Susan Schmidt Bies: Behind the scenes at the FOMC - how the Federal
Reserve determines monetary policy
Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve
System, at the Academic Speaker Series, University of Tennessee, Martin, Tennessee,
7 February 2005.
* * *
Good evening. I'm certainly pleased to be back in Tennessee with a chance to visit with some old
friends. I am often asked what it is like to be a Federal Reserve Governor and what I actually do. So I
thought I would give you an overview of the Federal Reserve System, to assure my friends that, yes, it
is a full-time job, and, yes, I did have to move to Washington to accept the appointment.
Before I start, let me offer the customary caution that the views I'll express are my own and don't
necessarily reflect those of other policymakers or staff members of the Federal Reserve. First, I want
to spend some time offering you a broader perspective on the Federal Reserve's purposes and
functions. Then I want to talk in more detail about how monetary policy is determined. At the Board,
we sometimes nickname this topic "Fed 101." In fact, the Fed has a wonderful website with just that
name. You can find it by going to www.federalreserveeducation.org and clicking on the "Fed101" tab
at the top of the page.1
The Federal Reserve System
The Federal Reserve System is generically described as the central bank of the United States. It
represents our nation's third, and I trust final, attempt to establish a central bank. You may well recall
learning in school that, in the late eighteenth and early nineteenth centuries, the Congress chartered
the First Bank of the United States and the Second Bank of the United States, but neither institution
lasted more than twenty years. The Banks' very existence was controversial and went to the heart of
the great national debate, which continues to this day, over which responsibilities and powers should
be handled at the federal level and which should be left to the states. Suffice it to say that, after the
charter of the Second Bank of the United States expired in 1836, we went without a central bank for
nearly eighty years.
A series of financial panics in the late nineteenth and early twentieth centuries, most notably the Panic
of 1907, revived the idea of creating a central bank to provide the nation with a safer, more flexible,
and more stable monetary and financial system. But suspicion of centralized power remained at the
core of the American psyche, and so the institution that the Federal Reserve Act established in 1913
was a central bank that assigned significant responsibilities for monetary-policy-making to regional
Federal Reserve Banks. The System that resulted consists of a governmental agency - the Board of
Governors - in Washington and, in twelve major cities, the regional Federal Reserve Banks, which
combine public and private elements. The role of the Board vis-à-vis the regional Banks was elevated
in the aftermath of the stock market crash of 1929 and in the early years of the Great Depression, but
the combination of centralized and regional responsibilities remains an important strength of the
Federal Reserve System, as I'll explain shortly when I discuss the formulation of monetary policy.
The role that the Fed's founders envisioned for the central bank was narrower, and more passive, than
the role that the Fed plays today. The emphasis was on providing currency and reserves to meet
seasonal demands and on assisting banks in accommodating the credit needs of commerce and
business. Indeed, until the 1920s, it wasn't clearly understood that the Reserve Banks' purchases and
sales of government securities influenced the supply of money and credit in the economy.
Today, the Federal Reserve's duties fall into four general areas - some that would have been familiar
to the central bankers in the Fed's early years and some that would have been unfamiliar:
•
maintaining the stability of the financial system and containing systemic risk that may arise in
financial markets
• supervising and regulating banking organizations to ensure the safety and soundness of the
nation's banking and financial system and to protect consumers from harm in their use of
credit and banking services
•
playing a major role in operating and overseeing the nation's payment system, including
providing certain financial services to financial institutions, the U.S. government, and foreign
official institutions
•
conducting monetary policy in pursuit of stable prices and maximum sustainable employment
We have an all-too-recent example of the Fed as a source of financial stability in its response to the
financial aftermath of the terrorist attacks of September 11, 2001, which occurred just before I joined
the Board in December 2001. As a commercial bank executive, I was impressed with the speed at
which the Fed responded when the normal settlement and information systems in check and securities
markets were interrupted. The Fed worked immediately through discount window lending, open market
operations, and other means to provide the financial and banking systems with sufficient liquidity.
It worked with public- and private-sector participants to keep markets open or, if circumstances forced
markets to close, to return them quickly to normal operations. As the operator and overseer of key
payment systems, it had to ensure that its own systems, as well as those of the private sector, were
operational. And on the Monday after September 11, it lowered the target federal funds rate to help
cushion the economic fallout of the blow to consumers' and businesses' confidence. Because the Fed
worked so effectively, bankers throughout the country could serve their consumer and business
customers and thereby help to minimize the economic effects of the terrorist attacks.
The Fed's role as the supervisor of banking organizations - both as the federal supervisor of the
roughly 900 state-chartered banks that have joined the Federal Reserve System and as the umbrella
overseer of more than 5,000 financial and bank holding companies - gives the Fed's staff and
policymakers the kind of hands-on experience and knowledge that is essential for a central bank
during a financial crisis.
