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.
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