Monetary policy is more art than science. In essence, Fed policy is a process of trial and error, observation and adjustment. The Fed's policies are often countercyclical to the business cycle. At best, Fed policy makers can hope to smooth the peaks and troughs of business cycles. In pursuit of this countercyclical policy approach, when output is excessive relative to the economy's sustainable potential and is potentially inflationary, Fed officials will lean in the direction of more restraint in their policy stance. They will tend to increase interest rates, eventually slowing aggregate demand and output growth to a more sustainable and potentially less inflationary pace. Conversely, when output falters and falls below the economy's sustainable potential, recession threatens. Accordingly, Fed officials will tilt their policy stance in the direction of greater ease, and lower interest rates. Lower interest rates serve to boost aggregate demand and output growth thereby lessening the threat of recession. A word of caution: Fed officials must feel their way along after implementing policy shifts because the effects from policy shifts are long, variable, and sometimes difficult to predict. The Fed enacts policy shifts based on economic forecasts. Economic forecasting is often an uncertain exercise.

One can develop an idea of the Fed's next policy objective by paying careful attention to various indicators of current economic activity. The key economic releases which serve as the Fed's intermediate policy indicators and that market participants should follow carefully include: nonfarm payrolls, ISM supplier deliveries, industrial production, housing starts, motor vehicle sales, durable good orders, labor compensation, productivity growth, and commodity prices. Table 4.1 gives the release cycles of these economic indicators. Consistent and meaningful changes in these economic indicators will signal changes in the business cycle and in Fed policy.

It is extremely difficult to recognize meaningful and consistent changes in these economic variables: non-farm payrolls, industrial production, housing starts, motor vehicle sales, durable good orders, commodity prices employment cost index, and productivity growth. Even if changes in these variables appear consistent and meaningful, it is difficult to predict whether the changes in the economic variables are temporary or if left unchecked will be longer lasting.

If the Fed believes the changes in key economic variables are consistent and potentially longer lasting, they will take measures to influence the availability of credit in the economy which in turn influences aggregate demand and output growth. The Fed's most frequently employed policy tools include open market operations and changes to the discount rate. Less frequently, the Fed will employ changes in bank reserve requirements or verbal persuasion aimed at influencing bank behavior and capital market conditions with respect to the supply of credit to consumer and business borrowers, and even more rarely, the Fed may change margin requirements on stocks.

Through open market operations, the purchase or sale of U.S. government securities, the Fed either adds liquidity or funds into the market or subtracts liquidity or funds from the system. By changing the discount rate, the Fed changes the rate it charges depository institutions for the privilege of borrowing funds at the discount window. In January 2003, the Fed acted to tie the discount rate to the Federal funds rate. For financially sound member banks, the discount rate on primary borrowings at the discount window exceeds the Federal funds rate by 100 basis points. For secondary borrowings by less financially sound banks, the discount rate exceeds the Federal funds rate by 150 basis points. The combination of these tools can either make the cost of funds, that is, interest rates, cheaper or dearer. Open market operations work on the principles of supply and demand while changes in the discount rate directly alter the interest charged on funds. Discount rate changes are proposed by the board of directors of one or more district reserve banks for the approval by the board of governors of the Federal Reserve. Open market operations are conducted by the Federal Open Market Committee (FOMC) in a manner consistent with decisions made at the periodic FOMC meetings. The FOMC consists of the seven members of the board of governors plus five voting bank presidents.

Two policy tools, changes in the reserve requirements and verbal persuasion, are tools infrequently used to reinforce stated Fed policy aims and they are used to complement policy changes already enacted through open market operations. Discount rate changes are more commonly used to put into effect Fed policy aims implemented through open market operations. These tools are employed by the Federal Reserve board of governors to underscore a policy of easing or tightening. Figure 4.1 attempts to simplify the decision making and policy implementation process of the FOMC.

