As might be vaguely remembered from a high school government class as well as your occasional bout of watching CNBC, there is something called monetary policy that is related to Government spending (fiscal policy). I have noticed that a lot of people conflate the two: monetary policy and fiscal policy. They both affect the economy, but they are from separate entities. Fiscal Policy refers to government spending and tax policies, whereas monetary policy is the actions taken by the Federal Reserve. We will start with understanding the role and importance of monetary policy first, and fiscal policy will wait for a later date.
Expected manifestation in the real economy
In other words, monetary policy is the Federal Reserve’s actions that affect the current and expected path of short-term interest rates in order to fulfill their congressionally assigned dual mandate of maximum employment and price stability. But how exactly do they expect policy decisions to actually effect the real economy in a way that progresses it towards their mandated goals? Essentially, the Fed adjusts their stance on monetary policy, (interest rate policy, balance sheet policy, and arguably a few other things), and these changes influence short-term interest rates including market-based U.S. Treasury security rates and the rates that banks will lend to non-bank entities. This influence is due to the incentives given by the Fed in their change of their interest rate, think of it like a floor on interest rates, if I can lend to the Federal Reserve, the central bank of the United States (the borrower with the lowest risk of default), then why would I lend to a business or individual at a lower interest rate when there is a higher probability that they will not pay me back? It is in this way that the Fed influences short-term interest rates because they technically do not directly control them. So, this change in short-term interest rates affects overall financial conditions in the real economy, making money easier or harder to borrow. This then influences the financial decisions of households and businesses. You would be more likely to borrow more to buy a house when you have to pay a lower interest rate, just to give an example of a relevant household decision. This influence on household and business decisions then leads to citizens behaving in a way that moves towards maximum employment and financial stability.
Communicating to the public
It is important to bear in mind that the Fed is an entity with both public and private sector interests. Congress supplies the Fed with Monetary policy goals, but the Fed is an independent agency, so they technically are not obligated to implement them. However, it is in their best interest to do so since most of the higher positions in the Fed’s structure are appointed by the president and confirmed by the senate. Nevertheless, they are independent from the government in a way that is supposed to incentivize them to make their decisions based on objective analysis in the interests of the American public, rather than their own political interests.
Since the Fed is accountable to both congress and the American public, it is important that they remain as transparent about their policy and actions as possible. As an example of this transparency, the Fed issues a statement every January that lays out their goals for monetary policy while also explaining the policy framework the FOMC plans to use.
Goals of Monetary Policy
As mentioned, multiple times in the past few posts, the Fed has two congressionally mandated goals for monetary policy: maximum employment and price stability. In every January since 2012, the Fed has issued a statement expressing how they plan to progress towards these goals and the framework in which they will work. In August of 2020, the FOMC released a revised statement that reiterated the main points of their previous statements but recognized that the level of the Fed funds rate that seemed to be optimal, with respect to full employment and price stability, has declined. This means that if the Fed wants to maintain these goals, they must keep rates lower and will be constrained by its “effective lower bound” (zero) more frequently.
One thing to bear in mind is how to define these goals. The FOMC themselves stated that maximum employment is a “broad-based and inclusive” goal that can change due to reasons that are unrelated to monetary policy. So, the employment goal is not fixed at a specific value and must be assessed in real time. Now, it makes sense the maximum employment should have a fluctuating value. There are certain economic conditions in which the total amount of people that can be employed would decrease, like economic depressions or situations where the number of businesses decrease significantly. Typically, in this situation, the Fed would drop interest rates with the aim to stimulate the development of more businesses to increase the number of jobs. However, in excess this produces malinvestment and the misallocation of scarce resources. Which leads me to ask whether it is in the public’s best interest to have maximum employment in the economy or maximum production in the real economy. They are not necessarily the same thing.
