Inflation Targeting and the Federal Reserve

What is the Federal Reserve?

The Federal Reserve (the Fed) serves as the central bank in the United States of America.  It was formed in 1913 to help create safer banking practices and promote financial stability.  Today, the Fed’s stated goals are to “promote the objectives of maximum employment, stable prices, and moderate long-term interest rates.[1]

(1) Maximum Employment:

  • When unemployment is high, the economy is not operating at its full potential, which can lead to lower production and output (lower GDP)
  • There is always going to be some level of unemployment in an economy (called the natural rate of unemployment)
    • Structural unemployment occurs when the skills an unemployed person has does not match the skills needed on the market
    • Frictional unemployment occurs when a worker is transitioning between jobs.  The worker may have other job opportunities available to him, but chooses to be unemployed in order to hold out for a better offer (high salary, better benefits)
  • Hence, the Fed does not target an unemployment rate of zero, but it does seek to promote full employment, which occurs when the demand for labor equals the supply of labor

(2) Price stability (or low and stable inflation):

  • Inflation occurs when the supply of money increases relative to the demand for money
  • A rising price level creates uncertainty in the economy and makes it difficult to plan for the future
  • History suggests that inflation leads to lower economic growth
  • When prices are changing, it is hard to convey whether the change in the price of a particular good or service is due to changes in the demand for the good or because money was injected into the economy (i.e. inflation distorts prices)
  • According to the Fed, “When prices are stable and believed likely to remain so, the prices of goods, services, materials, and labor are undistorted by inflation and serve as clearer signals and guides to the efficient allocation of resources and thus contribute to higher standards of living.”[2]

(3) Interest Rate Stability:

  • According to the Fed, fluctuations in interest rates create uncertainty in the economy and make it harder to plan for the future
  • An increase in interest rates create large capital losses on long-term bonds and mortgages and can also lead to the failure of the financial institutions who hold them

How is the Federal Reserve Structured?

The Federal Reserve System is comprised of twelve district banks, headed by a Board of Governors.  The seven members, who comprise the Board of Governors, are appointed by the President of the United States and confirmed by the U.S. Senate.  Each Board member comes from a different district bank and serves a fourteen-year term.  The seven members of the Board of Governors also sit on the twelve-member Federal Open Market Committee (FOMC), which sets the monetary policies of the country through influencing the availability of money and credit in the economy.  The five other members of the FOMC serve as presidents of different district Reserve Banks, whose membership rotates annually.  However, the President of the Federal Reserve Bank of New York is always a member of the Committee.

What tools does the Fed have at its disposal to promote its stated goals?

There are three main tools the Fed uses to promote maximum employment, price stability, and interest rate stability.

(1) Open Market Operations:

Open Market Operations are the most common way the Fed changes the monetary base, which is the amount of currency in circulation plus the total amount of reserves in the banking system.  The Fed can change the monetary base by purchasing or selling bonds on the market.  Open Market Purchases of bonds expand the monetary base; increase the money supply and lower short-term interest rates.  Open Market Sales decrease the monetary base and the money supply and raise short-term interest rates.

Over more recent years, the Federal Reserve has focused its attention on affecting the federal funds rate, which is the interest rate on overnight loans that banks lend to one another.  An open market purchase results in a larger quantity of reserves supplied on the market, which lowers the federal funds rate.  Conversely, an open market sale leads to a decrease in the quantity of reserves supplied on the market, which raises the federal funds rate.

(2) Discount Rate:

Another method by which the Fed can affect the money supply is through setting the discount rate, which is the rate at which the Federal Reserve lends money to commercial banks.  After the Federal Reserve Board set the discount rate, banks then have to decide whether or not they will borrow money from the Fed and how much they will borrow.  Typically, a lower discount rate will lead to higher borrowing and an increase in the money supply, while a higher discount rate will discourage bank borrowing and decrease the money supply.