Historically, the Federal Reserve, under different chairmen, has introduced two contrasting techniques for implementing open market operations (see Figure 4.1). Initially, the Fed has used as its operating procedures (guidelines) a rigid federal fund rate target, generally in effect from the late 1920s through the late 1970s. More recently, Fed officials have introduced a more flexible Federal funds rate target. When the Fed uses a rigid Federal funds rate target, Fed open market operations tend to have procyclical results. That is, during economic expansions, the Fed's use of a rigid federal funds rate target, in the face of increasing money and credit demands, would result in the full accommodation of these demands, thereby triggering an acceleration in money and credit growth, excessive real growth, and the mounting threat of inflation. Conversely, during economic downturns, the Fed's use of a rigid Federal funds rate target, in the face of declining money and credit demands, would result in weakening money and credit growth, slowing real growth, and lessening inflation pressures. Fed chairman William McChesney Martin Jr., who was Fed chairman from 1951 to 1970, started the transition to a more flexible Federal funds rate target. He sought to achieve countercyclical effects when he introduced his "leaning against the wind" policy approach. Under this approach, if economic growth appears too strong relative to the economy's sustainable potential and consequently, potentially inflationary, the Fed would tighten its policy stance and increase its Federal funds rate target in order to restrain money and credit growth with the aim of slowing aggregate demand and output growth, thereby, lessening inflationary pressures. Conversely, if economic growth weakens, the Fed would "lean" toward an easier policy stance and lower its Federal funds target in order to stimulate economic growth. Under Fed chairmen Paul Volcker (1979–1987) and Alan Greenspan (1987–2006) still greater flexibility was introduced into the Fed's federal funds rate target in order to enhance countercyclical policy actions.

Figure 4.1. Fed Policy Objectives, Intermediate Indicators and Alternative Open Market Operating Procedures

Regarding the intermediate policy indicators in Figure 4.1, Fed chairman Volcker tended to place primary policy emphasis on curtailing money and credit growth. In Volcker's own words in a statement before the Joint Economic Committee of the U.S. Congress on June 15, 1982, "[a] basic premise of monetary policy is that inflation cannot persist without excessive monetary growth, and it is our view that appropriately restrained growth of money and credit over the longer run is critical to achieving the ultimate objectives of reasonably stable prices and sustainable economic growth." Subsequently, however, Chairman Greenspan found it necessary to lessen the Fed's emphasis on monetary and credit growth in favor of greater policy emphasis on a wider range of intermediate indicators of the real sector, inflation, and auction (financial) markets. Greenspan feared that owing to globalization, securitiza-tion, and, most importantly, financial product innovation such as hedge funds, money and credit growth was no longer a reliable predictor of economic activity and inflation. Greenspan also placed more emphasis on transparency and verbal persuasion in seeking to increase the effectiveness of monetary policy.

The monetary policy transmission process has always been a long and variable one. In the past the banking system, the conduit for monetary policy, was the dominant source of credit for consumers and businesses. Typically, it has taken from six to twelve months for a shift in monetary policy to work its way through the banking system and capital markets to impact aggregate demand and output. It takes even longer for a given policy shift to influence price behavior. Complicating this process in today's world, a declining share of credit is supplied through the banking system and a rising share of credit is supplied through globally integrated capital markets. As a result, the Federal Reserve today more than in the past, must be highly attuned to financial market participants' perceptions of Fed intentions and potential market impact of the Fed's perceived intentions. The banking system remains the point of contact for the Fed when it initiates shifts in policy stance. However, Fed intentions and related market expectations of their intentions remain a critical concern in the transmission of Fed policy shifts. This process results in capital market asset price and interest rate adjustments that ultimately influence changes in aggregate demand, output growth, and inflation.

Fed authorities began in February 1994 to immediately announce policy decisions. (See Figure 4.2 for policy statements following FOMC meetings.) Today's Fed monetary policy transmission process is a transparent one. Monetary policy transparency easily conveys Fed policy intentions. Typically, Fed officials, through speeches, interviews, and congressional testimony, will seek to prepare financial market participants for any policy shift that may be in store in upcoming policy meetings. Clear information on current Fed policy helps the monetary policy transmission process operate more effectively. Under former Fed chairman Greenspan, the Fed sought to be more transparent, and refined its methods of communication.

