Monetary policy is an important factor in the development of the financial market and the real economy. By affecting the amount of money in circulation, monetary regulators, namely central banks, seek to achieve their goals in various fields. The activity of the Federal Reserve monetary policy makes the subsequent impact on the behavior and expectations of financial market participants, not only in the USA but all over the world. However, recent changes in the monetary policy of the Federal Reserve System have led to the risk of the creation of liquidity. Now it is important to keep interest rates as close to zero as possible, and the changes should not increase the federal funds rate.
An Analysis of Previous and Current State of Monetary Policy, Its Success and Failures
The investigation of the success or failure of US monetary policy is possible only within the perspective of the data from last year. During the period of 1992-1999, the unemployment rate, the deviation from the inflation target, and the indicators of the state of the financial system were three of the most important variables for the Fed’s policy. The monetary policy was characterized by a high degree of reaction to the unemployment rate and the deviation of inflation from the target level. At the same time, the coefficient of the indicators characterizing the state of the financial system was the most significant component among the three principal ones. In contrast, the response to the performance of the real economy excluding unemployment, as well as the value of assets in the stock market, were not statistically significant (Bernanke, 2013). Thus, it becomes obvious that the policy regime succeeded in that period of time. An increase in the unemployment rate by 1% made the Fed lower the target interest rate by approximately 1.62% in order to stimulate the economy and prevent a recession. The better the condition of the financial system was, the higher the federal funds rate was going to climb (Bernanke, 2013).
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During the period of 1992-1993 and in 1998, the now-former Federal Reserve Chairman Alan Greenspan diverged from the traditional policy. He might have been motivated by the fact that the Fed had greatly reduced the federal funds rate to prevent the spread of financial instability. In the first case, the rate was below the predicted values. Prior to 1992, the rate, on the contrary, had been higher than predicted by the Taylor rule. Greenspan, therefore, pursued a policy of gradually changing rate in order to fight inflation, governed by the principles of a soft landing and the process of the tightening cycle. However, his policy had failed, and there was a threat of a recession in the US, causing the Fed to cut rates lower than the usual rule required. In autumn 1998, the federal funds rate greatly reduced due to the default in Russia, although at that time the US economy was developing and there was no need for a strong monetary stimulus.
The results of the analysis of the period from 2000 to January 2006 differ significantly from the results of the previous period. The most important factor then was the state of the financial system, while in the previous period, the level of unemployment was considered to be an issue of utmost importance (Woodford, 2009). However, even during the next period Fed still continued to focus precisely on the unemployment rate.
The second phase of Greenspan’s presidency was characterized by a lack of response to the deviation of inflation from the target. Fed policy could be a catalyst for the mortgage and financial crises. The higher risks occurred during the period of 2002-2006, when the Fed kept rates too low, thus implementing the expansionary policy. Such decrease can be explained by the fact that the Fed followed the policy of neutralizing the effects of the prolonged recession in 2001, associated with the crisis caused by the previous high-tech companies, namely dot-com crisis, the decrease of the prices in the stock market, and geopolitical uncertainty after the terrorist attacks of September 11, 2001. However, even though lowering the interest rate to such an extent was excessive, the Fed still kept all the power.
Firstly, the Fed did not react to the deviation of inflation from the target as strongly as it was suggested by the hierarchy of factors according to the Taylor rule. Secondly, the Fed did not pay sufficient attention to the characteristics of the financial market. A low rate of interest has led to the fact that high-risk financial assets were bought at the expense of short-term borrowings. Due to the low-interest rates leverage, risk inclination, and speculation on the commodity markets, the growth of the prices in the real estate field occurred. While in 1998 and 1999 the property prices (House Price Index) grew by 7% and 8% per year, in 2000-2003 they ranged from 9% to 11%, then in 2004 and 2005 from 15% to 17% respectively (Woodford, 2009). However, the price growth started to slow down in 2006. Then in 2008, the real estate prices have fallen sharply, putting an end to the mortgage and financial crises. Thus, the Fed implemented the expansionary policy without taking into account the rapid development of the financial system (Bernanke, 2013).
