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Economic Education

Feducation: Traditional and Non-Traditional Monetary Policy Tools

FeducationWhat monetary policy tools did the Federal Reserve use prior to the Great Recession? What did it do differently during and after the Great Recession? Episode 2 of the Feducation video series includes a simple demonstration of Open Market Operations and a discussion of non-traditional monetary policy tools.

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Transcript
For those of you who don’t me, my name is Mary Suiter, and I’m the Economic Education Officer for the Federal Reserve Bank of St. Louis. I’d like to welcome you to our second in this series of Feducation, and our topic today is Traditional and Nontraditional Monetary Policy Tools.

Feducation was developed in 2012 to provide economic content and to equip people with a better understanding of the Federal Reserve and it’s policy actions. Our second session focused on traditional and nontraditional tools that the Federal Reserve uses to conduct monetary policy.

The Federal Reserve has a dual mandate to promote two objectives—maximum employment and price stability—and those mandates are given to us by Congress. So what do what do they mean?

Well, maximum employment does not mean zero unemployment. It means that we want as many Americans who want to work—we want them working, we want the economy growing—with as many factors of production employed as possible and used efficiently. And, we also want price stability, so we want a low and stable rate of inflation over an extended period of time.

So, those are the goals of the Fed. How do they go about achieving—how do we go about achieving—those goals?

Monetary policy is an interest rate or money-supply tool that a central bank might use to achieve its goals. Traditional monetary policy in the U.S. targets the Federal Funds Rate—the interest rate that banks charge one another for overnight lending. Our most common tool, Open Market Operations, involves buying and selling government securities. We also have Discount Window Lending, so that when the demand for money puts upward pressure on interest rates, we can diffuse some of that pressure through lending, which supports our Open Market Operations.

So, how do we use Open Market Operations to accomplish our goals? We’re going to do a little demonstration here to show you how that works, and I’m going to ask for a volunteer…

I needed someone from the audience to serve as the Treasurer, and official record-keeper. Then, I asked for more volunteers, and handed out candy bars, as well as $5,000 checking-account balances—simulated $5,000 checking-account balances, of course.

The first order of business was to determine the money supply, which in basic terms, is the amount of currency, and the amount of money that people hold in checking accounts.

I asked those holding $5,000 deposits in bank accounts to raise their hands, so that our Treasurer could determine the money supply.

Eleven, OK; so that is, eleven times five. So, our money supply in here is $55,000. Now, I represent the Fed, and I have a portfolio of assets, all right? I have a portfolio of assets like the assets you hold: candy bars. And it’s a valuable asset for our society. First of all, it’s chocolate—how could you go wrong? It has lots of antioxidants in it. It’s really a great time to hold these assets, and I have a portfolio of these assets.

Now the Fed—our Chairman, our Board of Governors, the Open Market Committee—they’ve been studying the economy, and based on the statistics they’ve looked at and the trends they anticipate, they’ve decided that they need to sell—I represent the Fed—and they need to sell some of the securities in their portfolio. So, I’m going to sell some of my candy bars. Is there anyone in here who is willing to buy a candy bar from me for a thousand dollars from your account?

Sure enough, there were more than a few willing buyers. We crunched the numbers, and after selling five candy bars, the money supply in our economy shrank to $50,000. This money—the money that banks have in their accounts—are bank reserves. When I collect payment for my securities, my candy bars, I’ve pulled money out of the buyers bank accounts and banks have less money to lend. When this happens, the money supply decreases. So what will happen to interest rates if there’s less money available to lend? When the money supply decreases, interest rates go up.

Now what if, because of what’s going on in the economy, the Fed decides to buy? What if I buy candy bars, and I’m not going to—I’m not going to take your candy bars away from you. We’re just going to pretend in this case. What if I buy candy bars? I’m going to take your candy bar and what am I going to put in your account? Money. And so what happens to the money supply?

When I pay people for their securities—their candy bars—there’s more money in bank accounts. Banks are able to lend more and the money supply increases.

When the money supply increases, interest rates go down. And so this is traditional monetary policy—buying and selling short-term securities, and affecting the money supply and the interest rate. This is what we did during the financial crisis—we used the monetary policy tool to push interest rates almost to zero. But once short-term interest rates are at zero, then what do we do?

With an economy that was struggling under high unemployment, and with a tepid recovery underway, the Fed (as well as other central banks around the world) was left to determine what types of policy to undertake to help stabilize the economy. Analyzing academic research, and looking at some things Japan had done in recent history, the Fed decided to use some nontraditional policy tools to affect the economy.

The first of these tools is large-scale asset purchases, which has been dubbed “quantitative easing,” and the Fed has implemented three rounds. The first round consisted of buying government and agency securities, the second round was government securities, and the third round started with mortgage-backed securities, and then added government securities. The idea was that by purchasing these securities, we’d reduce the supply of the securities in the market, driving up the prices, and pushing the interest rates on long-term securities down. The purpose was to help the economy, and, by pushing long-term interest rates down, it would benefit people buying houses or cars—long-term kinds of lending.

We also did some portfolio restructuring, which was called Operation Twist. Operation Twist involved buying long-term securities, but at the same time selling short-term, so the mix of the assets we held was different. We held more long-term securities, and fewer short-term securities, thereby restructuring our portfolio.

Another important nontraditional policy tool we’ve used is our communication strategy. Ben Bernanke, our current chairman, is the first chairman to provide press conferences following a Federal Open Market Committee meeting. In addition, the FOMC began using extended-period language, or forward guidance. Meaning that for the first time, the Fed began suggesting expected time frames for the duration of interest rates and/or policy actions. The objective is to let the market—to let businesses and consumers—know what the Fed has done, and what their plans are for the future. With the hope that this will instill confidence, and encourage people to borrow and to spend—because they have more confidence in the market.

Thank you very much for spending your lunch hour with us—we appreciate it. We hope it was a helpful session, and we look forward to another Feducation. Thank you.

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