The Federal Reserve and Monetary Policy - Assignment Example

The Federal Reserve and Monetary Policy The Federal Reserve’s policy makers can influence interest rates in three general ways. The first is by trying to control the money supply through open market transactions. The second major way they try to influence interest rates in through the Federal Reserve’s ‘discount policy’, which includes setting the discount rate and the terms of discount lending. That influence over the discount policy will in turn affect the money supply and interest rates as we will later see. The third way that the Federal Reserve can influence interest rates is through reserve requirements that banks are required to maintain, or the amount of money that banks must maintain on hand as available funds that are not available for lending (Hubbard, 1994). All three of the Federal Reserve’s monetary policy methods have an effect on the monetary base. The monetary base is the overall supply of money in the economy. In turn, if the monetary base is affected, then supply and demand of the reserves will be altered along with the interest rates (Hubbard, 1994). The primary tool the Federal Reserve uses is called open market transactions. The Federal Reserve will attempt to change the monetary base, or the total supply of money, by either making purchases or sales of securities in the open market (Hubbard, 1994). These transactions will then have an affect on interest rates. If the Fed makes an open market purchase of Treasury securities, then several things happen. The first is that the price of the securities will increase. In turn, the yield will decrease and the money supply will expand (Hubbard, 1994). On the other hand, an open market sale will decrease the price of the Treasury securities, which will in turn increase their yield and contract the money supply. Open market purchases will usually cause interest rates to fall and are termed an expansionary policy of the Federal Reserve. Open market sales will usually increase interest rates and are termed a contractionary policy of the Federal Reserve (Hubbard, 1994). A second tool, and the oldest one, is where the Federal Reserve affects the discount policy. The discount policy is the setting of the discount rate and the terms of discount lending (Hubbard, 1994). It is not used as frequently as open market transactions, since changing the discount rate is not as easy to do as simply engaging in open market transactions. Also, the Federal Reserve has better control over open market transactions. The discount rate is defined as the rate at which the Federal Reserve’s Central Banks lend money to other banks or financial institutions (Hubbard, 1994). Overall, an increase in the discount rate is contractionary when it indicates that the Federal Reserve wants to raise short term interest rates. A decrease in the discount rate is expansionary when it indicates that the Federal Reserve wants to reduce interest rates for the short term (Hubbard, 1994). The third tool that the Federal Reserve uses to try to control interest rates is the required reserve requirements, or the supply of money that banks are required to hold. An increase in the reserve requirements will reduce the available open money supply in circulation. This is because banks will be required to hold onto a larger amount of funds and not put them as available for lending or available to be put into general circulation for the public. If nothing else changes, when the Federal Reserve increases the reserve requirements of banks, it is a contractionary policy. A decrease in the reserve requirements is expansionary policy (Hubbard, 1994). 2. The yield curve is a graph showing yields to maturity on different default-risk free instruments as a function of maturity (Hubbard, 1994). There is generally an inverse relationship between short term and long term interest rates as the time to maturity increases (Hubbard, 1994). Yield curves can be flat, which would indicate that the yields on the short-term obligations are the same as for the long-term obligations. In reality, the slope is usually positive or upward sloping. Short term securities receive lower interest rates, while long-term securities receive the highest interest rates. That would indicate that the longer the wait until the obligation matures, the higher an interest rate is received (Hubbard, 1994). This seems logical since the short-term interest rates are more easily predictable, and hence less risky than those investments that are held for a long period of time. As time passes, inflation will generally increase, along with the risk that future cash flows will not be as secure as the short-term issues (Hubbard, 1994). For the past 3 years a major department store chain has averaged approximately $10 billion in long-term debt. Their debt is in the form of bonds that have been sold to investment funds and the public. For the sake of argument, let us assume that either now or one-year from now they wish to add an additional $5 billion to finance store expansion. This is a given, management has already made this expansion decision and it does not need to be commented on. How could changes in Federal Reserve policy affect the store's decision of when, now or in one year, to raise the additional debt? Federal Reserve policy would have an impact on when the store would decide to raise additional debt. Since debt issuance is involved, the funds would be raised through issuance of corporate bonds versus issuance of company stock. If the economy is struggling, it might be a likely time when companies issue debt since the interest rates would probably be low. We are currently in a recession, and the Federal Reserve would be looking to expand the economy. As a result, the Federal Reserve will use techniques such as open market purchases as described above in order to reduce interest rates and encourage consumers to spend. Anytime the Federal Reserve is using expansionary policy is a good time for companies to issue corporate bonds. This agrees with a research study performed by Christopher Barry, et al. (2005). His study found that managers prefer to issue corporate debt when interest rates are unusually low (Barry, 2005). If interest rates in the example were expected to fall even lower, then the company may want to wait one year before issuing debt. However, if it is not certain if interest rates will fall much lower due to contractionary policy by the Federal Reserve, then the company may prefer to issue the corporate debt immediately. T. Woodruff (2010) lists several factors that a company might want to consider in regards interest rate trends. One is the Department of Labor employment reports. The article mentions that low unemployment sometimes will indicate inflation for the future (Woodruff, 2010). Since this report shows all non-farm payroll information, it is helpful to look for increases in employment trends as possible indicators of higher future interest rates (Woodruff, 2010). Another item mentioned in the article is employment cost and productivity report. It is helpful to look at increasing wages as an indicator of higher inflation (Woodruff, 2010). A third item is the consumer price index. This is the price of a “basket of goods and services” as defined by economists. If this indicator rises, it is found to be one of the best indicators of higher inflation and higher interest rates. Final items mentioned in the article are the producer’s price index and the gross domestic product. If the gross domestic product rises too quickly, inflation and higher interest rates may be close behind (Woodruff, 2010). References Barry, C.B., et. al. (2005). Interest Rates and the Timing of Corporate Debt Issues. 1-50 http://sbuweb.tcu.edu/vmihov/Research/BMMRDebtTiming08312005.pdf Web. accessed 30 August 2010. Hubbard, G.L. (1994). Money the Financial System and the Economy. 500-547. Woodruff, T. (2010). The Basics: A borrower’s guide to forcasting interest rates. 1-3 http://moneycentral.msn.com/content/Investing/Realestate/P39219.asp Web. accessed 30 August 2010. Read More