Monetary Policy - The Financial Levers That Tame Business Cycles

Himalaya.
Do you want to transform the way you learn? As
regular listeners of this show, no, Himalaya is a new
audio first learning platform with over one hundred and fifty
courses on personal and professional development, taught by instructors like
Arthur Malcolm Gladwell, divorce court judge Lynn Toler, mindfulness expert
Sharon Salzburg, and many other thought leaders.
What Himalaya is doing is different than a typical podcast
is These are carefully curated audio courses rather than just
more folks talking. Each Himalaya audio course is organized so
that each lesson is a digestible, fifteen minute episode that
focuses on the big ideas. Think of it as a
pack of snack sized lessons that will nourish your brain.
It's the best way for busy people like you and
me to hit learning into our lives, and Himalayas curated
learning tracks make it easy to find courses you'll love
on the topics you need to transform your life.
Excelling it remote work, speaking with impact, anti racism at work,
top mental health tools, start your first online business. These
are just some of Himalaya's extensive library of practical and
transformative courses. If you're looking to grow, there's something for you.
For a limited time. Think Like an Economist. Listeners can
go to himalaya dot com and enter promo code econ
at checkout for a fourteen day free trial. That's Himalaya
dot com into the promo code econ at checkout for
a fourteen day free trial.
At a press conference following the one year anniversary of
the COVID nineteen pandemic, Federal Reserve Chairman Jerom Powell explained
that the FED would be keeping interest rates at close
to zero for quite.
Some time in order to help the economy recover.
Even though unemployment had fallen a bit, it was still
high compared to pre pandemic levels. Powell also explained that
inflation was below the fed's target of two percent per year.
The FED set's monetary policy, which is all about how
central bankers help keep the macroeconomy working smoothly. Monetary policy
is our subject on this week's Think Like an Economist
with me Betsy Stevenson and.
I'm Justin Wolfers, we're teaching you the tools from economics
to help transform your life and the world around you.
Where the interest rates are high or low, Nesta and
Tebakoli fires with us.
In recent episodes, we've been talking about the impacts of
interest rates on the macroeconomy, and in this episode, we're
going to dive into the role central banks play in
setting interest rates and helping to keep the economy operating
out potential.
We're going to take a look at what goes on
in the world central banks like the Federal Reserve in
the United States, the European Central Bank or ECB in Europe,
the Bank of the England or Bank of Japan, or
in countries like Australia or Canada or India, the central
banks called the reserve bank, and in China it's called
the People's Bank of China.
Every country has a central bank, and in most cases
they add just the interest rate to try to tame
the ups and down to the business cycle. Most central
banks focus on trying to achieve low and stable inflation
as well as low and stable unemployment, but they affect
those outcomes indirectly, primarily by adjusting the interest rate.
We're going to focus on the FED, which is the
US Federal Reserve, the central bank in the US, but
the mechanics are pretty similar in most of the world's
leading economies.
Eight times a year, the FED holds a meeting called
the Federal Open Market Committee to set interest rates, and
it's attended by the Fed's governors as well as the
presidents of the regional Federal Reserve banks.
The center of the US system is the Federal Reserve
Board of Governors, and the chairman of the Federal Reserve
Board runs the Federal Open Market Committee, which has to
reach a decision across the twelve voting members of what
to do about interest rates and monetary policy. Well, this
is a meeting, perhaps like a meeting you've been to
where you have to make a decision. The decisions here
are pretty high stakes.
Picture a room and not burn in the room which
has a big table and the Chair of the Federal
Reserves sitting right in the middle. So right now, that's
J Powell. He'll start by deciding who's going to speak
and in what order.
And exactly what are these experts we'll discussing at the
Federal Open Market Committee.
There are three main questions they're trying to answer. First,
what are your forecasts for the US economy? Second, what
are the right policy choices given those forecasts? And third,
how should the FED communicate its plans to the public.
So first it's about forecasts.
Yeah, So the chair starts by asking for one to
share their views about the current state of the economy
and their projections for where things are going to go.