In the period from February 2006 to December 2012, the period indicator of real economic activity was recognized as the main factor of monetary policy (Bernanke, 2013). In previous years, this indicator was not important in politics due to the statistical insignificance in the corresponding regressions. Ben Bernanke, the next Federal Reserve Chairman, was the one who began to focus on this indicator, unlike his predecessor. The growth of the importance of this factor could be based on several factors. Firstly, the growth of the US economy at that time was particularly dependent on personal consumption or private sector demand — especially in the light of government spending cuts. Secondly, US export became more important as the indicator of the real economy state of growth, because the European Union, the main importer of goods from the US, started to experience economic difficulties. Thus, the Fed began to focus on a variety of indicators of the real economy. High attention to the unemployment rate was also justified. Bernanke’s attention to the factors characterizing the state of the financial market was regarded in a positive way. The Fed began to pay attention to the stability of the financial system as a whole in order to minimize systemic risks and to prevent the growth of all kinds of financial risks. At the same time, the Fed began to pay more attention to the integral indicator of the real economy and the financial market (Bernanke, 2013). Years of Bernanke’s leadership are characterized by the decrease of attention toward inflation. Inflation became less important in terms of the methods of the independent component.
However, the purpose of the Fed’s open market operations was to maintain the level of the federal funds rate (FFR). On December 16, 2008, FFR was at a record low level of 0,0-0,25%. Thus, it was impossible for the Fed to reduce the rate in order to achieve its goals, which created an economic situation close to a liquidity trap. In regard to the discount policy, since February 19, 2009, the rate for primary and secondary loans remained unchanged: 0.75% and 1.25% respectively. The minimal value of rates on loans was 0.15% reached in November 2009 and April 2011, with a large number of seasonal fluctuations. On February 9, 2012, that rate was set at 0.20%.
Generally, the scheme of formation of mandatory reserves is as follows: when the liabilities amount to 11.5 million dollars, the reserve is not set. With liabilities between $ 11.5 to 71.0 million dollars, the reserve is 3%, and if the amount is more than 71.0 million, the reserve is 10%. It should be noted that since October 2008, the Federal Reserve Banks have been paying interest to the compulsory and excess reserves, which was a tool for stimulating monetary policy (Bernanke, 2013). The global financial crisis exposed the US monetary policy shortcomings. It showed a lack of sufficient effective tools to deal with the crisis. Under these conditions, the Fed introduced a new tool for influencing the monetary and credit sphere — the program of quantitative easing (QE), used in the case where the interest rate was so low that it could not be used to increase the money supply (Bernanke, 2013). The negative effect of the program was the possibility of strong inflation which could have occurred during the recovery of the economy. The first round of quantitative easing, QE1, was held in 2008 and aimed to support US businesses, which in turn would have been able to organize new workplaces. However, the measure was not justified. The implementation of QE2 was provided due to a slowdown in economic growth and the deterioration of the situation in the labor and real estate markets (Rotemberg, 2013). The main purpose of QE2 had been to fight deflation, and this goal was realized. Another Fed’s unconventional monetary policy tool was the so-called “Operation Twist”, an attempt to stimulate the economy without printing money and without expanding the Fed’s balance sheet (Rotemberg, 2013). Janet Yellen, the head of the US Federal Reserve today, continues the general trend of the rhetoric of her predecessors.
Thus, the monetary policy of the United States is an integral component of the macroeconomic policy of the country. However, in present days the traditional monetary tools are already unable to fully contribute to the fulfillment of their objectives, namely to stimulate economic growth and to reduce unemployment. It means that the mechanism does not give the Federal Reserve to perform as an independent government agency.
The Issue of the Necessity of Changes in Terms of Present and Future Situations
The central banks of the last half of the century were able to control the level of unemployment and inflation by adjusting interest rates under normal economic conditions (Rotemberg, 2013). However, the recession was so considerable in 2008 that the Central Banks have currently exhausted the supply of their usual tools that could have had a significant impact on the economy, thus potentially limiting their own ability to maneuver in regard to the monetary policy. Consequently, the interest rates of most central banks decreased virtually to zero, as in the US — 0-0.25%, Bank of England — 0.5%, the European Central Bank — 0.05% (Rotemberg, 2013).
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At the same time, the US economy is showing steady growth, even taking into account the international comparisons. So, US GDP growth amounted to 2.1% and the unemployment rate fell to 5% from a peak of 10% in 2009. At first glance, the evidence is in favor of raising the Fed’s interest rate and increasing the probability of folding loose monetary policy in the US. In addition, pension funds, insurance companies, and millions of US citizens who have savings are interested in higher interest rates. However, a lot of things can happen if there is a regime change at the Fed level. That is why the rate should remain unchanged. It can be explained by the following: the case for tighter monetary policy is not sufficiently substantiated.
