Prosperous nations have institutions that foster broad participation in the governing process at all levels, and afford opportunities for its citizens to be employed and participate in producing goods and services - and to share in the fruits of production.
These goals are not always attained - nations have periodic bouts of unemployment and national output well below potential. When this happens, government is generally held responsible. Some critics will insist that "government is the problem" - it tries to do too much or "gets in the way." Others believe that government either does too little, or does the wrong thing.
Either way, institutions of government, the Congress, and mainly the President and executive branch, ultimately will be held responsible.
After the Great Depression of the 1930s, followed by four years of wartime prosperity, the nation did not want to return to the dismal times of the 1930s. Congress enacted the Full Employment Act of 1946 that decreed that the federal government should play an active role in promoting full employment.
It gets back to institutions once again. There are many private and public institutions, including corporations, organized labor, universities and technical schools, and effective government that need to be in place and functioning. But that's all long-run stuff. In the shorter run, what public policies are available to promote full employment?
We have fiscal policy, federal spending and taxing controlled by Congress and the President that directly affects the economy, and monetary policy conducted by the nation's central banking system, the "Fed."
Let's take a closer look at the Fed and monetary policy with its goals and limitations. The role of monetary policy is to affect the supply of money and credit in the economy with the objective of promoting employment while preventing inflation.
The Fed has three basic tools with which to influence the money supply: The reserve requirement, the discount window, and open market operations.
Our banking system operates on a "fractional reserve" basis. A fraction of a bank's deposits must be kept on reserve either in vaults or as deposits in the Central Bank. The remainder can be loaned out as part of the nation's money supply. If the reserve requirement is raised or lowered, this either decreases or increases the nation's money supply. The reserve requirement is changed only infrequently.
The discount window is where banks can borrow on a short-term basis from the Fed at the "discount rate." If the rate is raised, this discourages banks from borrowing.
By far the most frequently used method for influencing the nation's money supply and availability of credit is "open market operations," where the Fed buys and sells government securities on the open market, thereby affecting the "federal funds rate."
Since the amount of reserves a bank wants to hold can change as deposits and transactions change, a bank may need additional reserves on a short-term basis. It can borrow them from other banks that may have more reserves than they need. These short-term loans take place in private financial markets called the "federal funds market." The rate at which these loans occur is the "federal funds rate." This rate fluctuates with the demand and supply of reserves.
The Fed can influence this rate through its open market operations. If the Fed wants the funds rate to fall, it buys government securities from banks. This increases the banks' reserves, putting downward pressure on interest rates. Also, recall that buying government bonds increases their price, and bond prices and interest rates are inversely related.
If the Fed wants the funds rate to rise, it does the reverse, selling government securities.
If all this seems like a rather indirect way to affect employment and the economy, it is. You can lead a horse to water but you can't make him drink. If he's thirsty, of course, he will.
The Fed can lower short term interest rates, thereby relieving potential borrowers of the restriction of high interest rates. But if business management doesn't see the market for increased product, or that the additional money can't be profitably invested, lower interest rates will not be sufficient incentive to borrow.
Just as the business person is ill-advised to borrow without a profitable return on newly invested money, so the consumer who is already in debt, or has inadequate income, is ill-advised to borrow even at low interest rates.
It is in this sense that monetary policy is asymmetric in its application to recession as opposed to an expansionary economy. Low interest rates do not necessarily mean that businesses and consumers will borrow and spend sufficiently to get the economy out of recession. However, if interest rates are raised sufficiently high, they will definitely curb borrowing and spending. Because of this, the Fed needs to be cautious about raising interest rates too rapidly.
Open market operations are conducted by the Federal Open Market Committee (FOMC), consisting of the seven-member Fed Board of Governors and five of the 12 Federal Reserve District presidents who serve on a rotating basis.
The FOMC, chaired by Janet Yellen, is followed closely by the mainstream press and financial media. Even a hint by Yellen that the Fed will eventually tighten monetary policy in the future seems to shock Wall Street bankers and fund managers, irrationally in my view. If tighter money and higher interest rates are in conjunction with an expanding economy, higher interest rates are the correct move and should be welcomed, rather than throwing Wall Street into panic. But then, I have always been skeptical of the "rational markets" theory.
An "easy" or expansionary monetary policy is definitely correct policy following recession as we have recently experienced. However, correct as it may be, it is only an indirect measure. We should not be shocked that the Fed cannot by itself produce economic prosperity.
Next week: Rationale of a counter-cyclical fiscal policy.
