Monetary Policy: Key Takeaways

This picture was sourced from Pepi Stojanovski on Unsplash

The Covid-19 pandemic has introduced an era of profound strife and uncertainty. In the simplest terms, this pandemic has created two huge problems in the areas of public health and economics. To make matters worse, these public policy domains are, generally speaking, at odds with one another. This post will focus on the economic dimensions of this crisis at a high level.

When a national economy experiences macro level shocks there are two primary policy tools at the disposal of government and quasi-government actors – Monetary Policy and Fiscal Policy. The former is focused on addressing interest rates and the supply of money in circulation, it is generally managed by a central bank (such as the Federal Reserve). The latter addresses taxation and government spending, it is generally determined by legislation. Specifically, this post will proved an overview of monetary policy and explain how it is utilized by the Federal Reserve to promote certain outcomes within the national economy.

Monetary Policy

Monetary policy is typically carried out by Central Banking authorities, in the United States it is carried out by the Federal Reserve – often referred to as “The Fed.” Monetary policy involves two primary actions:

  • Establishing base interest rates.
  • Influencing the supply of money (most often carried out through policies of “quantitative easing” which increase the supply of money in the nation.

The Fed has typically used monetary policy to stimulate the economy or check its growth. When the Fed cuts interest rates, it’s sending a signal to individuals and businesses that they should borrow money and spend it in the economy. Conversely, when the Fed increases interest rates the aim is to encourage saving, rather than spending. This acts as a brake on inflation and other issues associated with rapid growth.

More specifically, the Fed has looked to three primary policy levers when influencing rates and borrowing activities – Open market operations, changing reserve requirements for other banks, and setting the discount rate.

Open market operations refer to measures carried out on a daily basis. These operations occur when the Fed buys or sells U.S. government bonds, thereby injecting or withdrawing money out of the national economy.

The second, changing reserve requirements, relates to the percentage of deposits that banks are required to keep in reserve (i.e. cash on hand at any given time). The key takeaway here is that through it’s control over reserve requirements, the Fed is able to directly influence the amount of money created when banks make loans to individuals and businesses. This is important to keep in mind in the present, as reserve requirements have become relatively lax.

Finally, the Fed has dominion over the discount rate. The discount rate is the interest rate the Fed charges on loans it makes directly to financial institutions. The key takeaway here is that the discount rate has an overarching impact on short-term interest rates across the entire national economy.

Conclusion

Ultimately, monetary policy is more of a high level tool. It’s focus lies on expanding and contracting the money supply while influencing borrowing and saving behaviors, however it has less of an impact on the real economy. The key takeaway with monetary policy is that it exists to dictate banking behaviors in the national economy through its control of interest rates and the money supply.

In normal times, the Fed’s focus will be placed on contractionary or expansionary measures. In times of crisis, however, their focus shifts to providing enough liquidity in the financial system to maintain solvency. This, in large part, helps explain the measures taken by the Fed over the last couple of weeks.

If you made it this far, thank you for taking the time to read this! I will be following up on this post with a post that provides a similar overview of fiscal policy. If you found this information valuable, please like and share it with others.

Covid-19 & Financial Markets

This picture was sourced from CDC on Unsplash

As Covid-19 (Novel Coronavirus) continues to spread through the global system, and increasingly through U.S. metros, the financial markets have certainly taken notice. Volatility is on the rise and major indices have dropped as much as 11% over the course of this week. Many practitioners, government officials, and pundits have attempted to downplay the Covid-19 outbreak – arguing that the volatility of the market is the result of an overzealous media. The Federal Reserve, in typical fashion, cut interest rates in an attempt to stimulate the economy. It didn’t work.

So, why is the market reacting with such profound volatility? Because this is about more than finance. Contrary to popular belief, investors are not guided by the notion of lower rates being equivalent to higher market caps. As Sina Kian puts it in his recent Politico article Coronavirus: The Real Reason the Markets are Worried – “They’re worried about the human and economic costs of the virus itself. “

It’s Not About Monetary Stimulus

A phrase that is often thrown around in finance is confidence and what we’re seeing from investors in the financial markets is a lack of it. Confidence is not solely tied to stock performance in the literal sense, confidence also relates to the ability of public and private sector leaders to manage a particular set of circumstances. Up to this point, confidence in Washington has been shaken. The market (in aggregate) is looking for signs that the crisis can be addressed in a competent manner. There is nothing artificial stimuli, such as rate cuts and quantitative easing, can do to prevent the spread of a virus and that’s why these schemas have failed thus far.

The market, vis-a-vis it’s participants, is seeking tangible solutions to tangible problems. How will the government contain the outbreak and address existing cases? What is to be done about disruptions in global supply chains? How should reductions in revenue streams in key industries and in key companies be addressed in the midst of a black swan event? These are complex questions that cheap access to capital cannot comprehensively address.

Conclusion

This is a rare instance when public and private sector interests are in alignment and one in which public policy decisions will have a profound impact. Ultimately, the focus should lie on addressing the dynamics of the virus itself. This will begin to restore confidence in the financial markets and help bolster economic considerations moving forward.