Historically, the Fed policy transmission process has worked largely by manipulating the cost of credit as supplied by the banking system. Specifically, to effect a policy shift, the Fed has traditionally begun by changing the composition of bank reserves. For example, more Fed restraint means the Fed manipulates a rising share of borrowed to total reserves, resulting in an increase in the cost of reserves. The increased cost of reserves is reflected in a higher Federal funds rate. (The Federal funds rate is the rate on bank reserve balances held at the Fed that are loaned and borrowed among banks, usually overnight.) Conversely, less Fed restraint (more ease) means the Fed manipulates a declining share of borrowed reserves to total reserves. This action results in a declining cost of reserves that is reflected in a lower Federal funds rate. Borrowed reserves are those reserves that banks borrow temporarily at the Fed's discount window for purposes of adjusting their reserve positions. Banks traditionally try to avoid borrowing at the Fed discount window. There is a perception that such borrowings are a sign of financial weakness. Banks that are forced to borrow temporarily at the discount window will, generally, first turn to other sources of loanable funds such as Federal funds or repo borrowings. Figure 4.1 describes the importance of bank reserves to Fed policy implementation.

Figure 4.2. Sampling of the Federal Reserve's Official Statements of FOMC Actions, First Half of 1994

Banks, when faced with greater Fed restraint and a rising cost of loanable funds, find their net interest margins narrowing or their profits declining. In that case, the yield curve typically flattens or, when the Fed is tightening aggressively, inverts as short-term rates are pushed above longer term rates. Under these circumstances, banks have less incentive to increase their investments and loans. This results in a decline in the availability of funds and an increase in the cost of bank credit to consumers and businesses. Therefore, consumers and businesses will cut back on their borrowing and spending. This in turn results in a declining rate of increase in real economic growth and eventually, a moderation in inflation pressures. Conversely, a Fed move toward an easier policy posture reduces banks' cost of funds. Banks find their net interest margins widening or profits increasing because the fed funds rate is far more elastic than long-term interest rates and the yield curve will steepen. Banks' incentive to increase the availability and reduce the cost of credit increases. This stimulates consumer and business borrowing and spending, thereby spurring real economic growth and eventually triggering a rise in inflationary pressures. The only exception to our converse case is in the environment of an inverted yield curve such as the U.S. government bond curve in the early 1980s. Despite the Fed's efforts to ease short-term rates in the initial stages, the reduction in the cost of funds to banks may not have a significant impact on potential profit margins if the yield curve is inverted enough. Long-term rates may be too low on a relative basis to short-term rates to make bank or other financial institutions' extensions of long-term credit profitable, at least initially.

To view this monetary transmission process from the investment side, Fed policy shifts set off a chain reaction. For example, in the case of a Fed shift towards a more restrictive policy posture, investors who hold short-term credit market instruments such as Treasury bills or money market mutual funds will find interest rates on their short-term investments moving up to higher and more attractive levels relative to yields on longer-term bonds. Accordingly, investors will shift their investments down the yield curve. They will sell longer-term bonds and place the proceeds in shorter-term money market investments. This process will result in rising longer-term interest rates. Rising longer-term interest rates will, in turn, make the returns on bonds more attractive relative to the returns on stocks. As a result, investors will sell stocks, place the proceeds in bonds, and stock prices will decline. As capital market expectations of future Fed restrictive intentions are formed, these portfolio asset adjustments between money market investments, bonds, and stocks will be hastened and intensified.

Since the mid-1970s, there has been a sharp decline in the proportion of bank credit to total credit available. The bank share of total credit continues to fall. In mid-1970, it was 55%. By 2006, the banks' share of total credit was reduced to 25%. The main factors contributing to the declining bank share of total credit have been globalization of credit resources, securitization, and financial product innovation. The result has been a rising share of credit extended directly through the capital markets to consumers and businesses. Among the major new nonbank institutional suppliers of credit through the capital markets are mutual funds, hedge funds, pension funds, finance companies, and insurance companies. Currently, with the advent of the information revolution, these nonbank lenders are virtually in as good a position as bank lenders to assess market and credit risks.

Today, the Fed's policy transmission process works increasingly to a greater extent through capital market asset price adjustments and interest rates (that is, bonds, stocks, etc.) than through the availability of funds. As in the past, the Fed initiates a policy shift by changing the composition of bank reserves. As we have previously explained, there is a resulting change in the cost of funds as reflected in a change in the Federal funds rate. The Federal funds rate prompts positively correlated changes in short-term market rates. These changing costs of short-term credit include bank loans made at the prime rate and funds raised in the commercial paper market. The impact on capital market price adjustments work in the following manner: as short-term borrowing costs rise, borrowers find longer-term borrowing rates relatively more attractive. Eventually, corporate bond and fixed-rate mortgage offerings increase, driving up longer-term interest rates. This impact of Fed policy shifts on short-term and long-term market interest rates is magnified as Fed intentions are recognized by capital market participants. The participants form expectations of further Fed tightening (easing) moves, thereby affecting longer-term interest rates. Longer-term interest rates are influenced by the average of expected short-term rates plus a term premium that includes inflation expectations. The effect of capital market participants is reflected in the changing shapes of the yield curve as the Fed funds rate changes.