This is where we can really hear about regional differences
from the fedbank presidents from around the country who share
their findings and analysis from crunching the numbers and also
from having spoken to local businesses as well.
To clarify, in the US, there are regional federal Reserve banks,
and those presidents all come to the meeting to share
their vues and take turns as voting members.
Right, and that helps paint a full picture of where
different experts think the economy might be headed. Because behind
the people attending the FOMC meeting are hundreds of people
studying the US economy and trying to forecast where it's headed.
Because the big decision, which is what's the right policy choice,
depends on understanding exactly what's going on with the economic outlook.
So they're discussing what should happen to the interest rates.
Remember, the real interest rate is the opportunity cost of
spending for consumers who might decide it isn't worth saving
as much if interest rates go down. Or who might
decide to borrow to buy a car or a house
because interest rates.
Have gone down.
Similarly, businesses might decide to borrow more or make greater
investments of interest rates go down. Of course, the opposite
is also true. They raise rates, both consumers and businesses
might decide to spend less today save more for tomorrow.
The FED will raise the real interest rates when the
economy is overheating and inflation is high, so that people
will spend less, and it will lower the interest rate
when the economy may be underperforming and inflation's low, so
that people spend more today.
Yes, remember, the FED is aiming for stable inflation and
a sustainable employment rate, which they influence through interest rates.
Once it debated all the options about how these are
going to affect the economy, the FED chair tends to
recommend a course of action and the rest of the
committee votes on it.
And the final question at the meeting is about how
the FED should communicate its plans to the public.
Yeah. FED chairs needs to be really careful about what
they say and to whom. Even a small offhand comment
at a party has been known to leak out, get
spread by the press, and make big waves in financial markets.
The third Chair issues this statement and holds a press
conference after every meeting explaining their decisions, and they also
publish their forecasts. This is relatively new that the FED
aims for this greater transparency. It's all about trying to
help people set clear expectations.
And we talk about expectations a lot when we talk
about the macroeconomy.
That's right. Expectations are absolutely critical to macroeconomics. It's because
when people are trying to decide what to do, they're
not just thinking about the state of things today. They're
also thinking about the future. So if people think the
Fed's going to raise rates in the near term, well
they may make different decisions than if they thought that
the interest rates would continue to be low for a while.
The FED trace to shape expectations through these statements and
press conferences and releasing their forecasts, and they try to
give some guidance on what they may do in the future.
This is known as forward guidance, and it's all about
trying to shape expectations.
Language really matters here. Recently, the FED said it wasn't
going to raise rates based on simple forecasts of an
economic recovery. They said they were going to wait for
evidence of a recovery.
This led them to say that they didn't expect to
raise interest rates for a period of three years. The
idea is to convince people they can rely on the
FED to keep interest rates low, therefore spending in the
economy high for the next three years. The hope is
that this spurs more business investment.
The feds two goals are stable prices or stable inflation,
and a maximum sustainable employment rate. These are known as
the Fed's dual mandate. Now let's dig into these a
little more. First, stable prices, what do we mean by this?
When inflation's sufficiently low and stable, most people can make
plans and basically ignore inflation. They can focus on doing business.
Over the past few decades, most central banks have turned
to targeting a very specific low inflation rate and trying
to keep inflation there. Most developed countries aim to keep
inflation around two percent a year.
The FIT started announcing its target to the public in
twenty twelve, with the hopes that this would convince people
all across the economy that inflation would in fact be low.
And stable by being really transparent about the inflation rate
they're targeting. The hope is that their expectation will trickle
through the economy as price centers raise their prices in
line with that low and stable expected inflation rate of
two percent.
So the goal was, if we convince people there'll be
low inflation, that'll create the reality of low inflation.
We always hear about the dangers of inflation, though, so
why do we have two percent inflation? Why do we
want any inflation at all?
There's a few reasons for this. One is that if
we had no inflation at all, it's going to be
really hard for employees to cut wages if the economy
were to turn down. If there's inflation, you can cut
people's real wages just by not adjusting their money wages,
and that can help buffer some economic shocks.
