The federal open market committee (FOMC) is a key body for formulating monetary policies of the Federal Reserve System (the central banking system of United States). Monetary policy involves the measures that are employed by the central bank system such as the Federal Reserve, to control money availability and credits so as to enhance national economic goals. Federal open market committee is, therefore, mandated to develop these policies in order to stabilize prices, ensure full employment, ensuring a sustainable model of international trade and payments and promoting economic growth. The body is also responsible in making key decisions relating to the behavior of open market operations (sales and purchases of both federal agency and U.S government securities) and directing System Operations in foreign currencies (Santow PP. 209-211). This paper pays high attention to the identification of various policy tools that FOMC has developed and utilized since 1970, how the great recession and financial crisis of 2007-2009 altered these policy tools and the analysis of the possible policy tools that FOMC will employ in order to normalize the economic interest rate levels.
Price control policy was adopted by FOMC at the end of 1970 in order to curb the rate of inflation that had risen due to the implementation of stimulation-accommodation policy. Arthur Burns had been appointed as the chairman of Fed board, after which he decided to adopt the stimulation-accommodation policy after recession in 1971. This policy aimed at stimulating federal government`s spending through increasing its open market activities. After economic recovery had been achieved, the fed policy used to accommodate the stimulated spending business still through making purchases in the open markets. The combination of these two activities (stimulating and accommodating the stimulated spending business) resulted to higher inflation rates. The increased inflation rates then resulted to increase of prices of goods and services. FOMC developed statutory wage and price control policy in an effort of stabilizing these prices. However, this attempt did not manage to tame the rate of inflation, which made the federal government experience the climax of inflation at the end of 1979 (Arthur pp. 695–696).
The federal open market committee employed this policy in order to control the monetary base of the Federal Reserve System. This policy was developed in late 1979 under the chairmanship of Paul Volcker. The short-term interest rate is the amount of money that banks charge on each other in order to preserve the Federal Reserve requirements (Santow PP. 209-211).
This policy tool was implemented in 1980 after the congress enacted the depository deregulation and monetary control act. The policy required Federal Reserve System to specify the reserve requirements of all member banks and to include all depository financial institutions. Moreover, a member bank reserve interest rates were abolished, and instead tax was imposed on non-member financial institutions (Santow PP. 209-211). This policy contributed to the termination of inflation of the federal government in 1988, which in the long run enhanced the growth of U.S economy.
Price level stability was implemented in 1991 by FOMC under the chairmanship of Greenspan. The development of this policy was through lowering the growth rates of public currency public holdings (M1) and public currency holding plus the time deposit in the same financial institution (M2). At the end of 2004, this policy tool managed to reduce the annual inflation rate of the federal government from 4% to 2%, while short-term and long-term interest rates declined to 3.5% and 7% respectively (Arthur pp. 695–696).
Ways in which the great Recession and Financial Crisis of 2007-09 changed the list of tools available for FOMC use
At the onset of great recession and financial crisis of 2007-09, the target of FOMC on financial funds rate was 5%. However, due to continuous severity of the financial crisis, it became impossible for FOMC to maintain this stipulated target. Instead, FOMC had to reduce its financial funds rate to almost zero level, thereby making it to enter into a non-unique territory of performing monetary policy while the policy interest rates are at their lower extreme (Andrés, David & Edward pp. 665-90).
In addition, although the monetary policy continued with ease, the functionality of the credit markets continued worsening every day. This situation made the Federal Reserve to seek and adopt extraordinary measures in order to bestow liquidity and support the functioning of credit markets. Some of the measures that were employed included the establishment of numerous emergency lending facilities and creating or extending the currency swapping agreements with other central banks in the world. The central banking system also led stress test of the biggest bank holding companies in U.S, thus setting platforms for these companies to raise capital (Andrés, David & Edward pp. 665-90). These actions, together with other host interventions from other policy makers in united stated and all over the work contributed to the stabilization of global financial markets.
Policy tools that the FOMC will most likely deploy to return the economy to normal interest rate levels.
In order to normalize federal interest rates full employment and stabilize prices, the FOMC has concentrated in acquiring long-term security assets, specifically the agency and treasury securities, since these are the chief security types that the Federal Reserve is allowed by the Federal Reserve act. One way by which the purchase of these long-term securities positively impacts the economy is through portfolio balance channel. This channel`s underlying factor is that various categories of financial assets are not ideal substitutes in investors` portfolios. Imperfect substitutionality of assets, therefore, exists, and this means that changes in the supply of various assets that are available to the private investors can influence both the prices and the yields of those assets. For example, when Federal Reserve purchases mortgage-backed securities (MBS), it can increase the prices and at the same time lower the yields of those securities (Chair PP. 6-7). The simultaneous rise of asset prices and decline of their yields simplify the overall financial conditions and arouse the economic activity through avenues that are analogous to those of conventional monetary policy.
In most case, when Federal Reserve wishes to alter interest rates, it directs its target to the federal funds rate. When fed intends to alter overnight rates, it can do so by selling or buying securities in order to set total reserves at a point that shift the rate up or down. Therefore, the federal funds rate serves as a platform for interest rates in the entire economy. In the recent past, fed was granted the power to pay interest on excess reserves. Thus, as economy improves, most banks would opt to loan out their excess funds to Fed, in order to earn them interest. However, since money in Fed is free from risks, the interest rate that banks would acquire after lending their money to Fed may act as a floor for other rates in the market. Most banks would opt to let their money stay in Fed until when the rate of return on the loan surpasses that of Fed`s offering (Chair PP. 6-7).
This tool applies on non-bank institutions such as financial institutions, primary dealers and money market funds. The reverse repos involve an agreement when fed wishes to sell some of its securities to these non-bank financial institutions, on the condition that it would repurchase the securities with an interest at a later date. The interest rate that these non-banking institutions would be granted by Fed becomes the reverse repo rate. Since Fed is free from risks, most of these non-banking institutions would prefer to lend Fed their excess reserves intend of lending borrowers in the market (Chair PP. 6-7). Since Fed has now the control of excess funds for the non-banking institutions, it becomes possible for it to raise rates gradually.
Communication is an important tool for central banking and is more important when economic conditions require more policy stimulus especially when interest rates are at the lower bounds. Federal Reserve has recently adopted forward guidance policy tools that help investors and private forecasters to be at pal with the anticipation of when federal funds rate will commence to rise (Chair PP. 6-7).
It is, therefore, evident that the federal open market committee has developed and utilized a wide range of policy tools since 1970. Some of these policy tools include price control, price short-term interest rates, price level stabilization among others. Moreover, the great recession and financial crisis of 2007-09 resulted to the reduction of federal fund rates to almost zero. Consecutively, FOMC can deploy numerous policy tools such as interest on excess reserves, reverse repos, communication and balance sheet channels in order to normalize the economic interest rate levels after a great recession and financial crisis.
Andrés, Javier, J. David López-Salido, and Edward Nelson. “Tobin’s Imperfect Asset Substitution in Optimizing General Equilibrium,” Journal of Money, Credit and Banking, vol. 36, August 16, 2004.
Arthur F. Burns, “The Anguish of Central Banking,” Federal Reserve Bulletin, September 1987,
Chair Yellen, “Transcript of Chair Yellen’s Press Conference,” September 17th, 2014.
Santow, Leonard, “Do They Walk on Water?” Federal Reserve Chairmen and the Fed. Westport, Conn: Praeger, 2009. Print.