The federal reserve is the sole arbiter of monetary policy in the United States, with the US congress relinquishing that role to them with the passage of the Federal reserve act in 1913. The Federal Reserved is composed of a board of governors, who, in addition to the dozen Federal Reserve Presidents make up what is known as the Federal Open Market Committee (FOMC). Every quarter the FOMC convenes a meeting to determine what the monetary policy of the United States will be. At this meeting, the members decide whether to raise or decrease interest rates and thus expand or contract the money supply. FOMC members are supposed to be guided by market forces in the pursuit of containing inflation and maximizing employment.(Mayer 120) However, how exactly the FOMC achieves this end and how are they made responsible for the actions that they take is a question that immediately needs to be asked, given that the Federal Reserve is a private institution, and thus apparently free from political machinations when deciding monetary policy, but also free from public accountability when the actions they take are incorrect and can have such a devastating impact on people nationwide.
This paper will answer these questions and examine the mechanisms the FOMC uses in detail pointing out some of their success and failures, and summarize what the future monetary goals of the Fed might be with respect to interest rates, money supply, capital investments, supply and demand, and national GDP.
When we refer to the monetary policy, we define it as the Fed’s control of interest rates and the money supply. Ever since the great recession of 2007 in the US, the Fed has concentrated on interest rates, that is maintaining them as close to zero as possible to contain inflation, and stimulate the economy with low-cost lending. According to the FOMC, raising interest rates would result in a decrease in capital investments, slower economic growth and ultimately a decline in the GDP. (FDR.GOV). However, in their press releases, the Federal Reserve board does not discuss some of the more the negative elements of what having a central bank interest rate at zero for over a decade does to an economy long term. How it discourages savings, encourages debt assumption, consumerism, destroys the value of money, and impoverishes retired people on fixed retirement incomes, who even if they have a fund indexed to inflation, cannot makes ends meet, because the “true” rate of inflation is not what is reported publicly, given that its most salient elements such as food and energy are not included in the consumer price index (BLS.GOV).
The setting of interest rates known as “market operations” is not the only tool the Fed uses to set monetary policy. Reserve requirements and a setting of the discount rate are two others. Reserve requirements are set by the Federal Reserve Board and require all licensed lending institutions to carry a minimum amount of their deposits with their local federal reserve board. By enforcing this requirement, the Fed is thought of as bringing stability to the banking industry by controlling its liquidity. By example, should it reduce the reserve the federal requirement, banks will have more money to lend, and thus the fed will be following an “expansionary monetary policy.” By contrast, a higher reserve requirement, where the Fed wishes to curtail lending or fears inflation, is known as “contractionary monetary policy” whereby liquidity and economic activity are slowed. In practice, the federal reserve requirement is not as an effective tool in monetary policy as market operations for a few reasons. For one, small banks are exempt (FDR.GOV). that is banks with less than million 15 million in deposits. Secondly, banks can borrow from the federal reserve itself to meet their reserve requirements. This feature is known as the federal reserve discount window. They can also borrow from each other. If the design of the federal reserve board is one to try and promote stability in the banking system, allowing banks that cannot maintain even a 10% reserve requirement seems contradictory. With central interest rates near zero, the federal fund rate, which is the rate banks charge each other, can be manipulated by the federal reserve, much like it does with interest market operations, through the purchase of securities and treasuries, when it wants the rate to rise, and the sale of securities and treasuries when it wants the rate to fall. This is the third monetary tool of the Federal reserve’s monetary policy. Although not mandated, banks are “encouraged” to set the federal fund rate close to the Fed’s targeted rate. During the recession of 2008, do to solvency fears, banks were reluctant to lend to each other and business and consumer credit dried up as a result. In response, the federal reserve board dropped the rate to zero. This action, along with the fed’s “Quantitative Easing” policy, with what essentially amounts to the printing of free money, is why the US dollar as the world central reserve note is under threat. Its only saving grace to date has been that other world currencies such as the Euro are hardly in any better condition.
When the interest rate changes as a result of the Fed increasing, or decreasing the federal fund’s rate, the change has an impact on the entire economy. The amount a company is willing to invest is the first variable. Low-interest rates should produce greater investments, and a higher interest rate less. The variable and trends are best expressed by the following chart:
Clearly, this is an indication that interest rates are low and will remain as such for the foreseeable future. The feds cannot raise interest rates even by a single percentage for fear of inflation, and bankrupting consumers and businesses that have leveraged their assets on loans and mortgages where such an increase would result in their insolvency.
For businesses, though, the low-interest rates should make capital investments more viable. A near zero interest rate should be more than sufficient to overcome what is termed the “opportunity” costs associated with capital ventures. A higher interest, i.e. 5% or 6% would curtail investment, as the rate of return for most ventures would not be able to cover the increased expenditures.
In summary, this paper has looked at how the federal reserve board sets and controls the monetary policy through the setting of interest rates and the controlling of the money supply. Some of the negative consequences of the fed’s actions have also been noted. It is without question that the Federal reserve board has a powerful arsenal at its disposal beyond just the ability to set the discount and federal funds rate. The open market operations ability to purchase and sell securities to banks assures the fed can manipulate the interest rate to increase or decrease as it sees fit. However, the question remains if any private institution should have complete control over a state’s money supply, the “mandate’ to create full employment, with no restrictions in place from elected officials and what the long-term consequences will be for the devaluation of the US dollar. Since, 1913, the American dollar has lost 95% of its value. (Pilon 2009), as a result of an easily understood premise. The more dollars in circulation, the less value that money will have.
- “CPI News Releases.” U.S. Bureau of Labor Statistics. U.S. Bureau of Labor Statistics, n.d. Web. 19 Dec. 2016. Food and energy not included.
- “Features: Monetary Policy.” Federal Reserve Board: News & Events. N.p., n.d. Web. 19 Dec. 2016.
- Mayer, David A. The everything economics book: from theory to practice, your complete guide to understanding economics today. Avon, MA: Adams Media, 2010. Print.
- Pilon, Mary. “The Buying Power of a Dollar, on a Downswing.” The Wall Street Journal. Dow Jones & Company, 2009. Web. 21 Dec. 2016.
