The Fed: Making Use of All Policy Tools by Richard May

When the Fed decides to remove accommodation from its policy, which it already has hinted at doing with its recent tapering, it will need to start thinking about reducing the size of its balance sheet as well as preventing inflation and future bubbles in both the asset and housing markets. Once tapering has progressed to the point where the Fed is no longer making monthly purchases of long-term bonds, therefore, it should consider starting to sell some of its securities, a fitting conclusion to the quantitative easing program that the Fed has put in place.

The Fed Funds interest rate is a separate tool from the QE, whose purpose is to affect short-term interest rates, not long-term ones. Therefore, changes regarding the Fed Funds rate should not be tied to changes in QE. However, if the economy seems to be returning to pre-recession levels, the Fed should not hesitate to raise the Fed Funds rate, as that is the primary tool that it uses. As to the magnitude by which the rate will be raised, that should depend partially on the Fed’s forecast on the economy and the different paths that the economy would take based on differing interest rates, and partially on future predictions of different economic indicators to adhere to the Taylor Rule.

In terms of other interest rates, the Fed should keep an eye on the discount rate and the interest paid on excess reserves, but as the economy recovers, these tools should be secondary to the Fed Funds rate. Because these interest rates affect specific aspects of the financial market, only when these factors change drastically should the Fed touch them. For example, if bank lending, as it has been doing, stagnates to the point where trillions of dollars of excess reserves are being held at the Fed, then the interest paid on those reserves should fall (ignoring the zero-bound) until bank lending reaches an acceptable level. Also, if the economy proves slow to recover, but the Fed still needs to shrink its balance sheet, lowering the interest on excess reserves to increase lending while at the same time selling securities provides a way to enact expansionary policy while also reducing the size of the Fed’s balance sheet.

Also, because the Fed has a responsibility to ensure the stability and survival of the financial market, it should take a more active role in bank regulation. The Fed is the institution that knows its own goals, and whether or not they are being achieved, better than any other organization. Because the actions of banks significantly impact the financial market as a whole, and the Fed knows better than anyone else where the financial market needs to be, it follows that the Fed would know what the banks ought to do to keep the financial market stable and growing. Therefore, the responsibility to institute regulation to incentivize banks to do what’s best for the market should lie with the Fed.

Timing of Fed Policy Choices by Nina Sheridan

The Fed must think in advance. It should not have the effects of its expansionary policy still being felt once the economy is fully recovered. In order to decide when the Fed should stop its bond purchases altogether, it should look at all of the different economic indicators, but particularly those that relate to unemployment and price stability.

If the unemployment rate remains the same or continue to decrease, and inflation is projected to remain stable, the Fed should end its purchases by continuing to taper at 10 billion a month, leading to an end of the program in the next seven months. Unemployment is at a five year low, but is projected to only fall to 6.3% by December according to Fed projections. This is above the long run unemployment rate, and with the labor force participation rate down 2.7% from five years ago, it would only be appropriate to end the taper earlier if the labor force participation rate rose to previous levels.

The next step the Fed must take in removing its accommodative policy is raising the Fed Funds rate. This cannot begin until the Quantitative Easing program has ended, because even with the taper, the Fed is still buying long-term securities, which is expansionary policy. After the Quantitative Easing program has ended, the Fed should look at the indicators to decide when to implement the contractionary policy of bringing the Fed Funds rate back to normal levels. The Fed should wait until inflation has risen back to the target 2%, real GDP growth is above 3%, and the unemployment rate has fallen to 6%, which is in the range for long run unemployment (5.2%-6% according to the Fed). Inflation is important to consider because raising the Fed Funds rate is a contractionary measure, and we do not want to risk a decrease in the inflation rate when it is already so low. If the expected inflation rate rises unexpectedly, the Fed should reconsider the timing, and it would likely be appropriate to begin to increase the Fed Funds rate earlier.

