Financial Markets and Institutions (2-downloads)

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T H E   P R A C T I C I N G   M A N A G E R

Using a Fed Watcher

As we have seen, the most important player in the determination of the U.S. money

supply and interest rates is the Federal Reserve. When the Fed wants to inject

reserves into the system, it conducts open market purchases of bonds, which cause

their prices to increase and their interest rates to fall, at least in the short term. If the

Fed withdraws reserves from the system, it sells bonds, thereby depressing their price

and raising their interest rates. From a longer-run perspective, if the Fed pursues

an expansionary monetary policy with high money growth, inflation will rise and inter-

est rates will rise as well. Contractionary monetary policy is likely to lower inflation

in the long run and lead to lower interest rates.

Knowing what actions the Fed might be taking can thus help financial institution

managers predict the future course of interest rates with greater accuracy. Because,

as we have seen, changes in interest rates have a major impact on a financial insti-

tution’s profitability, the managers of these institutions are particularly interested

in scrutinizing the Fed’s behavior. To help in this task, managers hire so-called Fed

watchers, experts on Federal Reserve behavior who may have worked in the Federal

Reserve System and so have an insider’s view of Federal Reserve operations.

Divining what the Fed is up to is by no means easy. The Fed does not disclose

the content of the minutes of FOMC meetings at which it decides the course of

monetary policy until three weeks after each meeting. In addition, the Fed does not

provide information on the amount of certain transactions and frequently tries to

obscure from the market whether it is injecting reserves into the banking system

by making open market purchases and sales simultaneously.

Fed watchers, with their specialized knowledge of the ins and outs of the Fed, scru-

tinize the public pronouncements of Federal Reserve officials to get a feel for where

monetary policy is heading. They also carefully study the data on past Federal Reserve

actions and current events in the bond markets to determine what the Fed is up to.

If a Fed watcher tells a financial institution manager that Federal Reserve con-

cerns about inflation are high and the Fed will pursue a tight monetary policy and

raise short-term interest rates in the near future, the manager may decide immedi-

ately to acquire funds at the currently low interest rates in order to keep the cost

of funds from rising. If the financial institution trades foreign exchange, the rise in

interest rates and the attempt by the Fed to keep inflation down might lead the man-

ager to instruct traders to purchase dollars in the foreign exchange market. As we

will see in Chapter 15, these actions by the Fed would be likely to cause the value

of the dollar to appreciate, so the purchase of dollars by the financial institution

should lead to substantial profits.

If, conversely, the Fed watcher thinks that the Fed is worried about a weak econ-

omy and will thus pursue an expansionary policy and lower interest rates, the finan-

cial institution manager will take very different actions. Now the manager might

instruct loan officers to make as many loans as possible so as to lock in the higher

interest rates that the financial institution can earn currently. Or the manager might

buy bonds, anticipating that interest rates will fall and their prices will rise, giving the

institution a nice profit. The more expansionary policy is also likely to lower the value

of the dollar in the foreign exchange market, so the financial institution manager

Access

www.federalreserve

.gov/pf/pf.htm

and review

what the Federal Reserve

reports as its primary

purposes and functions.

G O   O N L I N E

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Part 4 Central Banking and the Conduct of Monetary Policy

might tell foreign exchange traders to buy foreign currencies and sell dollars in order

to make a profit when the dollar falls in the future.

A Fed watcher who is right is a very valuable commodity to a financial institu-

tion. Successful Fed watchers are actively sought out by financial institutions and

often earn high salaries, well into the six-figure range.

S U M M A R Y

1. The three basic tools of monetary policy are open

market operations, discount policy, and reserve

requirements. Open market operations are the pri-

mary tool used by the Fed to control interest rates.

2. The conduct of monetary policy involves actions that

affect the Federal Reserve’s balance sheet. Open mar-

ket purchases lead to an expansion of reserves and

deposits in the banking system and hence to an

expansion of the monetary base and the money sup-

ply. An increase in discount loans leads to an expan-

sion of reserves, thereby causing an expansion of the

monetary base and the money supply.

3. A supply-and-demand analysis of the market for

reserves yields the following results: When the Fed

makes an open market purchase or lowers reserve

requirements, the federal funds rate declines. When

the Fed makes an open market sale or raises reserve

requirements, the federal funds rate rises. Changes in

the discount rate may also affect the federal funds rate.

4. The monetary policy tools used by the European

Central Bank are similar to those used by the Federal

Reserve System and involve open market operations,

lending to banks, and reserve requirements. Main

financing operations—open market operations in

repos that are typically reversed within two weeks—

are the primary tool to set the overnight cash rate at

the target financing rate. The European Central Bank

also operates standing lending facilities that ensure

that the overnight cash rate remains within 100 basis

points of the target financing rate.

5. The six basic goals of monetary policy are price sta-

bility (the primary goal), high employment, economic

growth, interest-rate stability, stability of financial

markets, and stability in foreign exchange markets.

6. A nominal anchor is a key element in monetary policy

strategy. It helps promote price stability by tying

down inflation expectations and limiting the time-

inconsistency problem, in which monetary policy

makers conduct monetary policy in a discretionary

way that produces poor long-run outcomes.

7. Inflation targeting has several advantages: (1) It

enables monetary policy to focus on domestic con-

siderations; (2) stability in the relationship between

money and inflation is not critical to its success; 

(3) it is readily understood by the public and is highly

transparent; (4) it increases accountability of the cen-

tral bank; and (5) it appears to ameliorate the effects

of inflationary shocks. It does have some disadvan-

tages, however: (1) Inflation is not easily controlled

by the monetary authorities, so that an inflation tar-

get is unable to send immediate signals to both the

public and markets; (2) it might impose a rigid rule

on policy makers, although this has not been the case

in practice; and (3) a sole focus on inflation may lead

to larger output fluctuations, although this has also

not been the case in practice.

8. There are two types of bubbles, credit-driven bubbles,

which are highly dangerous and so deserve a response

from central banks, and bubbles driven solely by irra-

tional exuberance, which do not. Although there are

strong arguments against having monetary policy

attempt to prick bubbles, appropriate macropruden-

tial regulation to reign in credit-driven bubbles can

improve the performance of both the financial system

and the economy.

9. Because interest-rate and aggregate policy instru-

ments are incompatible, a central bank must choose

between them on the basis of three criteria: measur-

ability, controllability, and the ability to affect goal

variables predictably. Central banks now typically use

short-term interest rates as their policy instrument.

10. Because predicting the Federal Reserve’s actions can

help managers of financial institutions predict the

course of future interest rates, which has a major

impact on financial institutions’ profitability, such

managers value the services of Fed watchers, who are

experts on Federal Reserve behavior.

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Chapter 10 Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics

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asset-price bubbles, p. 243

defensive open market operations,