Rising longer-term interest rates and declining stock prices will increase the cost of capital. Increasing the cost of capital decreases business investment. Also, higher longer-term rates depress housing activity. In addition, declining financial asset prices depress consumer wealth and consumer spending, resulting in a decline in the pace of real economic activity. This process serves to moderate inflationary pressures. Commodity prices are likely to be falling in such an environment. Moreover, increasing interest rates will generally cause the value of the U.S. dollar to appreciate in the foreign exchange markets relative to other currencies. A stronger U.S. dollar will cause a decline in exports and a rise in imports, all other factors being equal. This rising trade deficit also serves to dampen economic activity.

Important influences on the global financial environment include: market deregulation or regulation, financial innovation, integrated global financial markets, and advanced information processing and communications technology. There is a massive pool of mobile capital that relentlessly seeks out countries where business activity generates the highest possible return for a given amount of risk. In order to compete effectively for capital from global investors, countries must pursue disciplined macroeconomic policies and pro-business microeconomic policies including deregulation and privatization. Countries competing for capital must aim for balanced and sustained noninflation-ary growth.

A more sobering lesson for modern-day central bankers is their reduced effectiveness in controlling massive global capital flows and related financial asset price bubbles. At times this has been manifested in capital market participants' overly optimistic view of central bankers' abilities and desire to stave off debt defaults. This may be particularly true in the case of staving off sovereign and quasi-sovereign debt where there is a history of central bankers providing meaningful amounts of liquidity. The legacy was underscored in the Mexican financial crisis in 1995. The U.S. government provided amounts up to US$50 billion to the Mexican government, staving off a debt default. The benefits of staving off the Mexican default were not without drawbacks. This lesson can be found in the Asian financial crisis that began in mid-1997. The Asian financial turmoil began in the rapidly growing economy of Thailand and spread to the other Southeastern Asian countries of Malaysia, Indonesia, and the Philippines. These developing countries had benefited from an abundance of foreign liquidity. But the heavy capital inflows eventually resulted in excessive growth, mounting trade deficits, and speculative financial bubbles typically manifested in frenzied local bank-financed speculation in equities and real estate. The currency crisis in these Southeast Asian countries was triggered as escalating trade deficits scared away global money managers, triggering a rapid depreciation in their currencies, with interest rates rising sharply in response. As the bubble burst, real estate and equity prices plummeted. This unforeseen instability posed a major threat to the affected countries' banking systems, as bad debts mounted.

It was not until equity market selling pressures spread to Hong Kong that the rest of the world began to take serious notice. With the return of Hong Kong to Mainland China, the Chinese government kept the Hong Kong dollar pegged to the U.S. dollar as a matter of political principle. Nevertheless, speculators continued to attack the Hong Kong dollar on the assumption that it had to fall in line with other southeastern Asian currencies in order for Hong Kong to remain competitive. In its effort to fight off the speculative attack on the Hong Kong dollar, the Hong Kong Monetary Authority was forced to sharply increase interest rates, thereby weakening the Hong Kong real estate market and threatening Hong Kong banks with mounting bad debts.

Table 4.2. Changing Values in Asian Equities, Bonds, and Currencies

Next, the Asian currency crisis spread to the larger South Korean economy, where the heavily indebted financial system was vulnerable, and ultimately to the huge Japanese economy which was still attempting to recover from the bursting of its own 1980s financial bubble. Then, like a rapidly spreading contagion, the Asian currency depreciation and equity market plunge spread to Latin America and even eastern Europe and Russia where previously high-performing debt and equity markets registered extremely disorderly declines, and ultimately to declines in the western European and U.S. stock markets. Table 4.2 illustrates the magnitude of these Asian market declines.

