The Federal Reserve: Monetary Policy

Topics: Monetary policy, Federal Reserve System, Central bank Pages: 9 (2958 words) Published: September 2, 2013
Introduction

Monetary policy is the key tool used by Federal Reserve to monitor and control US economy. According to Vance Roley and Gordon H. Selon, in their article “Monetary Policy Actions and Long-Term Interest Rates”:

“It is generally believed that monetary policy actions are transmitted to the economy through their effect on market interest rates. According to this standard view, a restrictive monetary policy by the Federal Reserve pushes up both short-term and long-term interest rates, leading to less spending by in interest-sensitive sectors of the economy such as housing, consumer durable good, and business fixed investment. Conversely, an easier policy results in lower interest rates that stimulate economic activity”

How interest rate change and the level of interest rate actively reflect the economy of US. While it is generally accepted that short-term interest rates are determined primarily by Fed monetary policy (via the Fed Funds rate), long-term interest rates are often thought to be influenced by other factors, such as long-term inflationary expectations and the long-term outlook for the Federal budget deficit (Duke, 2006) Also, economists and policy makers are believe in expectation models, which states the relationship between short term (FFR) and long term interest rate: long-term rates are determined primarily by short-term rates through market expectations of future short-term rates.

Under expectation theory, the nominal long tern interest rate should be close to the average of current and expected nominal short - term interest rate when we make them to have same maturity, say, the yield on a 10-year Treasury note should be comparable to the yield on a 1-year Treasury bill that is rolled over each year for ten years. However, the short term and long term interest rate does not always goes along in real life. Since the middle of 2004, the Federal Reserve has increased its key Fed funds rate eight times by a total of 200 basis points, or two percentage points. Over this same period, the yield on the 10- year Treasury note has remained essentially unchanged. And to further control the influence of housing bubble and financial crisis since 2008, the short-term rate almost fall close to zero.

When interest rates are close to zero, there is another way of affecting the price of money: Quantitative Easing (QE). The aim is still to bring down interest rates faced by companies and households and the most important step in QE is that the central bank creates new money for use in an economy to stimulate economy and create new investment opportunity. Between November 2008 and March 2010, the Federal Reserve conducted massive asset purchases known as quantities easing (QE1). In QE1 the Fed purchased approximately $1.75 trillion of assets consisting of $1.25 trillion mortgage-backed securities (MBS), $300 billion Treasury securities, and $200 billion federal agency debt. Between November 2010 and June 2011, another phase of quantitative easing known as QE2 was implemented, consisting of an additional purchase of $600 billion long-term Treasuries. Moreover, in September 2013, Fed expanded its holding of long-term securities with open-ended purchased of $40 billion of mortgage debt to boost growth and reduce unemployment. This paper examines how federal funds rate will affect the term structure in US and the relationship between long-term and short-term interest rate (federal fund rate).

Literature Review

The literature contains many studies that analyze the impact of QE, monetary policy and short-term rates on long-term interest rates. Cook-Hahn and Cohen-Wenninger both found that the Federal funds rate had a significant impact on long-term rates. Cook-Hahn found (using daily data) that between 9/74 and 9/79, a one percentage point (100 basis points) increase in the Funds rate target results, on the day of the target change, in a 13 basis point movement in the 10-Year Treasury Bond Rate and a...
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