Federal Reserve chairs love to talk about their toolkit. But what’s in it?
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America’s central bankers love to talk about their toolkit. Tune in to any of their testimonies, speeches or public appearances and chances are it will come up. Ben Bernanke did it. Janet Yellen did it. Current Fed Chair Jerome Powell does it, too.
Talking about the Fed in this way makes them seem like the plumbers or construction workers of the economy. That image is not far from reality. The Fed’s main job — its dual mandate as it is often called — is to keep inflation low and to maintain full employment. That means that many of the things that fall under the Fed’s purview have to do with patching up leaks in the economy and ensuring that things are flowing smoothly. And since the Great Recession, the Fed has also been tasked with making sure that many of America’s financial institutions have a strong enough foundation to weather another economic downturn.
So is Powell walking around the Fed wearing a hard hat, tools in hand?
Let’s take a peek into the Fed’s toolkit …
All those bills in your wallet? They are made by the Fed.
“It’s a very good business to be a central bank because you can create money out of thin air,” said Frederic Mishkin, who previously served as a Federal Reserve governor from 2006 to 2008 and is now a professor of banking and financial institutions at Columbia University. “If I was the Frederic Mishkin central bank, what I could do is I could actually take pieces of paper and write Frederick Mishkin notes. I can hand them to you and buy things from you. I could buy bonds, I can buy new Federal Reserve buildings, whatever … In a sense, the Federal Reserve is actually able to do the same thing. In fact, when you look at those little pieces of paper in your pocket that you use as currency, they all say Federal Reserve Notes and the Federal Reserve can basically just print them up.”
The Federal Reserve doesn’t just make sure that we have nice fresh crisp bills in circulation. It also ensures that there is enough money flowing into the economy to keep it chugging along.
The Fed’s ability to create money out of thin air is one of its core tools – it’s kind of like the various building materials such as putty, metal or screws that are used to fix whatever is wrong.
Not only does the Fed decide how much money to print but it also decides how much it should cost to borrow money.
One of the main ways the Fed carries out its dual mandate is by setting short-term interest rates. The short-term interest rates determine how much interest banks pay to borrow from each other overnight.
Think of interest rates as a wrench that the Fed uses to either open or close a valve that controls the flow of money in and out of the economy.
If interest rates are high, fewer people are likely to take out loans and invest back into the economy. High interest rates also make saving more appealing as the money you’ve put away tends to grow faster. On the other hand, if the interest rates are low, money sitting in the bank is not really growing and low interest rates make borrowing money seem more appealing. So people and businesses are more likely to take out loans and put money back into the economy.
Usually, the Fed lowers interest rates during an economic downturn to revive the economy.
Then when the economy is doing better, the Fed has to make sure that there is not too much money in the economy because that could cause the economy to overheat – with too much money flowing into the economy, prices could go up causing inflation to rise at a higher pace. In that case, the Fed would increase interest rates in hopes of encouraging people to save and to discourage high volumes of loans, limiting the flow of money into the economy.
What if the wrench doesn’t work?
Usually lowering short-term interest rates used by the banks also has downward pressure on long-term rates.
During the Great Recession, the Federal Reserve lowered short-term interest rates from more than 5 percent to near zero percent. Interest rates remained near zero percent for about seven years, before the Fed finally raised them in December 2015.
Once the Fed got to zero on short-term interest rates, it had to come up with a different way to put pressure on long-term interest rates. Essentially, the central bankers used the wrench to open up the valve as far as it would go and had to come up with a plan B if they wanted to open it up further.
“In a way, this was like they were going and looking for different tools,” Miskin said. “They found that their usual socket wrench wasn’t working, so then they had to look for different kind of wrenches and screwdrivers and other things in order to get it to work and, in a sense, there was a lot of experimentation.”
That’s when they turned to non-conventional monetary policy, including quantitative easing.
Remember that money that the Fed can make appear out of thin air? Well, after the Great Recession, the Fed took that money and bought assets that are directly tied to long-term interest rates such as government and agency securities and mortgage-backed securities.
“The idea was that by purchasing these securities, we’d reduce the supply of the securities in the market, driving up the prices, and pushing the interest rates on long-term securities down,” Mary Suiter, the Economic Education Officer for the Federal Reserve Bank of St. Louis, said in a “Feducation” video about the Fed’s toolkit. “The purpose was to help the economy, and, by pushing long-term interest rates down, it would benefit people buying houses or cars — long-term kinds of lending.”