I think the Fed will begin to raise the Fed Funds rate towards the end of 2014 or the beginning of 2015. A recent Wall Street Journal survey shows economists predict that real GDP growth with be 3% in the third and fourth quarter of this year. It is highly likely that the QE program will have ended by this point. The CPI is projected to be 1.9% by December of 2014, very close to the Fed’s target. Unemployment is not predicted to be below 6%, but I think if the other indicators show good signs and unemployment continues to decrease, the Fed will start to incrementally raise the rate.

Future Fed Policy by George Qian

The US economy has seen steady growth since the recession. Now, the Fed is ready to begin to remove some of its highly accommodative monetary policy. The Fed has started to taper Quantitative Easing and should continue with the trend until the purchases are ended altogether. However, the Fed shouldn’t touch the Fed Funds rate until the labor market and inflation have reached an adequate level.

In the December FOMC meeting, the Fed started the process of scaling back the $85 billion-a-month bond-buying program by $10 billion, $5 billion in mortgage-backed securities and $5 billion in long-term Treasury securities. In the January meeting, the Fed continued the process of tapering by cutting another $10 billion. However, there have been some recent weaknesses in economic data, such as a .8% decrease in January manufacturing and the addition of only 113,000 jobs last month and 75,000 jobs in December, but that data is mostly attributable to severe weather, instead of a faltering economic recovery[1]. Now, since the Fed has already set a trend of tapering, the public is expecting further tapering, as the Treasury yield has recently risen based on speculation that the Fed won’t stop tapering. Also, Quantitative Easing is meant to target long-term interest rates, and long term projections for inflation, economic growth, and unemployment remain stable. Given the current and projected economic conditions, the Fed should continue the trend of tapering by $10 billion a month until they end the purchases in December, unless there is a notable change in the outlook of the economy such as the continuation of weak job growth.

            Even though the Fed has started tapering and has projected a stable price level and economic growth in the long run, the persistently low inflation and distorted unemployment rate should keep the target Fed Funds rate at near zero way past the time when QE has ended. The last time inflation has risen to or above the target rate of 2% was back in April of 2012. The current year-to-year core PCE inflation is only at 1.2%.[2] The unemployment rate of 6.6% is getting closer to the 6.5% threshold; however, the current low unemployment rate is partly caused by discouraged workers: the labor force participation rate is at 63%, a level similar to the recession in the late 1970s.[3] In the short run, the Fed should continue with its forward guidance of keeping the Fed Funds rate at near zero. As the unemployment rate gets closer to the threshold, the Fed should take a look at other indicators such as the labor force participation rate and U-6. The pre-recession levels for labor force participation rate and U-6 are 66% and 8-9% respectively.[4] Once the labor force participation rate has reached 64.5% and U-6 has reached 10%, the Fed should start raising the Fed Funds rate by a quarter percent each meeting. Even though inflation has been persistently low, there are signs of increasing levels of inflation and the long-run projection still remains stable and inflation is expected to be at 1.5% in 2014 and rises up to 1.6 to 2.0% next year. Therefore, the Fed should begin raising the Fed Funds rate around mid-to-late 2015.

            With the improvements in the economy, the Fed has begun reducing its expansionary policy by scaling back the bond-buying program. However, the economy is not yet ready for a rise in the Fed Funds rate. So, the Fed should continue with its forward guidance and

---

[1] http://money.cnn.com/2014/02/07/news/economy/january-jobs-report/

[2] http://www.investing.com/analysis/pce-price-index:-core-inflation-remains-far-below-the-Fed-target-200926

[3] http://data.bls.gov/timeseries/LNS11300000

[4] http://portalseven.com/employment/unemployment_rate_u6.jsp

How Should the Fed Take its Next Step? by Anthony DeSantis

-->

When the time comes for the Federal Reserve to take the next step in its monetary policy actions, it should do so by raising the target for the Federal Funds interest rate and maintain that rate by selling securities in the open market.  Of the three traditional tools that the Fed uses to set its monetary policy – open market operations, minimum reserve requirement, and discount rate – using open market operations to influence the Fed Funds rate is the most significant because it affects monetary and financial conditions, which in turn have a bearing on key aspects of the broad economy including employment, growth and inflation.