The Fed's examiners and supervisors seek to ensure not only the safety and soundness of the
banking system but also the financial strength of individual banking organizations and the
effectiveness of their systems for complying with anti-money-laundering, consumer-protection, and
other laws. In fact, the Congress charged the Federal Reserve Board with writing the rules that
implement consumer protection laws such as the Truth in Savings Act and the Truth in Lending Act,
though each of the various federal banking agencies enforces the regulations for the institutions within
its purview.
Given all the attention paid to the Board and its Chairman, you may be surprised to learn that more
than 21,000 of the Federal Reserve System's roughly 23,000 employees work not in Washington but
at the twelve regional Federal Reserve Banks. A substantial portion of these employees work in vital,
but often unsung jobs, keeping the payment system operating smoothly. The System's employees
handle the distribution of U.S. currency and coin throughout the nation and the world. They also clear
and process checks and electronic payments, such as the direct deposit of paychecks, and they
facilitate the electronic transfer of huge sums between large financial institutions.
Monetary policy
But it is monetary policy - and the Fed's principal monetary lever, the federal funds rate, which is the
interest rate on overnight loans of reserves between depository institutions - that earns the Federal
Reserve all that ink and airtime. Deciding on the appropriate policy from among the various options
keeps nineteen policymakers and a staff of more than four hundred Ph.D. economists at the Board
and the Reserve Banks quite busy.
The chief monetary-policy-making body within the Federal Reserve is the Federal Open Market
Committee, or FOMC. It meets eight times a year but can confer by telephone more often if necessary,
as it did in 2001 as it responded to incoming economic information as well as economic shocks from
terrorism, and as it did again in 2003 as policymakers sought to understand the economic effect of the
war in Iraq. The FOMC has nineteen participants - the seven Governors of the Federal Reserve Board
and the twelve presidents of the Reserve Banks. Although all actively participate in discussions at the
meetings, only twelve have votes at any one time on the Committee. Each of the seven members of
the Board wields a vote, as does the president of the Federal Reserve Bank of New York by virtue of
that Bank's unique responsibility for implementing monetary policy decisions through the open market
operations of its Domestic Trading Desk. The responsibility for casting the remaining four votes
alternates among the remaining eleven Reserve Bank presidents: Two vote every other year, and the
other nine vote every third year.
But the important point to remember is that, in a consensus-driven body such as the FOMC, the
identity of a member who casts a vote in any given year is less significant than the fact that each
member of the FOMC participates fully in the deliberations. The presidents, in particular, bring to the
table analyses of economic and business conditions in their districts. The boards of the Reserve
Banks also contribute a wealth of anecdotal information to supplement the torrent of hard economic
data the Fed analyzes. Moreover, they make recommendations to the Board on the discount rate, the
rate the Fed charges on its own loans to financial institutions. The information from the Reserve Bank
boards, along with other economic intelligence, is summarized in a report known as the Beige Book,
which is publicly released about two weeks before each FOMC meeting. The FOMC also consults
other books of other colors. But I'm getting ahead of myself.
Let me describe the routine at a typical FOMC meeting. After seating ourselves around the
twenty-seven-foot-long, polished mahogany-and-black-granite Board table, we begin punctually at
nine o'clock. After approving the minutes of the previous meeting, our first order of business is a report
from the Manager of the System Open Market Account at the New York Fed, who focuses on
conditions in domestic and international financial markets. That report is followed by a presentation
from the directors of the Board's Divisions of Research and Statistics and International Finance, who
deliver the Board staffs' economic forecast as represented in the Greenbook, which FOMC members
have usually had the weekend to study. The Greenbook contains the staffs' summary of recent
economic information, a baseline economic forecast, which is the staff's best estimate, and scenarios
based on possible alternative future events. Then comes the first "go-round," in which every member
of the Committee offers his or her assessment of current economic conditions.
We may usefully digress here to consider how the Board staff arrives at its forecast and to describe
what role the forecast plays in policymakers' deliberations. An important, perhaps obvious, point to
make is that it is not - I repeat, not - the FOMC's forecast. The economic staff of each Reserve Bank
independently advises its president. And the economic staffs of the Reserve Banks and the individual
members of the FOMC may or may not agree with elements of the Board staff's forecast. Indeed,
FOMC members sometimes couch the presentation of their economic views in terms of where those
views coincide with and diverge from the Greenbook's forecast. That description, in and of itself, gives
you some sense of the staff's influence of the forecast. It sets the parameters of the discussion.
So what kind of forecast is it? It is a forecast based on human judgment. But this judgmental forecast
is informed by sophisticated econometric models. The staff's core, large-scale structural model has
been dubbed FRB/US - pronounced "ferbus." But that model is not the only one the staff uses. Indeed,
the staff uses its suite of smaller-scale models to probe the vulnerabilities of the core model. But as
seductive as modeling is to us economists, we must remember that no model can fully capture a
dynamic, ever-evolving economy such as ours. Thus, the staff's forecast, and I'm sure the individual
forecasts of each FOMC member, are in the end judgmental assessments.