First of all, the United States practically does not experience inflationary pressure exerted by the demand, and the dynamic of inflation tends to decrease (Rotemberg, 2013). The average wage growth has slowed down. Simultaneously, consumer price inflation in the US fell from 3% in 2011 to 0.8% in 2014. In addition, there is no reason for inflation from the supply–side economics, and the producer price index has negative dynamics. Thus, the sharp increase of rate could trigger deflation in the nearest future. Secondly, the rapid growth of the volume of US government debt is a possible cause for the conservation rates being at the current levels in the last few years, which stands at 100.4% of GDP (Rotemberg, 2013). The expected tightening of monetary policy may increase the yield of 10-year government bonds (UST) from the current 2.27%.
Thirdly, despite the relatively high rate of growth of the US economy compared with the EU and developing countries, the dynamic of GDP growth and industrial production is slowing. The growth of industrial production in the US in October was at 0.3%, against a gain of 2.1% in April and 2.6% in March. Thus, rate changes can have an impact on GDP. The decline in unemployment is largely explained by demographic processes, an increase in the degree of automation, the proportion of smart innovative products, and financial services in GDP structure. The dynamic of reduction of unemployment to 5% allows to conclude that at the moment, the state of full employment has still not been achieved, since the historical lowest unemployment rates were observed before the recession in 2007 year — 4.5%, and in 2000 — 4.0% (Rotemberg, 2013).
Also, the possible increase in interest rates can lead to the strengthening of the dollar position, reducing foreign demand for the products from the United States. It, in turn, can slow down the export from the country and make it more expensive (Rotemberg, 2013). 40% of sales and 50% of the profits of US companies are from foreign markets. Thus, the trend of the dollar appreciation against the major currencies and the global nature of world trade have had a negative impact on the dynamics of profits of US corporations. The growth of the total profits of companies included in the top 500 has shown signs of slowing since the third quarter of 2014 till this moment. The tightening of monetary policy could increase the pressure on prices in the raw materials market, reduce investors’ risk appetite, and outflow the capital (Rotemberg, 2013). However, the decision to keep US interest rates at the current level will support the global trade and the emerging markets that have used currency devaluation in order to increase export competitiveness (Rotemberg, 2013). Considering the modern conditions, the Fed takes advantage of the issuer of a reserve currency — 60% of international reserves in the world are US dollars. It means that the confidence of economic actors is pursuing a policy aimed at price stability, while also promoting economic growth and preventing the formation of bubbles. At the same time, one of the most effective and actively used Fed’s tools in recent years has been verbal interventions that allowed Fed to manage people’s expectations without making significant adjustments to the interest rate policy.
If attempting to make a prediction for the next 10 years, it is important to take into consideration the low level of interest rates, which means that the Fed’s maneuvers are very limited. Almost the only thing that they could still do is to actively use rhetoric in order to achieve their goals. The possibility of implementing the tighter monetary policy in the US can not be excluded, but a situation where the Fed will limit itself to verbal intervention, refraining from growing rates for a long time, still seems to be the most likely scenario (Rotemberg, 2013). Furthermore, the US economy will face a recession if the Fed does not introduce new tools, including those aimed to increase the inflation targets and nominal GDP targeting. It will imply the printing of money to the extent necessary in order to achieve certain goals. Until the end of 2018, the Fed should raise rates only once (Rotemberg, 2013). Economy is not sufficiently stable. However, at the same time, America’s economic situation will remain fairly reliable over the next decade. In fact, the economy is rapidly growing, as energy production is increasing. Declining exports will give the United States a certain margin of safety in the fight against the global crisis during the next 10 years.
Federal Reserve policy was both successful and had failures in the different periods of time. However, in the period from 2000 to 2006, the Fed’s monetary policy, implemented by lowering the interest rate, turned out to be excessive. Due to the low-interest rates, the leveraged growth occurred, as well as risk inclination, speculation on the commodity markets started, and the growth of the real estate prices. In the period from February 2006 to December 2012, Fed switched to measuring the activity of the real economy, which was a positive move, but since December 16, 2008, the federal funds rate has been at a record low. Thus, the Fed is unable to achieve its goals, which creates the unique economic conditions close to the concept of a liquidity trap. At the moment, the traditional monetary tools are already unable to fully contribute to the fulfillment of FRS objectives: stimulating economic growth and reducing unemployment. However, the sharp increase in rates in the near future could trigger deflation in the USA. It could also increase the yield of 10-year government bonds, thus increasing the cost of both public and corporate debts. The federal rate change can have an impact on GDP and unemployment, and reduce foreign demand for the products from the United States, thus slowing down the export. Although the United States can expect a recession in the next decade, the country will experience it while using the existing safety margins, changing the current tools without increasing the federal funds rate.