                  When the Fed sells securities in the open market, there is a transmission mechanism that follows.  The sale of securities decreases the supply of money in the economy and deducts the purchase amount from the bank's reserves. This reduces the amount of money the bank has to lend, which increases interest rates.  This increase in interest rate causes consumption and investment spending to decrease, thus decreasing aggregate demand.  As a result of the decrease in aggregate demand, its key components such as real GDP and unemployment will fall and rise respectively, while the price level also falls.  Raising the Federal Funds rate should be done at a slow or moderate pace.  Increasing by .25 percentage points at a time allows the Fed to monitor how the economy reacts to this change, and be able to adjust its policy based on the results.  Selling many of these securities could also avoid a potential buildup of inflationary pressures caused by the large quantity of reserves on bank balance sheet. While the Fed has currently instituted programs such as reverse repurchase agreements and term deposits to indirectly drain these large quantities of excess reserves, in the long run the direct sale of these securities in the open market is the most logical solution to the problem, as its balance sheet will return to more normal levels and most of its remaining security holdings will be Treasury securities.

                  While an increase in the discount rate or in the minimum reserve requirement are also valid options for how the Fed could pursue its next step in monetary policy, neither of these tools impact the overall economy as the open market operations does.  The discount rate, which is the interest rate on loans from the Federal Reserve to a bank, is more commonly used in a situation where financial system conditions are unstable.  However, this has more to do with the finances of the bank, and not the spending and investment by firms and households in the economy.  Increasing the minimum reserve requirement could be more effective than changing the discount rate because it would decrease the amount of funds available for banks to make loans with since they have to hold more reserves.  This tactic also poses an important issue, though, in that it would cause immediate liquidity problems for banks with low excess reserves that cannot meet the new requirement.

                  It is important to note that while raising the target for the Fed Funds rate and selling securities in the open market to maintain this increased rate are contractionary measures, they are not a signal that the economy has reached or is about to reach its potential output and thus the time has come to scale back that growth.  Instead, these measures are the beginning of the contractionary actions on the current expansionary monetary policy.  Following the completion of the Quantitative Easing program, the next conceivable step for the Fed is to slowly increase the Fed Funds rate.  This change will not only show that the economy has improved over the last few years, but it will also instill confidence in consumers and investors alike that economic growth is expected to continue in the future.

The Future for Yellen’s Fed by Joey Caffrey

When the time comes for the Fed to take the next step in terms of scaling back its accommodation it will need to figure out not only how to do so but how to communicate doing so.  As Bernanke emphasized in his time as the Chairman of the Fed, communication is key.  Once Janet Yellen and the Fed decide that it is time to further scale back its accommodation they need to make a strong case to the public that it is time to do so.  Assuming that the economy is strong once these discussions start happening, it is important that the Fed use the evidence in a convincing manner to show that the economy will hold up without accommodation.  The market has relied on the Fed’s accommodation for quite some time, and for that reason the Fed needs to be very clear with its communication as to what its plans are for the Fed Funds Rate and other policy tools in the future.  Bernanke adeptly laid out the future of the Fed Funds Rate by setting the unemployment rate threshold, but Yellen will need to begin to give further guidance to the public by hinting what exactly would trigger an increase in the Fed Funds Rate.

            Specifically, the Fed needs to be clear about what it will do with the Fed Funds Rate once the threshold of 6.5% for unemployment is reached.  However, the Fed should continue to be clear that the unemployment rate is just a threshold and not a trigger.  Also, it would be best to wait until the tapering is finished to address the Fed Funds Rate.  This way, the Fed can analyze the effects of the taper and get a good measure on the strength of the economy before moving forward.  Of course the inflation rate is another thing that the Fed needs to be wary of, because although the unemployment situation has been getting better the inflation rate is still lower than its 2% objective.  It would also be wise to make sure the indicators for unemployment do not have any serious underlying caveats before changing the Fed Funds Rate.  Taking into account all the indicators on the economy, the picture will likely become clear quite soon that it is time to remove the highly accommodative policy.  It started with the taper, and the Fed Funds Rate is the next, and likely final, step.

