The Federal Reserve Bank of the United States is the bankers’ bank. It issues charters for banks to operate and regulates all the commercial banks in the country. If a bank in the United States does not follow the Fed’s rules or if it ends up insolvent, the Federal Reserve will seize the bank and have the FDIC liquidate it. The Federal Reserve Bank also creates the money we use in this country and is responsible for conducting Monetary Policy. Monetary Policy is the active use of setting or influencing interest rates and increasing or decreasing the Money Supply to steer the U.S. economy. In implementing its Monetary Policy, the Fed has two objectives:
- To achieve full employment in the U.S. Economy
- To keep inflation under control (the target rate of the Fed is 2% annual inflation – defined as a 2% annual increase in the rate of price increases in Personal Consumption Expenditures not including Food or Energy)
Theoretically, the Federal Reserve Bank can create unlimited amounts of money, but in normal times, the Fed increases money enough to support the growth of GDP because everyone needs money to buy goods and services. For example, a trillion dollars of money buys two trillion dollars of GDP in the course of a year, if you expect the GDP to grow by 10% this year, the Fed needs to facilitate that growth by creating 10% more money and injecting it into the economy. This relationship between GDP and the Money Supply is central to the Quantity Theory of Money. The Quantity Theory of Money states that the growth rate of Gross Domestic Product (nominal GDP) and growth rate of the Money Supply are equal:
This is supported in the long run by empirical evidence. Moreover, we can use this equation to create other equations. Since we can separate the growth rate of nominal GDP into the growth rate of real GDP plus the growth rate of prices over time (inflation), we can write this as:
We can then substitute equation (B) above into equation (A) and get:
Rearranging (C) gives us the Infation Equation:
Equation (D) tells us about an important constraint on the Fed’s ability to create unlimited amounts of money. If the Fed allows the Money Supply to grow faster than the growth rate of real GDP, prices will rise; that is, we will have inflation. The Inflation Equation prompted Nobel Prize winning economist Milton Friedman to state, “Inflation is always and everywhere a monetary phenomenon.”
Figure 16.13. M2 and Infation by Bkwillwm is used under a CC BY-SA 3.0 License.
Friedman advocated for a steady rate of monetary growth at a moderate level. This, he felt, would provide a framework under which a country can have little inflation and much growth. If we look at the data, it appears that the Fed has followed this advice (until just recently):
Figure 16.14. Board of Governors of the Federal Reserve System (US), M2 (DISCONTINUED) [M2], retrieved from FRED, Federal Reserve Bank of St. Louis; September 30, 2021.
Unfortunately, the Quantity Theory of Money assumes a constant ratio of annual Gross Domestic Product to annual Money Supply (M2). This ratio (GDP/ M2) is called the Velocity of Money. It actually shows the turnover of M2 or equivalently how many dollars of GDP does one dollar of M2 buy in a year. When Milton Friedman was doing his Nobel Prize-winning research, this ratio was quite stable. However, this relationship has broken down in recently, so now we likely need to revise Macroeconomic Theory. See the graph of Velocity of Circulation below.
Figure 16.15. Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock [M2V], retrieved from FRED, Federal Reserve Bank of St. Louis; September 30, 2021.
The Federal Reserve is very diligent about trying to fulfill its dual mandate of full employment and low inflation. They accomplish this by lowering short-term interest rates and increasing Money Supply during recessions. This makes it cheaper for commercial banks to borrow money in the wholesale credit markets and for bank customers to borrow money. Conversely, the Fed raises short-term interest rates and decreases the Money Supply when inflation appears to be in danger of moving above their target rate of two percent. This makes it more expensive for both the banks and their customers to borrow money.
The short-term interest rate that the Fed controls is the Federal Funds Rate. The Federal Funds Rate is the rate that banks lend each other overnight. However, all short-term interest rates in the market follow the Fed Funds Rate, so this rate effectively becomes the wholesale cost of funds to the banks. That is, this is the rate at which banks borrow money. You can see from the following graph their historical record. (The gray bands are recessions.)
Figure 16.16. Board of Governors of the Federal Reserve System (US), Effective Federal Funds Rate [FEDFUNDS], retrieved from FRED, Federal Reserve Bank of St. Louis; October 3, 2021.
The lesson here is that the Fed has dropped short-term interest rates when recessions occur in order to stimulate the economy and conversely raises short-term rates in economic expansions to guard against inflation accelerating. Although forecasting the future is very difficult to do, the Fed tries, with their economic modeling, to anticipate the movements of the business cycle at least a year in the future; based on that, they calibrate their interest rate actions. The full effects of Federal Reserve Monetary Policy actions take approximately eighteen months to filter through the credit markets and the economy. You can see from the graph above that in the previous recession (December 2007 to June 2009) the Fed Funds Rate was reduced from 5% to 0%, and it was reduced to 0% again in the Pandemic Recession. This means that the banks’ cost of money was almost zero, leading all short-term rates to drop precipitously again.