It’s as if the Fed was drilling holes into specific markets and then pushing money in through them. By buying government backed securities, the Fed gave money to the U.S. government that could then be invested back into the economy. Similarly, by buying mortgage-backed securities from banks, the Fed increased their cash reserves making it easier for them to lend to their customers.
The Fed is often described as “data centric.” To figure out what to do, the U.S. Central bank looks at inflation data, unemployment, spending, lending, etc. The data — which is collected by various government agencies — serve like measurements that help to create a detailed blueprint of the economy.
“It’s like a blueprint although it would be nice if it was that easy: you just look at the blueprint and know what to do,” Mishkin said. “It’s much harder than that. There’s a real art to central banking, to what the Federal Reserve does. They get information but what they really care about is what’s going to happen several years into the future because when they set monetary policy today it doesn’t have an immediate effect. We think it takes around a year to have a full effect on unemployment and output and maybe two to three years to have its effect on inflation.”
In order to figure out what to do, the central bankers then forecast what the economy will look like in the future and use that along with the data to figure out what tools to use.
If you woke up one day to find a bunch of construction workers walking around your home tightening and loosening a bunch of screws, you’d probably be a little alarmed (fine, maybe more than a little). Same goes for financial markets. That is why one of Fed’s most important tools is forward guidance.
Forward guidance is a simply jargon for communication.
In order not to spook the markets, the Fed regularly releases notes from its meetings, holds a handful of press conferences a year and even releases its economic forecasts.
Think of the forward guidance as a work notice. Just as your landlord might notify you that the water might be shut down in a week for construction, so does the Fed try to give advance notice to the markets about how many rate hikes it expects each year, how much quantitative easing it plans to do or when it plans to start shrinking its balance sheet.
If the Fed communicates consistently and accurately, the markets should barely blink when the Fed uses any of its tools.
In addition to having monetary tools, the Fed also has regulatory tools at its disposal.
Thanks to Dodd-Frank, the Fed is tasked with making sure that financial institutions are prepared for potential future crises. Since the Great Recessions, different types of requirements have been imposed on banks. For example, banks now have to maintain certain amount of capital — or deposits — in case of emergencies. And if they have more riskier assets, they have to hold more capital. These new capital requirements were put in place to minimize the need for future bailouts.
“The other part of Dodd-Frank was that some of the big banks and systemically important financial institutions had to submit living wills and some of those have actually been rejected on the grounds that this isn’t good enough it’s not strong enough,” said Josh Bivens, director of research at the Economic Policy Institute. “So so far I think there are some encouraging signs that the Fed is taking this seriously.”
The living wills are detailed plans that outline how banks and other large financials institutions would enter bankruptcy and liquify their assets if something were to go wrong. The idea is that if these institutions have viable plans for worst case scenarios, then the failure of one financial institution might not bring down the whole economy.
Another regulatory tool at the Fed’s disposal is the stress test. Every year, the Fed takes a look at large financial institutions and their balance sheets and subjects them to hypothetical “shocks” — nightmare economic scenarios like a huge drop in housing prices, a huge jump in unemployment or a stock market crash. If the banks don’t survive the hypothetical shocks, they could receive a failing grade and be told to get more capital onto their balance sheet.
However, as the month of May came to a close, Congress passed a bill repealing parts of Dodd-Frank, including a requirement that small and mid-size banks (banks with less than $250 million in assets) be subject to stress tests.
Living wills and stress tests are like a hammer that the Fed uses to squash certain risks within the financial system.
Does the hammer work?
It’s too early to tell, according to Bivens. “It’s basically like they’ve been handed these tools and whether they use them aggressively enough to restrain genuinely speculative risky behavior, I don’t think they’ve been put to that iron test yet,” he explained. “We’re getting close. Financial markets are very much recovered. Some of them are even looking a little expensive — if not bubbles, at the moment. So in the next couple of years we might really start to see the Fed have to decide about how strict they are going to be about these but I’m afraid we have not tested them yet and I’m a little afraid it’s taken so long for financial markets to recover that people have already forgotten about the last crisis.”
There is one main difference however, Bivens said from the last crisis. This time around, the Fed won’t be able to complain that they didn’t have the tools to do something at their disposal.
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