After the Greenbook session, the director of the Board's Division of Monetary Affairs briefs the
committee on the Bluebook, a document that presents policy options, usually two or three, for the
Committee's consideration and that offers arguments for and against each course of action. Not a
recommendation from the staff, the briefing is instead a vehicle against which FOMC members can
test their own thinking.
Finally, after hours of discussion and analysis, the Chairman speaks on the policy choice for the first
time. Until this point, his participation in the meeting has usually been limited to questions and to
comments aimed at keeping the meeting moving. After the Chairman makes his recommendation,
FOMC members react in the second go-round. Then we vote, and by then it is usually about one
o'clock and time for lunch. About an hour later, at around quarter after two, a statement publicly
announces our decision. As currently formulated, the announcement has four parts: the first states the
target for the federal funds rate; the second briefly explains the Committee's analysis of current
economic conditions; the third provides the Committee's assessment of the risks to price stability and
economic growth; and the last provides Committee members' votes.
The statement is a relatively recent innovation; it is about a decade old and, over that period, it has
evolved from a quite terse missive to the almost loquacious form it takes today. Before the advent of
FOMC statements, market observers had to infer shifts in monetary policy by watching the New York
Fed's open market operations, and trying to guess whether the Fed was easing or tightening monetary
policy.
As you may know, the Federal Open Market Committee decided this past December to begin
releasing the minutes of its meetings on an accelerated basis. Previously, our practice had been to
release the minutes on the Thursday following the next regularly scheduled meeting - that is, with a
typical lag of a bit more than six weeks. Under the new schedule, that time has been cut in half:
Minutes will now be released with a lag of just three weeks. This move is the latest in a long sequence
of changes that the Federal Reserve has implemented over the past decade to enhance the openness
and transparency of monetary policymaking.
Before reaching our decision to accelerate the minutes, we discussed the pros and cons of doing so at
some length at our December meeting. For a number of months, we had been experimenting internally
with accelerating the preparation of the minutes, and we agreed that the trial had been a success. The
minutes contain a more complete and nuanced explanation of the reasons for the Committee's policy
decisions and our view of the risks to the outlook than we can possibly include in a brief post-meeting
announcement. For that reason, speeding up the release of the minutes was seen as helping markets
interpret our policy actions in the context of evolving economic developments and so better anticipate
the course of interest rates.
Another advantage is that the minutes now will provide the public a more up-to-date context for
individual policymakers' public remarks. That is, when members of the FOMC give speeches, you will
know how their views compare with the range of other members at the last FOMC meeting. We
recognized, however, that there are risks to accelerated release: In particular, there is a possibility
that, at times, the markets could misinterpret the minutes. In the end, our clear consensus was that the
likely benefits outweigh the risks, and we decided to proceed with releasing the minutes on an
expedited schedule.
We went "live" with accelerated release beginning with the minutes of the December meeting, which
were published on January 4. The document was intensively covered in the press and received
considerable attention in financial markets. My impression is that most investors agree that the change
is an improvement in openness and transparency of monetary policy. However, it is important to note
that, when interpreting the minutes, readers should keep in mind that they are not simply a longer and
more-detailed version of the statement that the FOMC issues after each meeting. The statements are
intended to concisely convey the Committee's broad consensus. The minutes, however, are intended
to reflect the broad range of views held by members of the Committee, including views expressed by
just a few members. Thus, it is perfectly possible and appropriate that a statement in one part of the
minutes does not accord with another passage in the minutes.
If you want further details of how the discussion goes at FOMC meetings, transcripts are released
after five years. These are verbatim transcripts, but the names of companies who provide confidential
information are redacted, to encourage the sharing of forward-looking information with FOMC
members, who in turn share that information with others as we have our discussions.
Members of the FOMC also communicate to the public through speeches, which we all make at
various times during the year. As I noted in the disclaimer I gave at the start of this speech, when we
give speeches, we are speaking for ourselves, and not necessarily for the FOMC or in my case the
Board of Governors. The Chairman also delivers twice-a-year reports to the Congress on monetary
policy, where he speaks for the FOMC. The Chairman also testifies before Congress, giving his views
on economic policy.
These methods of communication are all important elements of the transparency necessary for an
independent central bank to function within a democracy. As I mentioned, our goals - price stability
and maximum sustainable employment - are set by law, but we are afforded the political
independence to make the sometimes unpopular decisions required to achieve those goals.
Appropriate transparency and accountability offer a necessary counterbalance to that independence.
Conclusion
I hope this gives you an overview of the broad range of purposes and functions of the Federal
Reserve System, as well as an insiders view of what happens behind the scenes at the FOMC. Next
time you hear or read a news account of the Fed's actions to change the fed funds rate, I hope you
appreciate all of the activities that go behind our decisions.