(3) The Reserve Requirement

The other method by which the Federal Reserve can affect the money supply is through changing the required reserve ratio, which dictates how much banks must hold in reserves based on the amount of checkable deposits the bank has.  When the reserve requirement is increased, the bank needs to hold a larger quantity of reserves for a given amount of deposits.  Increasing the reserve requirement decreases the money supply, while decreasing the reserve requirement increases it.  Thus, the Fed can influence the level of deposits by setting the required reserve ratio (the percentage of deposits a bank must hold in their vaults.)

Who else affects the Money Supply?

There are three main entities that affect the money supply.  Banks are able to affect the money supply by changing the amount of excess reserves they hold (the money they hold in reserves above the reserve requirement).  When excess reserves are low (e.g. banks have made more loans to consumers and businesses), the money supply is higher with all other factors held constant.  The money supply is also affected by how much a depositor decides to hold in currency, and by how much people borrow from banks.    

How do we know if the Fed is hitting its targets?

Maximum Employment:

Since 1948, there have been large fluctuations in the Unemployment Rate, which means employment has not been stable over the historical time period.

Price Stability:

As mentioned before inflation arises when the supply of money increases relative to the demand for money, which leads to a rise in the general price level of goods and services over time.  This lead economist Milton Friedman to declare, “Inflation is always and everywhere a monetary phenomena.”[3]  When the general price level of goods and services increases, it becomes more expensive for an individual to buy the same goods he was previously buying.  In other words, a dollar buys less.

The Consumer Price Index (CPI) is the most common method used to calculate inflation.  The Bureau of Labor Statistics collects the data that go into the Index.  The CPI is calculated by measuring the price of a “basket” of goods and services that are bought by the typical American household.  The Index is supposed to measure typical American citizen’s cost of living and gives people an idea of how prices have risen or fallen over time.

Some of the categories that are tracked in the Index are food and beverages, housing, apparel, transportation, medical care, recreation, education and communications, and other goods and services, such as water and sewer services.

Since the Fed’s establishment in 1913, there have been several bouts of monetary instability.  For instance, inflation skyrocketed starting in the early part of the 1970s.  Interestingly, the United States abandoned the Gold Standard in 1971, which indicates that prices were much more stable under the Gold Standard than they have been since the abandonment of the Gold Standard.

Some economists are concerned that the CPI index does not fully capture inflation in the economy.  First, the goods in the CPI index change from time to time, making it difficult to accurately document changes in prices since different baskets are actually being compared across time.  In other words, the 1970 CPI basket is different from the 2012 basket.  Economists are also concerned because it is unclear how the CPI adjusts for changes in the quality of goods and services.

While All Items CPI for All Urban Consumers (CPI-U) does incorporate energy and food prices in it’s measuring, the CPI index that is most commonly reported is the CPI-U for All Items Less Food and Energy.                                                                                                 

Interest Rates:

As previously stated one of the goals of the Federal Reserve is to stabilize Interest Rates.  First, it is important to understand what interest rates are and how they are determined.  According to Economist Irving Fisher, “The rate of interest expresses a price in the exchange between present and future goods.”

Interest rates depend on individual’s time preference, i.e., how they value a dollar in the future relative to a dollar today.  An individual who has high time preference focuses on the present and values goods and services today much higher than goods and services in the future, while an individual with low time preference puts more weight on the future.

There are several factors that can affect the interest rate.  “Together intertemporal preferences and transformation opportunities determine the sequences of outputs and interest rates. “

When interest rates increase, the structure of production becomes less roundabout, redistributing productive resources away from producer goods toward consumer goods. When interest rates rise, higher rates of return in production are necessary to compete with financial instruments such as relatively higher-yielding government bonds.

When the Federal Reserve manipulates the Interest Rate it distorts the market and either production possibilities will not be realized (if the market interest rate is higher than the natural rate) or producers will invest in projects they otherwise would not have if the market interest rate is artificially low.

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  1. [...] The Federal Reserve (the Fed) serves as the central bank in the United States of America.  It was formed in 1913 to help create safer banking practices and promote financial stability.  Today, the Fed’s stated goals are to “promote the objectives of maximum employment, stable prices, and moderate long-term interest rates.[1]” [...]