            The economy right now is not quite ready for the talk about whether or not the Fed should start to sell its securities.  Such a contractionary measure would only come once inflation starts to rise more closely towards its target, and if unemployment were to become exceptionally low.  Clearly, the Fed Funds Rate is the next thing on tap for the Fed, and other than that its other tools and strategies should stay just about the same.  Although the communication will now be coming from a different Chairperson, it is still one of the Fed’s most important tools and hopefully Janet Yellen will continue to lay out the path of the Fed’s policy for the public, as Bernanke prided himself on doing.  That being said, the economy is in a good place, this is a good conversation to be having, and hopefully the Fed Funds Rate will return to normal levels at the correct time. 

Consequences of the Breakup of the Euro

by Teodor Deliev and Trip Propper

The Euro is a currency union where multiple countries adopted a single currency— the euro. Though a currency union makes trade easier, it also disables individual countries from conducting monetary policy. Monetary policy in the member countries has to be conducted by the European Central Bank (ECB) since only one currency supply exists for all the countries in the Euro Zone.[1] The Euro started in 2002 and now consists of seventeen countries. However, the debt of several countries using the Euro — Portugal, Greece, Ireland— has sharply increased. Few economists believe that the Euro Zone will dissolve, but what would be the effect on the global economy if the Euro did dissolve?[2]

If the Euro Zone were to collapse, countries whose economies are performing strongly, such as Germany, could implement their own contractionary monetary policies and thus lower inflation. For example, England, which did not join the Euro Zone, is now able to use monetary policy to recover from the recession. In contrast, countries in a recession, such as Greece, could conduct expansionary monetary policies in order to increase aggregate demand and production. If Greece adopts the drachma (its currency before the euro), the government could use expansionary monetary policy to increase the supply of drachmas and thus depreciate (decrease in value) the drachma. As a result, Greek goods will become cheaper to foreigners, and Greece will produce and export more. This will stimulate Greece’s economy, increase the GDP and help the country climb out of its current recession. The collapse of the Euro Zone will also be helpful for Germany. As Germany converts back to the Deutsche mark, the demand for the Deutsche mark would increase and the demand for the other currencies would decrease. As a result the Deutsche mark would appreciate, and German imports would increase, and as a result, aggregate demand would decrease, therefore lowering inflation, which is currently high in Germany.[3]

The main negative consequences that would follow the break up of the Euro Zone are the effects of the new currencies and their exchange rates. First of all, having different currencies would hinder trade within Europe. Different currencies would have to be converted in order for countries to trade. Second, abandoning the Euro as a currency would affect consumer confidence and encourage households to “rein in their spending.”[4] A number of other countries are likely to enter into a “very serious recessions.[5] The United Bank of Switzerland predicts that the stronger countries might experience 20-25 percent contraction in GDP, while the weaker countries might suffer 50 percent contraction.[6]

Created in 1998, the Euro Zone united most of the EU members and adopted a single currency in order to encourage trade. Without different currencies, countries could not devalue their currencies and thus increase their exports. The financial crisis in 2008 brought turmoil in the Euro Zone and countries like Greece, Ireland and Portugal have experienced huge budget deficits. The ECB should implement any possible policies to keep the Euro Zone strong and to sustain healthy economies of the countries, because, if the Euro Zone collapses, countries can enter a recession “on a scale beyond modern experience in a Western democracy.”[7] However, countries such as Greece, Ireland and Portugal should withdraw from the Euro Zone in order to take control over their economies and stimulate economic growth.

Sources

“ECB: The European Central Bank”, n.d. http://www.ecb.int/ecb/html/index.en.html.

“Euro News - The New York Times.” New York Times, September 13, 2011.

http://topics.nytimes.com/top/reference/timestopics/subjects/c/currency/euro

index.html.

