There's a saying that, if all you have is a hammer, everything looks like a nail. For decades, the Federal Reserve wielded only a hammer as it maintained monetary policy. Then, five years ago, it borrowed a screwdriver. Today, we saw a sign that the Fed won't return the screwdriver it borrowed.
2 main jobs
One of the Fed's main tasks is to take care of monetary policy -- basically, adding and withdrawing cash from the financial system to keep inflation under control while also maintaining employment. This is called the dual mandate.
The dual mandate forces the Fed into a balancing act:
- If the unemployment rate gets too low, then people have tons of money to spend. That sends prices upward, and then people buy things now, before prices rise even higher, and the high demand causes prices to rise even faster. You end up in an inflationary spiral.
- If the inflation rate is too low, then people spend sluggishly. After all, if prices won't be higher a year from now, why rush to buy something? But because people aren't spending, businesses don't hire. You end up in recession.
The Fed's monetary policy body, the Federal Open Market Committee, tries to keep inflation low, but not too low -- around 2 to 2.5 percent -- and it tries to hold down the unemployment rate. To varying success over the years.
Introducing the hammer
The FOMC's tool has been the federal funds rate, which is the overnight interest rate for banks borrowing reserves among themselves. The federal funds rate influences other interest rates, such as the prime rate, which, among other things, is the base rate for home equity lines of credit and some credit cards.
The federal funds rate is the hammer that I mentioned above.
Here comes the screwdriver
When the financial crisis hit in 2007 and 2008, the Fed realized that it needed more than a hammer. So in late 2008, it borrowed a screwdriver: multibillion-dollar purchases of bonds. At first, the Fed bought Treasury notes, and later it added mortgage-backed securities to the mix.
The way I understood it, the Fed always had implied that these bond purchases were extraordinary measures -- that it would put away the screwdriver after the repairs were done. But that might not be the case.
Memo from Tarullo
Today, the Fed's longest-serving governor, Daniel Tarullo, delivered a lengthy speech to the National Association for Business Economics on the subject of monetary policy and financial stability. I've read a couple of articles about the speech, and it looks like the reporters missed the most newsworthy part of Tarullo's address, which came at the end (emphasis is mine):
Finally, it may also be worth considering some refinements to our monetary policy tools. Central banks must always be cognizant of important changes that may result in different responses of households, firms, and financial markets to monetary policy actions. There is little doubt that the conduct of monetary policy has become a good deal more complicated in recent years. Some of these complications may diminish as economic and financial conditions normalize, but others may be more persistent. Central banks, in turn, may want to build on some recent experience, adapted for more normal times, in addressing the desire to contain systemic risk without removing monetary policy accommodation to advance one or both dual mandate goals.
One example would be altering the composition of a central bank's balance sheet so as to add a second policy instrument to changes in the targeted interest rate. The central bank might under some conditions want to use a combination of the two instruments to respond to concurrent concerns about macroeconomic sluggishness and excessive maturity transformation by lowering the target (short-term) interest rate and simultaneously flattening the yield curve through swapping shorter duration assets for longer-term ones.
Tarullo is saying that, even after things return to normal a few years from now, the FOMC might use two tools, not just one. It can use the federal funds rate to tweak short-term interest rates such as the prime rate, and bond purchases to influence longer-term interest rates such as mortgages.
It looks like the Fed wants to keep the screwdriver as well as the hammer.
Follow me on Twitter @HoldenL.
Get real-time rate quotes with Bankrate's Mortgage app.