FIN HW 1.6 Federal Reserve

What are the three key economic outcomes the Fed is seeking before it raises interest rates?

A stable dollar relative to other currencies, steady oil prices and a stronger job market (one that shows greater growth in wages).

How will the Fed get rid of the debt instruments

As the Treasury (and other) instruments mature, the Fed will receive (from the Treasury) the full payment of principal. The instruments will be paid in full, and will, therefore, cease to exist

Who is Ben Bernanke? Who is Janet Yellen?

Ben Bernanke is the former chairman of the Federal Reserve. He was appointed by George Bush and re-appointed by Barack Obama. He led the Fed during the Great Recession. His term ended on Jan 31, 2014. The new Fed chairman is Janet Yellen.

When interest rates are extremely low: Who benefits?

Borrowers. When interest rates are super low, the interest paid on borrowed money is low. This is one reason why we have seen so many companies issue debt recently.

What is fiscal policy? Who is responsible for conducting US fiscal policy?

Fiscal policy is what Congress does—which is determining how income tax revenue will be earned and spent by the US federal government. In other words, fiscal policy relates to taxing and spending.

If the Fed takes actions to increase interest rates, what would be the expected impact on GDP and inflation? Why is the expected impact a concern?

If interest rates rise, the demand for money falls. Accordingly, both inflation and GDP would be expected to fall. This is a concern because inflation is already lower than desired, and GDP growth, while positive, is "unexciting."

How might the reduction (tapering) and ending of the QE program harm the economy?

Stopping the QE could reverse all of the benefits: banks could lend less, people and companies could borrow and spend less, demand for goods and services could fall (that is GDP could fall) and inflation could fall--perhaps becoming deflation. We will have to wait and see!

What is the Fed's target for inflation (that is, the inflation rate the Fed believes is "consistent with stable growth")?

2%.

How might QE cause stock prices to rise?

If interest rates are low, investing in a financial instrument that pays interest might not be very attractive. As a result, savers might choose to invest in equity instruments (eg. stocks) instead of debt instruments (eg. bonds). The increase in demand for stocks would push up stock prices.

What is QE? What was the Fed purchasing and from whom?

In the program called Quantitative Easing (QE), the Fed bought long-term Treasury instruments and bundles of mortgages (called mortgage-backed securities) from commercial banks and other institutional investors. A unique feature of QE3 (Quantitative Easing, Round 3) is that it involved not only Treasury securities, but mortgage-backed securities as well. In this way, the Fed was hoping to bolster the housing market. In theory, if banks have more money to lend, they should reduce their interest rates and lend to more homebuyers. Since homebuyers can afford the low interest rates, they should borrow more money and buy more homes.

What does "conduct monetary policy" mean?

It means "control the money supply." This mandate was assigned to the Federal Reserve by Congress. "The money supply" basically means all of the money in circulation.

When interest rates are extremely low: Who is harmed?

Savers and debt investors. When interest rates are super low, the interest earned on savings accounts and debt investments (like corporate bonds and Treasury bills & bonds) is low. This is why retired people, especially, are complaining about low interest rates.

What does it mean to say that short-term interest rates are zero bound?

Short-term interest rates, such as the federal funds rate (the rate at which banks lend to one another) and the rate on 30- to 90-day Treasurys, are currently at approximately zero. Interest rates cannot get any lower than zero. If they did, borrowers would be getting paid to borrow.

Why does the Federal Reserve conduct monetary policy?

The Fed conducts monetary policy in order to control inflation and to promote economic growth.

Who will pay the interest expense on the Treasurys? Who will receive the interest income?

The US Treasury pays interest to the owners of the Treasury instruments. In this case, the Fed owns the Treasury instruments, so the Fed will receive interest.

When the final article states that the Fed might raise rates, which rate(s) is the writer discussing? Which rate(s) can the Fed increase directly? Which rate(s) must it use indirect methods to increase?

The article says the Fed is considering whether to raise the federal funds rate. But that statement is not quite accurate. What the Fed is actually doing is considering whether to raise its target for the federal funds rate. Although the Fed controls its own discount rate (the rate at which it lends to banks), the Fed cannot directly control the federal funds rate (the rates at which banks lend to one another).

The Fed has purchased more than $4 trillion in Treasurys and other debt instruments. In other words, the Fed has added more than $4 trillion of debt instruments to its balance sheet. From the Fed's perspective, are the debt instruments assets or liabilities?

Treasury issued the debt instruments; the Fed purchased them. In other words, Treasury owes money to the Fed. For the US Treasury, the debt instruments are liabilities. For the Fed, the debt instruments are assets. The Treasury owes money to the Fed (and to all other Treasury investors). When the Fed increased the money supply, the result was one branch of the US government owing money to another branch of the US government. It's like magic

How was QE intended to help the economy? What was the intended impact on the US money supply, interest rates, inflation and GDP? Did it work?

When the Fed bought the debt instruments, it caused cash to be injected into the economy; thus, the money supply rose. Banks made it easier to borrow, so people did more borrowing, which caused overall demand for goods and services to rise (that is, GDP rose). Of course, this put upward pressure on inflation, too. Economists generally agree that the first round of QE prevented a depression. Whether the subsequent rounds were required is still being debated.