Okay, but people really don't want to hear about WHOA
isn't this great? It lets us cut people's wages in
a secret way. But in a recession or a downturn,
if employers can't cut the real wage, they may have
to lay people off instead. So zero percent inflation might
lead to higher unemployment during recessions.
Another reason is it by ca keeping inflation above zero,
the FED has more room to cut the real interest rate.
This is a really important concept called the zero lower bound.
So the FED wants to try to lower interest rates
if we're in a recession, but it can't really lower
rates below zero percent because the real interest rate is
the nominal interest rate minus inflation. So if there's no inflation,
then the Fed has less room to maneuver to cut
the real interest rate. This has been one of the
things that's been challenging central banks across the globe over
the last few decades.
There's something else. If we were to target zero percent
rate of inflation, well, there's the risk that instead of inflation,
end up with deflation.
Deflation is when overall price levels are falling, which is
the same as a negative inflation rate.
Yeah, so it sounds great right now, as we all
want things to be on sale. So if I told
you that, you know, you're thinking about, I don't know,
going out and buying a new car, but it might
be five percent cheaper.
If you wait, what are you likely to do?
I will probably wait?
Right That is the problem of deflation.
If everyone does that, no one's buying cars the economy
into is a recision. It's worse than that. You've got deflation.
The economy into is a recession that's going to cause
more deflation exactly, and so it can create a spiral
of more deflation, more recission, more deflation.
The last reason that central banks tend to not aim
for zero percent inflation is that many economists believe that
the measured inflation rate overstates the.
Actual inflation rate.
Remember in our earlier episode about inflation, we looked at
how inflation rate calculations often don't take into account things
such as quality improvements in many products, which.
Might effectively reduce the cost of living.
So if we aimed for zero percent measured inflation, we
could actually end up with deflation.
So they aim for two percent inflation and the interest
rates to try to keep inflation stable at two percent.
But employment is also important to the Fed too, right.
Yes, the Fed STOL mandate is also about maximum sustainable employment.
This is what happens when the economy is operating at
its potential. It doesn't get rid of unemployment because some
unemployments caused by other factors, like the time it takes
you to look for a job, or if you need
to retrain to keep up with changes in the economy.
So what it's trying to do is target the lowest
sustainable rate of unemployment or the highest sustainable level of employment.
We've gone through what happens at the Federal Open Market Committee.
How does the FED choose the interest rate?
Well, policy makers start by thinking about something called the
neutral interest rate. This isn't an interest rate that you
can look up in the newspaper, because it's really more
of an idea than a specific interest rate. Think of
it as the goldilocks interest rate that will cause you
economy to be not too hot nor too cold.
It's a really important baseline because the idea is if
you set the reeling straight higher than its neutral rate,
it'll lead output to grow a bit more slowly than
its potential, leading to unused resources and unemployment. Or if
you keep the really straight lower than the neutral rate,
it'll push output to grow faster than potential, potentially sparking inflation.
Economists used to think that the neutral real interest rate
was about two percent. That it's been following as part
of a trend called secular stagnation. We'll talk about secular
stagnation in a bonus episode with Larry Summers. But the
implication is that today the neutral real interest rate is
probably less than one percent.
So we have the neutral real interest rate, which is
an important baseline. What else do these central bankers look
at when they're setting the interest rate?
They also compare inflation to their inflation target. If inflation's
higher than the fed's target, this is a signal to
the FEED that it should set the interest rate higher
than the neutral real rate so it can encourage people
in businesses to spend life and save more. That spending
less will reduce demand, which in turn will lead to
lower inflation.
It's not just the FAED that targets inflation, so does
the European Central Bank, the Reserve Bank of Australia, the
Bank of Japan, and the Bank of England and just
about every major country. In each case, policymakers look at
the gap between inflation and the target level of inflation
to guide them on just how much they need to
change the real interest rate.
And just a moment ago, you mentioned the output gap,
which is also closely related to the unemployment rate.
Yeah, when the economy is producing less than its potential,
then there are lots of unused resources, including unemployed workers.
