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The FOMC and its Impact on Monetary Policy

By: , dated January 25th, 2013

FOMC and Monetary Policy

Simply put, monetary policy is economic policy implemented through the control of the money supply. By increasing or decreasing the amount of money flowing through the economy, monetary policy can impact the growth rate of the country. The Federal Reserve System has several methods to implement monetary policy. For example, the regional banks, with the approval of the board of governors, can alter the money supply by changing the reserve requirements for banks within the system. However, the most powerful entity within the Federal Reserve System in terms of monetary policy is the Federal Open Market Committee (FOMC). This group, headed by the Chairman of the Federal Reserve Board, currently Alan Greenspan sets interest rates either directly (by changing the discount rate) or through the use of open market operations (by buying and selling government securities which affects the federal funds rate). The discount rate is the rate at which the Federal Reserve Bank charges member banks for overnight loans. The Fed actually controls this rate directly, but it tends to have little impact on the activities of banks because these funds are available elsewhere. This rate is set during the FOMC meetings by the regional banks and the Federal Reserve Board. The federal funds rate is the interest rate at which banks loan excess reserves to each other. While the Fed can’t directly affect this rate, it effectively controls it in the way it buys and sells Treasuries to banks.

The voting part of the FOMC is made up of the 7 members of the Federal Reserve Board of Governors and 5 of the 12 Reserve bank presidents. The president of New York’s Reserve bank is always a voting member (the open market operations are actually executed through his/her bank) while the other four members are rotated every year in equal proportions. The other presidents of the Reserve Banks attend each meeting and provide input, but do not vote. There are 8 scheduled meetings during the course of each year. However, when circumstances dictate, the Fed can make inter-meeting rate changes. While these are fairly rare, the inter-meeting rate changes signal an aggressive move by the Fed and can have a big impact on the markets. At regular meetings, the FOMC sets the federal funds rate by determining a plan of open market operations. The group of 19 also sets the discount rate, which technically is set by the regional banks and approved by the Board. Recently, the FOMC has begun announcing its actions at the end of every meeting. At these announcements, the chairman will generally announce what the committee has decided to do with the discount rate, the federal funds rate, and what the committee’s “bias” is. With the discount rate, the committee can increase it, decrease it, or leave it unchanged. Increasing interest rates, or raising them, is called “tightening” the money supply because in the long run it will reduce the amount of money flowing through the economy. Lowering interest rates, or cutting them, is called “easing” because it increases the money supply. Generally, analysts believe that changes in the discount rate will have little direct effect on things because banks can get credit from outside sources fairly easily.

Instead, changes are viewed with respect to how they will affect future changes to the federal funds rate. The Fed has the same three options with the federal funds rate. Generally, moves are made in increments of .25%. This is referred to as “a quarter point” or “25 basis points”. A more significant move is a half-point (50 basis points, or .50%). In particularly desperate circumstances, the Fed might make a 0.75% change to the rates, but this is not typical. These changes are actually undertaken through open market operations. By carefully buying and selling government securities, the Fed can actually change what other banks charge each other for short-term loans. Over time, as these changes take place, the money supply changes, affecting the economy as a whole. But, this does take time. Most analysts believe that monetary policy takes at least 6 months to start affecting the economy. So, in addition to all its other concerns, the members of the FOMC have to be able to predict what the conditions will be when these rate changes take hold, and this can be difficult. Finally, with its bias, the Fed indicates what it is thinking it might do in the future. Usually the announcement will say that the Fed continues to be concerned about increasing inflation (a tightening bias), that it continues to be concerned about slow growth (a loosening bias), or that it is not concerned about either (a neutral bias).

Of course, the remaining question is why the Fed wants to make all these changes to monetary policy and the economy. The mission of the FOMC is “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The way it tries to maintain this is by creating a sustainable level of growth in the economy. If growth is too fast, the goal of stable prices will be lost due to inflation. If growth is too slow, unemployment will rise, meaning the Fed is not properly maintaining maximum employment. Therefore, the Fed tries to use monetary policy to maintain a sustainable level of growth for the economy that will keep inflation and unemployment under control. Of course, there isn’t some interest rate level that is “correct” and will maintain sustainable growth; as circumstances change domestically and globally, the optimal interest rate for the U.S. will change. As an example, when the Japanese economy fell apart, it greatly affected the amount of exports sent to Japan. This in turn slowed down the U.S. economy, forcing the Fed to cut interest rates in an attempt to increase growth. Generally, the Fed is trying to execute what is known as a “soft landing.” If the economy is growing too fast, this is when the Fed raises rates to the point where the economic growth slows to a sustainable level, but not so tight that the economy slips into a recession (a decline in GDP for two or more consecutive quarters). If the economy is growing too slowly, the Fed will cut interest rates enough to spark sustainable growth, but not create increased inflation.

As a side note, when you hear someone refer to “the Fed,” they generally mean the Federal Reserve System. Sometimes it will sound as if the FOMC or the Federal Reserve Board is being called the Fed, but that is only because this committee sets policy for the system as a whole.

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