The Federal Reserve is the central bank of the United States that is charged with formulating the monetary policy for the country. The main aim of undertaking any monetary policy is to help achieve the national economic goals.
There are three tools of monetary policy controlled by the Federal Reserve; the discount rate, reserve requirements and the open market operations. The Federal Open Market Committee is tasked with handling open market operations to influence the federal funds rates. The FOMC congregates 8 times annually.
In these meetings they discuss the prevailing economic conditions and formulate appropriate policies to ensure that economic growth is maintained. The economy is in a sub-prime crisis at the moment, meaning that there is reduction of money supply in the economy. This results in a decline in output and a rise in interest rates. The next FOMC meeting should therefore adopt monetary policies that are aimed at reducing interest rates so that the banks can get money from the Federal Reserve and lend it to the public to spur economic growth.
During a sub-prime crisis, there is low money supply in the economy and this leads to low growth rate due to reduced investment. The low money supply leads to high interest rates that further hinder investment, and this is accompanied by high interest rates.
A sub-prime crisis results in increased currency-deposit ratio as the public withdraws their money from the banks and leave the banks with no money to lend out. This is because the population regards the bank deposits as risky since the banks can fall at any time during such a crisis. Money creation by banks through money multiplier is thus limited, and the result is a fall in money supply (Mishkin, 2010).
The banks on the other hand regard money lending as a risky venture during a sub-prime crisis. They reason that a significant number of borrowers are likely to default on their loans. The banks therefore prefer to hold onto the money they have in store, resulting in a high reserve-deposit ratio. This has a negative effect on the money multiplier and the money supply since there is a reduction in money available for banks to lend.
Low money supply
A reduction in money supply leads to a left shift of the LM curve and a subsequent rise in interest rates. The results of high interest rates can be seen from the declining investment rates in the private sector. A sub-prime crisis leads to a declining rate of capital formation. This is because the private sector considers bank loans as risky and expensive, and as a result, they cannot borrow huge sums of money due to high interest rates.
Reduced money supply in an economy can be remedied through appropriate monetary policies. The FOMC can, through open market operations, lower the interest rates of the economy (Mayes, 2007). Through the open market operations, the government can sell securities like treasury bonds and treasury bills to the public.
The money held by the public will be reduced, and the Federal Bank will have money to lend to the banks at a lower rate so that it is available to investors at good interest rates. This will encourage new investments that will boost economic growth.
Increasing the money supply usually has a positive effect on the challenges that the economy faces during a sub-prime crisis like low growth rate and high interest rates. Low interest rates stimulate capital investment thus leading to improved economic growth. It is upon the Federal Reserve to use the appropriate discretionary monetary policy to control the prevailing economic crisis.
The other result of a sub-prime crisis is the increase in inflation rates. This leads to high commodity prices thus people find it hard to meet their daily needs. In order to reduce inflation, the FOMC should adopt monetary policies that are geared towards reducing interest rates and stabilizing commodity prices (U.S. Bureau of Economic Analysis, 2012).
The FOMC and Monetary Policy
The FOMC is the top monetary policy-making body of the Federal Reserve System. It implements U.S. monetary policy through the System Open Market Account (SOMA). The FOMC meets every six to eight weeks to review the economy and set appropriate policy. It then issues a directive to the SOMA manager outlining what the FOMC considers to be the appropriate monetary policy for the coming time period until the next meeting.
The monetary policy tool used by the FOMC is through open market operations. It conducts these operations with primary dealers. These primary dealers have accounts at clearing banks, and when the Federal Reserve sends or receives funds from the dealer’s account at its clearing bank, the action adds to or reduces reserves in the banking system.
By adjusting the supply of reserve balances, the FOMC, through the open market operations, is able to influence the federal funds rate Mayes, 2007). This is the interest rate that banks pay when they borrow unsecured loans of reserve balances from each other overnight. The reason why banks borrow reserves in the federal funds market is to ensure that they have adequate balances in their accounts and to meet the reserve requirements put in place by the Federal Reserve.
Increasing the money supply
From the current economic outlook, there is need to increase the money supply in the market. The next FOMC meeting should therefore look into how to implement this. Through open market operations, the FOMC should initiate the process of purchasing securities from banks.
This means that the Federal Reserve will deposit money into the accounts of banks, thus the banks will have money to lend out. This means that individuals and businesses can get loans at reasonable interest rates and invest it. Increased investments will boost economic growth.
The more securities the Federal Reserve buys from banks, the more money that will be available for the banks to lend out. With more money available for lending, the interest rates will come down significantly, and this will encourage more people to borrow a lot for investment purposes.