That's a problem, and so central bankers also think about
the output gap and how they can address it when
they're setting rates.
Nearly every central bank takes a look at the state
of their labor market and the output gap when setting
interest rates, but they talk about it differently. In countries
like the US or Australia, the central bank is explicitly
told by the government that it needs to adjust rates
in response to both inflation and employment.
In other countries, the government tells the central bank to
focus only on inflation. For instance, the European Central Bank
says that its main aim is to keep inflation low,
but if you remember the Phillips curve, you'll know that
the output gap and unemployment also affect inflation, and so
the European Central Bank also ends up adjusting interest rates
in response to output and the state of the labor market,
but it does so because those things affect the future
of inflation.
When output exceeds potential, central banks tend to respond by
setting real interest rates a bit higher, understanding that this
will reduce demand, therefore reduce the output gap and reduce inflation.
Or if outputs below potential and people are unemployed. A
central bank will typically try to help people get back
to work by setting a real interest rate a bit lower.
Their hope is that this will stimulate more spending, leading
to more output and more hiring.
So far, you've been talking about the real interest rate,
where the FAT set's the nominal interest rate.
Yeah, and so this means that once the FED decides
on what the real interest rate should be, it needs
to add in inflation to it in order to get
the nominal interest rate, which is what it will ultimately announce.
And we call this the federal funds rate.
Yeah, the FED adjust a very specific interest rate. We
call that the Federal Funds rate. But as we'll talk
about in the moment, changes in that rate end up
affecting nearly every other interest rate in the economy, from
car loans to business investment loans.
So to wrap up, central banks like the FED start
by thinking about a baseline neutral real interest rate, and
they'll set that rate a bit higher if inflation is
likely to exceed its target. They'll adjust it a bit
lower if unemployment is likely to be high because output
is too weak. And of course they actually set a
nominal interest rate which is equal to their preferred real
interest rate plus inflation.
It's one more important thing. Central bankers don't just look
at today's inflation or unemployment numbers. They're also looking at
four casts of the future path of the economy, so
they can predict and get ahead of any looming problems.
Now, how exactly does the central bank set the interest rates?
As we discussed, the federalser sets one main interest rate
called the Federal fund rate. It's a pretty strange interest rate.
It's not one you're going to face in your daily
life because it's the rate that banks charge each other
for overnight loans.
But that rate really matters because when banks can borrow
from each other at low rates, they can link to
you and I and to millions of other people and
businesses at low rates too. So the effects of changing
the Federal Funds rate ripple out and affect the rate
on just about everything, from the rate on personal loans
to the interest rate on car loans to business loans.
You're saying that the Federal funds rate is an overnight
interest rate, or the interest rate on a one day loan.
Most loans last longer than this though.
Yeah, but when you think about a longer line, let's
say a two day line. We can think about a
two day line as a one day loan from today
till tomorrow, and then another one day line from tomorrow
till the next day. It means the interest rate on
a two day loan will be equal to the overnight
interest rate today plus whatever we expect the overnight interest
rate to be tomorrow.
You can take this logic even further.
The interest rate on a thirty day loan is equal
to today's overnight interest rate plus the rate people expect the
Fed to charge for each of the subsequent twenty nine days.
So now you're getting that sense of why expectations really matter.
What interest rate are they going to pay each and
every day over say the next thirty days, the next
sixty days, the next year.
Follow that logic far enough and you'll see that the
changes in the overnight interest rate affect the one year
interest rate, the two year interest rate, the ten year
interest rate, and so on.
So how does the FED set this overnight interest rate
that we call the Federal funds rate?
One answer is that it's complicated. The simpler answer is
that the FED effectively announces that it's willing to borrow
or lend any amount of money to banks at a
particular rate. So if the FED wants to set the
Federal funds rate at one point five percent, it'll say
that it's willing to borrow any amount of money at
one point five.
Percent overnight from these banks. By being willing to borrow
any amount of money at a particular rate, it's effectively
setting kind of a floor, meaning that other banks would
rather lend money to the FED at that rate than
lend money to anybody else at a lower rate. So
those banks will only lend money out to other banks,
or to you or to me if the rate is
at least as high as that floor.