- John Waelti's column appears every Friday in the Times. He can be reached at jjwaelti1@tds.net.
These goals are not always attained - nations have periodic bouts of unemployment and national output well below potential. When this happens, government is generally held responsible. Some critics will insist that "government is the problem" - it tries to do too much or "gets in the way." Others believe that government either does too little, or does the wrong thing.
Either way, institutions of government, the Congress, and mainly the President and executive branch, ultimately will be held responsible.
After the Great Depression of the 1930s, followed by four years of wartime prosperity, the nation did not want to return to the dismal times of the 1930s. Congress enacted the Full Employment Act of 1946 that decreed that the federal government should play an active role in promoting full employment.
It gets back to institutions once again. There are many private and public institutions, including corporations, organized labor, universities and technical schools, and effective government that need to be in place and functioning. But that's all long-run stuff. In the shorter run, what public policies are available to promote full employment?
We have fiscal policy, federal spending and taxing controlled by Congress and the President that directly affects the economy, and monetary policy conducted by the nation's central banking system, the "Fed."
Let's take a closer look at the Fed and monetary policy with its goals and limitations. The role of monetary policy is to affect the supply of money and credit in the economy with the objective of promoting employment while preventing inflation.
The Fed has three basic tools with which to influence the money supply: The reserve requirement, the discount window, and open market operations.
Our banking system operates on a "fractional reserve" basis. A fraction of a bank's deposits must be kept on reserve either in vaults or as deposits in the Central Bank. The remainder can be loaned out as part of the nation's money supply. If the reserve requirement is raised or lowered, this either decreases or increases the nation's money supply. The reserve requirement is changed only infrequently.
The discount window is where banks can borrow on a short-term basis from the Fed at the "discount rate." If the rate is raised, this discourages banks from borrowing.
By far the most frequently used method for influencing the nation's money supply and availability of credit is "open market operations," where the Fed buys and sells government securities on the open market, thereby affecting the "federal funds rate."
Since the amount of reserves a bank wants to hold can change as deposits and transactions change, a bank may need additional reserves on a short-term basis. It can borrow them from other banks that may have more reserves than they need. These short-term loans take place in private financial markets called the "federal funds market." The rate at which these loans occur is the "federal funds rate." This rate fluctuates with the demand and supply of reserves.
The Fed can influence this rate through its open market operations. If the Fed wants the funds rate to fall, it buys government securities from banks. This increases the banks' reserves, putting downward pressure on interest rates. Also, recall that buying government bonds increases their price, and bond prices and interest rates are inversely related.
If the Fed wants the funds rate to rise, it does the reverse, selling government securities.
If all this seems like a rather indirect way to affect employment and the economy, it is. You can lead a horse to water but you can't make him drink. If he's thirsty, of course, he will.
The Fed can lower short term interest rates, thereby relieving potential borrowers of the restriction of high interest rates. But if business management doesn't see the market for increased product, or that the additional money can't be profitably invested, lower interest rates will not be sufficient incentive to borrow.
Just as the business person is ill-advised to borrow without a profitable return on newly invested money, so the consumer who is already in debt, or has inadequate income, is ill-advised to borrow even at low interest rates.
It is in this sense that monetary policy is asymmetric in its application to recession as opposed to an expansionary economy. Low interest rates do not necessarily mean that businesses and consumers will borrow and spend sufficiently to get the economy out of recession. However, if interest rates are raised sufficiently high, they will definitely curb borrowing and spending. Because of this, the Fed needs to be cautious about raising interest rates too rapidly.
Open market operations are conducted by the Federal Open Market Committee (FOMC), consisting of the seven-member Fed Board of Governors and five of the 12 Federal Reserve District presidents who serve on a rotating basis.
The FOMC, chaired by Janet Yellen, is followed closely by the mainstream press and financial media. Even a hint by Yellen that the Fed will eventually tighten monetary policy in the future seems to shock Wall Street bankers and fund managers, irrationally in my view. If tighter money and higher interest rates are in conjunction with an expanding economy, higher interest rates are the correct move and should be welcomed, rather than throwing Wall Street into panic. But then, I have always been skeptical of the "rational markets" theory.
An "easy" or expansionary monetary policy is definitely correct policy following recession as we have recently experienced. However, correct as it may be, it is only an indirect measure. We should not be shocked that the Fed cannot by itself produce economic prosperity.
Next week: Rationale of a counter-cyclical fiscal policy.
- John Waelti's column appears every Friday in the Times. He can be reached at jjwaelti1@tds.net.
