China is cracking down on internet access and
deleting micro-blogging accounts to control news of Bo Xilai, the Chongquing
party chief who was ousted from office in March, while his wife remains under
arrest for the suspected murder of a British man late last year. Greece and
Spain still teeter on fiscal cliffs as they face desperately needed spending
cuts. If enacted, the spending cuts could plunge them even more deeply into
recession and exacerbate citizens’ unrest; if ignored, unrestrained spending
would propel an already untenable debt. Greece’s exit from the Euro, once
unthinkable, could become more likely if countries like Germany and France
become more xenophobic and less willing to support their debts.
Among all of the chaos, many ears in the US are in fact
tuned in to the Fed and today’s FOMC press conference to hear the Fed’s opinion
on the economy (and therefore QE3).
But what on earth is the FOMC? And what exactly does the Fed
do?
Anyone? Anyone? …
Bueller?
The Fed is fairly mysterious to most people (I used to envision
Ben Stein from Ferris Bueller’s Day Off), so I am dedicating this post to the
Fed: who runs it, what they do, and why we care.
i.
Who Runs the Federal Reserve
Most people have heard of Ben Bernake, the current Federal
Reserve chairman (and his predecessor, Alan Greenspan). But while Bernake
garners most of the media focus, there is actually an elaborate hierarchy
governing the Federal Reserve:
·
Board of Governors
o
7 governors (each with a 14 year term, appointed
by the president)
o
1 chairman (4 year renewable terms)
·
12 Regional Federal Reserve Banks (shown in the map below)
·
Federal Open Market Committee (FOMC)
o
7 Fed governors
o
5 of 12 regional bank presidents (1-year
rotating basis)
o
The FOMC meets 8 times per year to determine
monetary policy. Minutes are released from their meetings and posted to the Fed
website – these are closely monitored, because the FOMC’s plans for monetary
policy affect the interest rate and other critical aspects of the economy.
ii.
What are they trying to do?
The Fed has 4 avowed
primary goals:
1.
Conduct monetary policy to pursue maximum
employment and stable prices (their “2-fold mission”)
2.
Supervise and regulate banking institutions
3.
Maintain stability of financial system and
contain systematic financial market risk
4. Provide financial services, including playing a major role in operating the nation's payment system
What does this really mean? The main goal of the Fed is to
contain inflation (they benchmark 2% annual change in the price index for
personal consumption expenditures) and create the “maximum level of employment”
– i.e. setting monetary policy to encourage employment to be at the economy’s
full potential level.
The Fed mainly accomplishes this by setting the Fed Funds
Rate, the rate at which banks can borrow money. The lower the rate, the more it
stimulates the economy (banks have very “cheap” money, making them more likely
to borrow in order to invest in projects), but the lower rate means that the
Fed is pumping money into the economy, creating future inflation.
So how does the Fed decide on a rate?
The Taylor Rule is a useful guidepost.
Taylor Rule -> i = 2% + π + 0.5(π-2%) + 0.5(Y-YFE)/ YFE
Terms:
i = target interest rate
2% = the Fed targeted inflation rate
Ï€ = current inflation rate
Y-YFE = output gap (i.e.
how big the gap is between what our economy is producing and what it could
produce at full capacity)
Below is a graph of the Taylor Rule
(and an adjusted “Alternate Taylor Rule”) against the actual Fed Funds Rate (from Marquette Associates)
Interestingly, you will note in the graph above that the
Taylor rate suggested we needed a negative Fed Funds rate in 2009 – though of
course this is impossible as interest rates cannot go below zero. But this is
an important point. The Fed is “zero-bound constrained,” meaning that once
rates are at zero, its hands are largely tied in terms of further stimulating
the economy through low interest rates. It has contemplated trying "QE3," a third round of quantitative easing that would try to ensure rates near zero for a longer period of time, but this is unlikely unless the economy continues to significantly falter.
Another interesting implication here
is the gap between the Taylor rule and the Fed rates in 2002-2005, where the
Taylor rule suggested higher rates before the Fed actually raised them. Of
course hindsight is 20/20, but the Fed has been criticized by many of
contributing to the housing bubble by keeping rates too low for too long during
that time, allowing banks cheap money to give away to risky mortgages and other risky bets.
Also of note is the current 2012-2013
projected gap. Per the Taylor Rule, the Fed should now be raising rates to
1-2%, the Fed has publicly committed to leaving rates around 0% until 2014. With
the mixed economic news recently, it is hard to tell the Fed’s best course of
action, but leaving rates low for such an extended period of time will likely
lead to serious inflation issues once the economy begins to recover. Our
supposed economic “recovery” is largely because of QE1 and QE2, which has given us an addiction to cheap
money. If the Fed makes it clear that QE3 will not happen, the economy could be in for another drop.
So that’s the Fed in a nutshell.
Probably 75% of you now commiserate with the students asleep in Ferris Bueller’s
economics class, but for those who always secretly wondered what exactly the
Fed does, hopefully this has helped.
So no more scone recipes? It's alright - thank you for the run down on the Taylor Rule, we may need that for this weekend's Macro finals.
ReplyDeleteHa, actually I was writing this blog in order to procrastinate studying - but hopefully it will help anyway :o).
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