Over the long run, the average Federal Funds Rate has been 4.74%, so dropping the Fed Funds Rate to 0% is extraordinary. Sometimes the dual objectives of the Fed (full employment and low inflation) are in conflict. The negative correlation between high levels of unemployment and low rates of inflation is known as the Phillips Curve, after the economist who first wrote about this phenomenon. The historical record shows strong evidence for this relationship.
Figure 16.17.U.S. Bureau of Economic Analysis, Personal Consumption Expenditures (PCE) Excluding Food and Energy (chain-type price index) [DPCCRV1Q225SBEA], retrieved from FRED, Federal Reserve Bank of St. Louis; October 4, 2021. U.S. Bureau of Labor Statistics, Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis; October 4, 2021.
Note in the graph above that when the unemployment rate goes up (the blue line), the inflation rate (the red line) goes down (often with some lag). However, the traditional Phillips Curve (the inverse relationship of inflation and unemployment) has broken down in the last ten years, as you can see from the following graph. The unemployment rate decreased to a fifty-year low of 3.5% in February 2020, and inflation stayed below the 2% target of the Federal Reserve Bank. There are a number of reasons for this, but I do not have the space here to talk about it in detail.
Figure 16.18. U.S. Bureau of Economic Analysis, Personal Consumption Expenditures Excluding Food and Energy (Chain-Type Price Index) [PCEPILFE], retrieved from FRED, Federal Reserve Bank of St. Louis; October 5, 2021. U.S. Bureau of Labor Statistics, Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis; October 5, 2021.
For the rate of inflation, I am using the preferred inflation measure of the Federal Reserve Bank. This is the change in prices of Personal Consumption Expenditures not including food and energy (which the Fed considers too volatile). This price index is known as the PCE Price Index, excluding food and energy and its annual change is the rate of inflation.
The Fed not only lowered short-term interest rates to the lowest in sixty years, but beginning in the Great Recession, they performed some unprecedented actions under Chair Ben Bernanke to bring long-term interest rates down dramatically. At the start of the Great Recession, the Federal Reserve Bank had approximately $800 billion worth of assets. In 2008, the Fed increased their assets to $2 trillion by increasing the money on their computers. This is sometimes called printing money, but no paper currency is actually printed; instead, money appears electronically out of thin air. This is why money that has no gold or silver standard behind it is called fiat money.
If you look at the graph below, you can see that from 2008 to 2015, the Fed increased its assets to approximately $4.5 trillion. It used this money to buy long-term U.S. Treasury Bonds and mortgage-backed bonds issued by Fannie Mae and Freddie Mac, the government home mortgage agencies. This brought down long-term interest rates to their lowest in 50 or 60 years for Treasury and corporate bonds, as well as for home mortgages. The financial markets dubbed this action Quantitative Easing, although Ben Bernanke has said that he did not favor the term, instead preferring the name, “long term asset purchases.”
Figure 16.19. Board of Governors of the Federal Reserve System (US), Assets: Total Assets: Total Assets (Less Eliminations from Consolidation): Wednesday Level [WALCL], retrieved from FRED, Federal Reserve Bank of St. Louis; October 3, 2021.
As is evident from this graph, the Fed began to dispose of the trillions of dollars in bonds in 2018 by selling small amounts per month on the open market. However, as the Pandemic Recession took hold, the Fed revived their playbook from the Great Recession and increased the money on their computers within one month to $7.1 trillion. This additional money has been used to lend to banks, to buy more Treasury bonds, and to buy more bonds issued by Fannie Mae and Freddie Mac. The Fed is also buying bonds issued by major corporations and has begun a program called “Main Street Lending” whereby the Fed has set aside $500 billion to lend money to mid-sized corporations, which will be guaranteed by the U.S. government.
The effect of the Fed’s increased demand for long term bonds has brought the 10-year Treasury bond yield to .6% and 30-year home mortgages to 2.98%. These are the lowest rates ever in the history of U.S. financial markets. Additionally, Jerome Powell has stated that the Fed will keep both short-term and long-term interest rates at this low level “as long as it takes” for the economy to recover.
The fiscal stimulus passed by Congress and the monetary stimulus enacted by the Federal Reserve Bank worked remarkably well. By early 2020, the unemployment rate had dropped from almost 15% to a low of 3.5%, the lowest in about 60 years. However, in a cruel economic reversal, inflation took off, fueled by supply-chain bottlenecks due to the pandemic and as a result of the Russian invasion of Ukraine. By early February 2020, inflation was about 8% nationally in the U.S.
The Federal Reserve abruptly reversed its program of monetary stimulus and in 2020 raised short-term rates from effectively 0% to 3%. (the Federal Funds Rate). This caused the 10-year treasury bond yield to rise to 4.2% and 30-year mortgage rates to rise from 3% to 7%. As a result a number of economists and financial institutions predicted a recession in early 2023, which is unknown as of this writing.