Page 6 - ISQ - April 2022

INVESTMENT STRATEGY QUARTERLY

Monetary Policy Tools
achieved. These promises help to keep long-term interest
rates low, promoting growth.
Open market operations Reserve requirement
During the 2008 financial crisis, the FOMC lowered the federal
funds target range to 0-0.25%. Seemingly out of ammo, the FOMC
began its first Large-Scale Asset Purchase program (LSAP), which is
BOND
more commonly called quantitative easing (QE). In quantitative
easing, the Fed buys large amounts of Treasury and mortgage-
BOND BOND
backed securities each month. The Fed employed QE1, QE2, and
Buy or sell 3% or 10% of
demand deposits QE3 in the aftermath of the financial crisis, and restarted asset
purchases on a massive scale in the early stages of the pandemic.
The Fed’s asset purchases helped lower long-term interest rates,
Reserves Interest
although they seemed to become less effective at each stage.
Interest Loans Unwinding the balance sheet will work in the opposite way, raising
long-term interest rates.

The Fed’s asset purchases have ballooned the size of its balance
FED sheet to nearly $9 trillion (it was below $1 trillion before the
financial crisis and around $4 trillion before the pandemic). The
FOMC expects to begin unwinding its balance sheet later this year.
That will occur naturally over time, as the FOMC reinvests a portion
Interest on required Discount rate of maturing securities. The FOMC does not plan to sell securities
and excess reserves out of its portfolio outright, although it will be buying and selling
Source: Federal Reserve across maturities as the size of the balance sheet declines. The
overnight lending rate that banks charge each other for ultimate size of the balance sheet is uncertain; however, it will be
borrowing reserves. Reserves are balances held at the Fed to based on maintaining an adequate level of reserves in the banking
satisfy banks’ reserve requirements. Banks with excess reserves system.
can lend them to banks that need larger reserves. The federal
funds rate is a market rate. The Fed sets a target range and MONETARY POLICY IN PRACTICE
performs open market operations (buying or selling Treasury In theory, monetary policy uses the money supply to influence
securities) to achieve it (hence, the name ‘Open Market employment and inflation, but the money supply plays no role in
Committee’). The federal funds rate (and where it appears to be policy decisions. As Chair Powell testified in 2021: “The
headed) affects longer-term interest rates. In raising the federal connection between monetary aggregates and either growth or
funds rate, the Fed ‘tightens’ the availability of credit. Lowering inflation was very strong for a long, long time, which ended
the federal funds rate ‘eases’ credit conditions. about 40 years ago. It was probably correct when it was written,
but it’s been a different economy and a different financial system
The primary credit rate (sometimes still called the discount rate) is for some time.”
the rate that the Fed charges banks for short-term borrowing. The
Fed’s Board of Governors approves (or not) a request for a change Policy decisions are based on a wide range of information.
in the primary credit rate made by one or more of the federal The Fed doesn’t react to the economic data per se, but to what
district banks. Typically, the primary credit rate is changed at the the data imply for the outlook ahead. Economic data are
same time as the federal funds target. Note that the FOMC only subject to statistical noise and seasonal adjustment quirks
began to announce changes to the federal funds target in 1994. and are often revised. The Fed also relies on anecdotal
Before that, the discount rate, a posted rate, was viewed as the information collected by the district banks to gauge labour
main policy signal. market conditions and inflation pressures.

The Fed sometimes employs forward guidance, a conditional The FOMC arrives at its policy decisions by consensus. Officials
commitment to keep the federal funds rate low for a certain are in touch with each other before policy meetings and a
period of time or until some economic objective has been decision rarely hasn’t been worked out in advance. Occasionally,

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