The Economist: What’s the Fed up to?

The Federal Reserve took several actions in the first quarter that reversed programs begun more than a year ago to get credit flowing to families and businesses.

They raised the discount rate from 0.50 percent to 0.75 percent, closed two commercial paper funding facilities and the primary dealers and term securities lending facilities, allowed temporary swap arrangements with foreign central banks to expire and began winding down the term auction and term asset-backed securities loan facilities.

What is the Fed up to?

I wrote an article for ColoradoBiz more than a year ago discussing the tools of monetary policy at the Fed’s disposal and what it was trying to do in the face of the impending collapse of the international financial system. You will remember that the Federal Reserve’s mission is to provide maximum employment, stable prices and moderate long-term interest rates. To accomplish this, the bank has three major tools at its disposal:

• Open market operations. The buying and selling of U.S. Treasury and federal agency securities in the open market.
• Discount window lending. Lending to depository institutions directly from their Federal Reserve Bank’s lending facility (the discount window), at rates set by the Reserve Banks and approved by the Board of Governors.
• Reserve requirements. Requirements regarding the amount of funds that depository institutions must hold in reserve against deposits made by their customers.

Using these tools, the Federal Reserve influences the demand for and supply of balances that depository institutions hold on deposit at Federal Reserve Banks and thus the federal funds rate – the interest rate charged by one depository institution on an overnight sale of balances at the Federal Reserve to another depository institution.

Changes in the federal funds rate trigger a chain of events that affect other rates and, ultimately, a range of economic variables, including employment, output and the prices of goods and services.

The new programs and resulting purchase of securities over the last year increased the Fed’s balance sheet (holdings of these securities) from about $800 billion to more than $2 trillion. A simplistic view of this is that more than $1 trillion of new money was injected into the economy.

Because financial institutions were cautious about lending in the difficult economic environment of the last few quarters, most of this money remained in bank deposits at the Fed rather than circulating in the form of new loans to consumers and businesses. Now the Fed is beginning to withdraw that money in anticipation of a flood of lending in an improving economy.

The discount rate, the rate charged by the Fed when a bank needs to borrow from it directly, is a small piece of what the Fed does. More important is the federal funds rate, currently in a target range of 0 percent to 0.25 percent; at the beginning of the crisis it was 5.15 percent. The Fed continues to emphasize that it anticipates economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

The Fed emphasized that the modifications are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy.

As the economic recovery accelerates later in 2010 and in 2011, unemployed resources (labor, factories, etc.) will be put back to work. The unemployment rate will fall, consumers will become more confident and increase their purchases of goods and services, and over time prices will begin to rise.

The classic definition of inflation is too much money chasing too few goods. By slowly draining liquidity (i.e., avoiding too much money) from the financial system, the Fed hopes to avoid inflation.

If they get it right, they will fulfill their mission of full employment and stable prices. If they get it wrong, more problems lie ahead.

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