Above is a chart of the employment to population ratio. Essentially, it shows the percentage of the population that is employed. The specific data comes from the Current Population survey (Household survey). I just wanted to get a look at employment from a different angle than the typical unemployment rate. This chart also shows us how the definition of maximum employment changes. A Fed governor has recently stated that the U.S. economy is reaching maximum employment now when we are at just below 60% employment relative to the population. This ratio was even for around two decades between around 1985 to 2008 or so. This could be due to the fact that a lot of baby boomers are retiring and retiring early the past couple years, bringing down the number of labor force participants significantly. This fact is in February 2022’s Monetary Policy report that I went over on my YouTube channel and is public information on the Fed’s website. Labor force YouTube video
In terms of price stability, the FOMC has deemed long-term inflation of 2% had annually led to stable prices. I don’t know about you, buy when I think of something that is stable, I think it fluctuates minimally around a set value, not a continuous increase that compounds over time. However, I do see the utility of having an elastic money supply. Unfortunately, when the amount of elasticity is concentrated in a political or semi-political entity, it tends to be overused for any excuse until that fiat currency reaches its intrinsic value, zero. We see this with the Fed changing their tune on the 2% inflation target from a maximum of 2% in a year, to average of 2% a year. Their rationale for a 2% inflation target is that it will “enhance the Committee’s ability to promote maximum employment in the face of significant economic disturbances.”
Above is a chart of the 12-month percentage change in the CPI from January 2022 that is not seasonally adjusted. As you can see, it is separated into four different columns: All items, food, energy, and all items less food and energy. The green bar, all items less food and energy, is the Core CPI. If you needed another reason to know how the CPI is manipulated and BS (for Blue Sky), look at the increase in energy. Over 25% . By ignoring it for the Core CPI, they can print a lower number and the government can pay less on their off-balance sheet obligations like social security. I have written a post on the CPI (Linked here) if you want to read more about how it is measured and its implication.
Why is monetary policy important?
Money is half of almost every transaction in the modern world. Whenever you buy something from a business, you give them money, and they give you their good or service. That is a trade, and money is one half of it. So, monetary policy affects the money itself, whether that be through the cost of money (interest rate) or the supply of money. This is why it is so important to at least understand the basics of monetary policy. If interest rates increase, then it costs more to borrow money, meaning the actual cost of money has increased and it can be more difficult for some people to borrow it. If the money supply increases drastically relative to the amount of goods and services, then that money is worth less because it is not as scarce. So, monetary policy plays a massive role in anything that involves money.
Final words
The first thought that comes to my mind in closing is more generalized and not just specific to monetary policy. It has always dumbfounded me how so many people do not care enough to learn this stuff, even just the basics. Money, finance, macroeconomics, etc., plays a fundamental role in the world. Regardless of what you do in your life, it can severely alter your circumstances. This isn’t just talking about whether or not the stock market is going down, because it is easier for people to protect themselves from a collapse in the financial economy. However, it is much more difficult, and much less people have the resources to protect themselves in a collapse in the real economy. The price of apple stock probably will not affect your life that much, but a collapse in the amount of wheat or energy most certainly will.
Even from a much more positive perspective, no one cares as much about your money as you do. Everything you do in your life comes from a skill, it was either a skill for hire (that you paid someone to do for you) or a skill for life (that you did yourself). Things like getting braces or open-heart surgery would probably be best to be a skill for hire. Even if I was a heart surgeon, I’d probably hire another one if I needed to have a surgery on my heart. On the other hand, I believe that managing money should be a life skill. Again, no one is going to care for your money as much as you will. That is why financial education is so important.
Back on the topic of monetary policy and the federal reserve, the average person probably doesn’t need to go as far as I do (researching the Fed’s repo market and trying to understand the Eurodollar system) but understanding the context of these first few posts is pivotal to financial education. Even if you believe the Fed is all bark with no bite (an argument that definitely has some merit when you extrapolate to a global scope), understanding the basics of monetary policy, interest rates, the Fed’s structure and such is still vital.
To your Wealth and Future,
James Forsythe
For a YouTube Video of me explaining further
For a general overview of the Federal Reserve system
https://jamesdforsythe.com/overview-of-the-federal-reserve-system/
For more information on the entities of the Fed
https://jamesdforsythe.com/the-entities-of-the-federal-reserve-system/