The importance of the Asian financial crisis is that it illustrates the lessening influence that central bankers have on today's globally integrated capital market flows, apart from serving as last-resort lenders of liquidity. The role of last-resort lender, however, should not be minimized. The central bank and supra-led package of loans to Mexico in 1995 staved off a dramatic currency crisis that could have led to a debt default. With the stunning advances in information processing and communications technology, global money managers can move capital around the world at virtually the speed of light. This capital, as already noted, seeks out opportunities offering the highest risk-adjusted returns, but it flees from turmoil. The point is that the increasingly efficient global capital markets are linked more tightly than ever before. Apart from maintaining anti-inflation credibility and serving as lenders of last resort, central bankers, including the U.S. Fed chairman, may in the future have only a marginal influence on these massive global capital market flows and related financial asset price bubbles.

Moreover, and perhaps, since the Asian currency turmoil, it is the stark power of the global capital markets themselves rather than domestic politicians or central bankers that are forcing major financial system changes in the affected countries, including the desirable privatization of public corporations and large scale banking reform. The only means by which governments (or the IMF) can stabilize market forces is to respond by offering larger or more effective financial reform packages than global capital market participants expect. For example, global money managers are demanding that bank reform include provisions for allowing insolvent banks to fail and for the weaker banks to be acquired by healthy domestic or foreign financial institutions. In addition, taxpayer funds, along with deposit insurance, must be used to pay off depositors in failed banks. Also, most importantly, bank reform must make provision for transparency, including full disclosure of bad loans and off-balance-sheet items by banks and securities firms.

Huge, global pools of mobile capital may serve to actually discipline national and global macroeconomics policies. If, for example, any developed or emerging country tries to boost growth through overly stimulative macro-economic policies that are potentially inflationary for political reasons, its trade deficit will worsen and its currency will depreciate. Global institutional investors and money managers will become fearful of the increased inflationary threat and sell bonds, thus pushing long-term interest rates higher and helping to choke off growth in that developing or emerging country.

Former Fed chairman Greenspan was faced by a "conundrum" when he and his fellow policy makers began a prolonged series of rate firming actions mid-2004. Specifically, despite an impressive series of short-term rate-hikes, long-term rates actually declined, reducing the effects of Fed's firming actions. Eventually, Fed officials concluded that this atypical situation in which Fed policy was becoming less accommodative as the capital markets were becoming more accommodative, reflected a unique combination of low inflation expectations, a global savings glut, heavy global carry trades by hedge funds and other large institutional investors, and currency interventions, especially by Japan and China.

Accordingly, the best that any country can do for its citizens is to create a favorable economic climate for participation in the world economy. There are many important economic building blocks for positive participation in the world economy. These building blocks include deregulation, privatization, free markets, minimal government interference, longer-term productivity-enhancing measures (investment in education, job training, research as well as the implementation of technological innovations, and rewards for savings and investment), and, above all, central bank anti-inflation credibility and consistency. Longer-term price stability creates steady, predictable levels of economic growth. These are the rewards of pursuing a monetary policy that seeks price stability and, thereby, sets the stage for enhanced productivity.

In sum, while central bankers still play a key stabilization role in the effort to ensure that financial conditions are supportive of sustainable economic growth, the ability of central banks to influence massive global flows of mobile capital and related asset price bubbles is diminishing. This raises the spectre of additional currency crises from time to time, not unlike those in Mexico in 1995 and in Southeast Asia in 1997. To be sure, central bankers can help limit the private sector's speculative tendencies by maintaining a high level of anti-inflation credibility. Moreover, central banks can help contain the damage when asset price bubbles break by serving as last-resort lenders of liquidity. But in the final analysis, these central bank influences are marginal compared with today's sheer power of global capital market forces.

In general, central bankers have the mandate to create an investment environment which results in attractive risk-adjusted return on capital and stable capital flows. The Federal Reserve's policy transmission process influences the expectations of capital markets participants. While the Federal Reserve alters short-term borrowing rates, all lenders of capital adjust their cost of capital in response.

The Federal Reserve's policy shifts are countercyclical and affect the forward economic environment. Evident several months after the fact, the impact of these policy shifts is designed to enhance the economic environment. A positive economic environment attracts stable capital flows which ultimately aid stable, noninflationary economic growth. This is the ultimate goal of a central banker.

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