There are observers who believe that the continuous, rapid financial changes will continue causing instability in the financial linkages of the economy. This will in turn undermine the importance of money and credit aggregates as guides for monetary policy.
There are others who expect these volatile financial changes to settle, and restore to some extent, the importance of money and credit as policy guides. Regardless of the outcome of these debates, the Federal Reserve has been under obligation for some time now to reduce its reliance on numerical figures for money and credit when it comes to formulating monetary policy.
This has seen the FOMC adopt a wide range of financial and nonfinancial indicators in analyzing economic trends and in making monetary policy plans. With this new approach, the FOMC aims to institute a broad range of financial conditions that it believes are consistent with its final policy goals.
Short Term Policy Directives
Any action taken by the FOMC must be in line with its policy objectives regarding the performance of the economy. During their regular meetings to discuss the economic outlook and monetary policy, there are some crucial considerations they have to make. First, they have to look at foreign exchange market developments since their last meeting.
They also have to look at domestic financial market developments and system open market transactions in government securities during the period since their last meeting (Axilrod, 1997). In a situation like now, when the FOMC has to increase the money supply in the economy, it will still have to consider several factors and the effects that their move will have on other economic pointers.
They consider how the effect of their move on the economic growth or inflation will relate to their earlier forecasts and their long-term goals for the economy. The committee expects that when it makes a decision to increase the money supply through the open market operations, the resultant outcome must be consistent in helping it achieve its broader policies for economic growth and inflation.
As the FOMC meets during its next meeting, it should first review the monetary policy operations during the last meeting. The previous monetary actions have had a positive effect on the economy, albeit slow. The unemployment rate is declining as job opportunities increase. There is also increased borrowing by private investors as interest rates are falling.
There are indications of growth of GDP that was at 3.7% in 2011 and is now at 4.7% in 2012 (U.S. Bureau of Economic Analysis, 2012). It is clear that this trend is set to continue over the near term. The FOMC should aim to strengthen these positive changes by availing more money to the economy. The best approach is trade in short term securities that will result in money entering circulation within a short time and boosting economic recovery.
This means that at the end of the next meeting, the FOMC should direct the Open Market Desk to put less pressure on reserve positions until the following meeting. This would mean a lower level of the funds rate to enable banks to borrow more money. The banks will then have enough money to lend out at low interest rates and investors will take more loans.
Effects on the Economic Variables
By releasing more funds into the economy through the open markets operations, the FOMC is going to boost the various economic variables significantly. To begin with, the average national income is usually boosted if the factors of production are increased (Mishkin, 2010).
Lower interest rates mean that investors will have capital, which is a very major factor of production. More capital will lead to increased production meaning the Gross National Product will increase. Unemployment rates will also fall since new investments mean more jobs being created in the economy. The private sector will lead on this front due to the availability of capital in the form of cheaper loans.
The rate of inflation will also drop and consumers will have more money to spend. With consumers being empowered, there will be an increased demand for various goods and services. This in turn stimulates more investment and more production and the economy will grow slowly but steadily.
As long as these measures are implemented cautiously but steadily, the net outcome will be a positive outlook for the economy. The FOMC still has to keep an eye on other market indicators to ensure that other areas of the economy do not begin to suffer.
The economy has shown signs of recovering, even if the changes are coming in slowly. The FOMC is tasked with the crucial role of guiding the economy through this recovery phase even as it targets its long-term economic goals. The recent economic downturn left the country facing high unemployment rates, high inflation and reduced national average income.
Add this to the high inflation rates, it is clear that the picture was very bleak and the public was suffering. Things have started to improve but some of these problems are still there. To address these immediate concerns, the FOMC has to come up with a monetary policy that will, at least in the near term reduce inflation so that consumers can afford basic commodities.
They also have to lower interest rates so that investors can get the capital they need to increase production and create jobs. The best solution at this stage is to increase the money supply in the economy through the open markets operations. This will ensure that banks have money to lend out to be used as capital to stimulate production and economic growth.
Axilrod, S.H. (1997). Transformations to Open Market Operations. International Monetary Fund (IMF). Retrieved March 6, 2012, from http://www.imf.org
Mayes, D. (2007). Open Market Operations and Financial Markets. New York: Routledge.
Mishkin, F. S. (2010). The economics of money, banking & financial markets. Boston: Addison-Wesley.
U.S. Bureau of Economic Analysis (BEA). (n.d.). U.S. Bureau of Economic Analysis (BEA). Retrieved February 29, 2012, from http://www.bea.gov/