it is a much more complicated world we live in today. I’m just relieved to have a super smart, thoughtful person in that seat, rather than a “helluva job, Brownie.”

Stock market results are discouraging, but they are not the best barometer of how things are going. They are influenced by a sort of herd mentality and investor concerns. What we want to hear is whether banks are starting to lend to one another, that companies can find buyers for short term commercial paper in order to finance their day to day operations, and that financial organizations are looking beyond their mirrors and considering how to make money by lending to others.

As a quick review, fiscal policy is the use of the government’s power to tax and spend. Monetary policy is the other government lever on the economy, and uses the ability of the Federal Reserve to influence interest rates through changes in the supply of money.

In his lead in to the piece, Zarolli notes that Federal Reserve chairman Ben Bernanke gave strong signals that the Federal Open Market Committee will act vigorously to reduce interest rates when they meet later this week. Others, Zarolli reports, worry that monetary policy actions may not be sufficient to fight an economic slowdown. Hence the discussion of fiscal policy.

In order for the government to move its fiscal policy lever Congress and the President must agree on a solution. Any government spending or tax decisions require legislative action and a presidential signature. The requirement for action and agreement among politicians is the root of the problems associated with fiscal policy.

Fiscal policy is often ill-timed. We note a recognition lag – where members of Congress, lacking a full staff of forecasters and economists, are often slow to act on changes in economic conditions. They also tend to “read” data that affect their constituencies. There is nothing wrong with a member of Congress reacting to increased housing foreclosures or factory layoffs, but the story is often more complicated.

Once Congress decides action is needed they need to agree on a solution. As President Roosevelt took office in the the first third of the Great Depression he was successful in galvanizing Congress to pass a series of spending bills that would become part of his New Deal legacy. Today, in the absence of a catastrophic event and also missing a charismatic president Congress will be less focused and more argumentative. Many of the earlier solutions being floated involve tax cuts – either making earlier tax cuts permanent or granting one time tax credits or refunds. There are some spending proposals as well, including improving unemployment benefits and food stamp programs. Of a necessity, the final compromise will be a mixture, and it will not be well designed. We can safely assume that many Congressional leaders will use this opportunity to push longer term political goals, with only a partial nod to the economic situation facing us today.

Once Congress and the President agree on a fiscal solution, the implementation takes time. The exception is a quick tax rebate, such as we enjoyed in the summer of 2001. Other than a rebate most solutions won’t impact the economy until much later in 2008, if then.

And any fiscal stimulus puts greater strain on the federal budget deficit.

So, why do we bother? The strongest driving force for fiscal policy is the responsibility felt by members of Congress towards their constituents and supporters. In addition, the investment markets, both here in the United States and around the world, look for political leadership in tough times. No movement by Congress can be interpreted as a sign of weakness or lack of resolve and drive investors away from US assets.

Let’s watch this play out in the next month or two.

Addendum – January 12: From Greg Mankiw’s blog, comes this link to an excellent description of the issues surrounding fiscal policy. This is a pdf document (24 pages) written by Douglas W. Elmendorf and Jason Furman, posted by the Brookings Institution.

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.

The Federal Reserve Open Market Committee (FOMC) is made up of the seven governors of the Federal Reserve System plus the twelve presidents of the district Federal Reserve banks (5 of whom vote at any one time) and executes monetary policy.

They seek to speed up or slow down the economy by influencing short term interest rates. (It is a common misperception that the actions of the FOMC have a direct impact on long term rates, such as those for mortgages. There are some indirect impacts, but generally long term rates are driven by other factors.)

Let’s say that the economy is limping along, with anemic real growth in GDP. Unemployment is starting to inch up, and there are signs of a recession on the near horizon. To correct this malaise the FOMC seeks to lower interest rates. Lower rates encourage more business investment and more consumer purchases. To do this, the Fed needs to pump more money into the domestic economy. A greater money supply will, in the good old tradition of demand and supply, drive price down, which are interest rates in this case. To increase the money supply the FOMC instructs bond traders at the New York district Federal Reserve bank to buy US Treasury bonds held by investors and others. Buying those bonds releases more money into the economy, and lowers interest rates.

If, on the other hand, we are seeing signs of increasing inflation – driven either by increased demand from consumers and businesses, or by increased costs of inputs – then the Fed would like to cool the economy down. They need to spray some water on the hot coals, or to repeat another metaphor used in this case – to take away the punch bowl just as the party is starting to get good. To cool the economy, the Fed seeks to raise interest rates – making borrowing by consumers and businesses a notch more expensive. To raise interest rates, the FOMC will reduce the money supply by selling more U.S. treasury bonds. Those sales (on top of the normal sales of US bonds to pay for the federal government deficit) will take money out of the economy, and push interest rates higher.

So, what is the Fed Funds target rate? It actually represents the interest rate that banks charge each other for very short term (typically overnight) loans. These loans are often made to help banks meet their daily reserve requirements, as set by the regulatory function of the Federal Reserve. These are common transactions, and a necessary accommodation for banks who record millions of dollars in loans and deposits each day, with resulting reserve requirements going up and down, as well.

The FOMC monitors the Fed Funds rate and buys and sells U.S. treasury bonds to keep that rate at the target level.

Now recently there has been separate movement of a different rate – called the discount rate. That rate is what the Federal Reserve charges to loan funds to member banks – again for a short time period. Usually the discount rate is about a percentage point higher than the Fed Funds rate, so this loan capability is not used very often. Also, there is a bit of an informal stigma attached to drawing a loan from the Fed. If we remember that the Federal Reserve has banking regulation as another important part of its charter, going to the Fed for a loan because your bank’s cash reserves are low is a little like going to Dad asking for an advance on your allowance. You may get the money, but not without at least a raised eyebrow.