Fed Up?

News from all corners of the world seems recently to be edging towards extremism – politically and economically, domestically and abroad. The Dutch prime minister resigned yesterday amid deteriorated budget support. The Socialist French presidential candidate (Ms. Le Pen) is pushing her competitor Sarkozy to the right as well; Sarkozy is now proposing creating mandatory French-language exams for foreigners wanting to settle in France and tightening immigration restrictions. 

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-Y^FE)/ Y^FE

Terms:

i = target interest rate

2% = the Fed targeted inflation rate

π = current inflation rate

Y-Y^FE = 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)

What are the implications of the Taylor Rule?

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.