Ewing, Jack, and James Kanter. “In Euro Zone, Some See Risk of Currency Breakup.” The New York Times, November 17, 2010, sec. Business Day / Global Business.

http://www.nytimes.com/2010/11/18/business/global/18zone.html.

“Treasury fears effects of a euro break-up - FT.com”, n.d.

http://www.ft.com/intl/cms/s/0/eb62a6d4-eb77-11e0-a576

00144feab49a.html#axzz1aWwKUmza.

“Why collapse of the euro equals collapse of the EU – Telegraph Blogs”, n.d.

http://blogs.telegraph.co.uk/finance/andrewlilico/100011966/why

collapse-of-the-euro-equals-collapse-of-the-eu/.

---

[1] “ECB: The European Central Bank”, n.d., http://www.ecb.int/ecb/html/index.en.html.

[2] Jack Ewing and James Kanter, “In Euro Zone, Some See Risk of Currency Breakup,” The New York Times, November 17, 2010, sec. Business Day / Global Business, http://www.nytimes.com/2010/11/18/business/global/18zone.html.

[3] Ibid.

[4] “Treasury fears effects of a euro break-up - FT.com”, n.d., http://www.ft.com/intl/cms/s/0/eb62a6d4-eb77-11e0-a576-00144feab49a.html#axzz1aWwKUmza.

[5] Ibid.

[6] “Why collapse of the euro equals collapse of the EU – Telegraph Blogs”, n.d., http://blogs.telegraph.co.uk/finance/andrewlilico/100011966/why-collapse-of-the-euro-equals-collapse-of-the-eu/.

[7] Ibid.

European Bank Troubles

by Ah Young Yoo and Gabrielle Reisner

When one thinks about bank troubles in Europe, one might assume that these issues have to do with short term funding problems. However, the real concern has to do with long-term lack of availability of funds and the ensuing financial impasse. Despite European banks’ efforts to issue more stable bonds since the financial crisis, the ownership of financial debt could soon prove to be a threatening problem.[1] Banks are refusing to lend because they can’t borrow due to the unknown quantity of the total debt that Greece owes. Because they cannot get any investment since the investors’ risk of not being able to retrieve the investment is very high—with instable economies of a few European countries including Greece and Portugal—the local banks are holding onto the reserves they have in case those fragile economies go into default.[2] Because of this situation, European financial markets are in limbo and have been stuck in a rather inactive state since the 2008 financial crisis, and even worse, such conditions are affecting the worldwide financial market. Reduction of banks’ lending is resulting in a decreased ability to invest in physical and financial capital, which interferes with economy’s self-recovery. Many measures have been taken in order to financially assist the local banks[3] and trigger investment into Europe; many developed countries and European countries themselves put much effort into the Europe-wide recapitalization plan, wealth transfers have been attempted, and legislation for greater fiscal coordination has been passed. However, most of the remedies were proven to be not helpful or unsustainable due to their temporary nature.

If any of the European banks were to go bankrupt due to the ownership of an overwhelming amount of Greek debt, investments would go down the drain. As a result, people would lose confidence in the Euro and the Euro would crash. An extreme long term effect could be hyperinflation.

Given above circumstances, it may be a better solution to tackle the origin of the problem. Instead of giving fleeting remedies that will only be needed once more if the problem persists, supporting Greece and other countries with turbulent economies by international funding by the IMF or more loose regulations could cure the issue from the very bottom of it.

Sources

Aglionby, John. “Eurozone Crisis.” Financial Times: October 12, 2011.

Thomas, Landon Jr. “In Euro Zone, Banking Fear Feeds On Itself.” The New York Times: September 6, 2011.

---

[1] John Aglionby, “Eurozone Crisis,” Financial Times (October 12, 2011).

[2] Ibid.

[3] Landon Thomas Jr., “In Euro Zone, Banking Fear Feeds On Itself,” The New York Times (September 6, 2011)