The FED refers to this as the ample reserves framework,
or sometimes the floor framework, and this is essentially how
the FED sits a floor or a lower bound or
a minimum interest rate that one financial institution will be
willing to charge to lend to another.
And the FED also sets a ceiling. Basically, it says
will lend any amount of money at another interest rate
that you or I might call the ceiling, but they
call the discount rate. If a bank can borrow money
from the FED at say one point seventy five percent,
it'll never borrow money from others at a higher rate.
So there's a floor on the federal funds rate of
say one point five percent, in a ceiling of say
one point seventy five percent. What that means is that
the federal funds rate will end up somewhere in that
very narrow window.
By the way, all of this used to operate very differently.
So if you hear an economists talking about open market operations,
they're typically talking about how the FED used to operate.
What about quantitative easing? I keep reading newspaper headlines about both.
And sometimes they'll just call it q E. Now, remember
we said that the FED normally operates by affecting the
federal funds rate, which is the interest rate on overnight loans. Well,
quantitative easing it's just a terrible term for when the
FED tries to buy and so long term bonds as
a way of changing long term interest rates. So instead
of changing the overnight indust rate, quantitative easing is about
lowering long term interest rates like the rate on ten
year loans.
You'll often hear people talk about the Fed's balance sheets.
That's about the amount of these long term bonds that
they're holding on to and whether they plan to sell
them or buy more of them in the future.
And all of that's about affecting long term interest rates.
We've been talking so much about what's central banks do
and what financial institutions do, and they all sound so
abstract and distant from our lives. How do all these
adjustments to the federal funds that impacts us as everyday
people living and working in the economy.
It does affect us all because these changes in the
market for over an eight loans will ripple through the
economy and lead banks to change the industry they charge
consumers for credit cards, loans, mortgages, etc. So the federal
funds rate will really trickle out through the entire economy.
And it doesn't just affect the interest rate you're going
to pay on your car loan or on your mortgage.
Remember that the industry is all about changing the value
of consuming today versus consuming tomorrow.
And so it's going to change the spending plans that
make most sense for you. If interest rates are high,
you should probably save more because it's really worth saving.
And if interest rates are low, maybe there's a stronger
case to be made for spending more today.
And more demand today means businesses will hire more people.
That also means more output, and there could be supply constraints,
so we could see prices rising, pushing up inflation. It
all really depends on how much access capacity there is
in the economy.
So all of this is going to shape the opportunities
you're offered because the state of the labor market is
really dependent on what the FED does. It's also going
to affect the prices that you face at the supermarket
because inflation is largely determined by the Fed's actions.
And what can we be thinking about over the next
few days so that we can really get our heads
around all this.
You're going to be making a lot of decisions over
the next week. It might be whether to apply for
a new job. It might be whether to refinance your mortgage.
It might be whether to buy something today before the
prices go up or down. As you're making each of
those decisions, think about the role that the central bank
in your country is playing in shaping your decisions.
Yeah, one way to do that would be to think
about what would you actually do if interrotrates were higher,
or what would you do if interratrates were lower then
start to think about multiplying that by while all the
people in your country, and that'll give you a sense
of how you think the macroeconomy will move.
Betsy Justin, thanks for walking us through monetary policy.
This one's near and dear to our hearts. And as
my first ever job out of college was working for
the Central Bank And hey, Betsy, what was yours?
I was working for the Central Bank at the Federal
Reserve Board in Washington, DC. Thanks for listening.
There's a lot more from this show and others like
it on the Himalaya Learning platform.
Himalaya Learning provides bye sized courses from world class thinkers
and industry experts for you to enjoy in the app
on the go.
For exclusive content, including bonus episodes and supplemental materials, go
to himalaya dot com slash econ and enter promo code
econ at checkout for your first fourteen days free.
Himalaya dot com slash econ has a loads of great
shows like ours, so try it out using the promo
code econ at checkout to get your first fourteen days free.
It's time to
Think like an economist