Understanding the Market

The Federal Reserve Act states the objectives of monetary policy: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of [1] maximum employment

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, [2] stable prices, and [3] moderate long-term interest rates.” (numbers in [brackets] added)

If you have difficulty reconciling this sentence with textbook macroeconomics you are not alone. There is no obvious definition of maximum employment (zero unemployment?) or stable prices (zero inflation?) or moderate long-term interest rates

, but in any case the Fed must do all three simultaneously. Even if we do not precisely understand the Fed’s official instructions from Congress, we can see that they are fairly broad; a Fed chairman can always claim that a particularly policy was aimed at one of the objectives.

In contrast, other Central Banks whose have a single objective to maintain price stability (for example the ECB, see here) and attach secondary importance to employment and growth. There are a number of other jobs for the Fed described in the Federal Reserve Act but they are of lesser importance.

Congress created the Fed and holds a good deal of power over it. The Humphrey-Hawkins legislation (see section 108 of the rather large pdf) required the Fed to report to Congress twice a year about how it is meeting its objectives; while the legislation expired in 2000

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, the Fed chairman voluntarily testifies before Congress twice a year (more often if there are important issues) and is required to answer a number of questions on various issues.

If Congress is not happy with the Fed’s performance they could theoretically redesign the system and replace the Fed with something else. While it would take a major crisis to provoke such a reaction, this scenario happened during the Great Depression. In 1942, Congress took interest rate policy away from the Fed and gave it to the Treasury Department (see here); the Fed only regained its independence in 1951.

So the Fed is very responsive to Congress. The Fed Chairman routinely endures lengthy questioning from Congress about many topics in an effort to be responsive to the concerns of Congress (a search on youtube.com for Fed Chairman Bernanke produces over 1000 videos

, many of which appear to involve Congressional testimony), and tries to carefully explain policy to preserve the Fed’s independence in the future.

The Fed chairman technically has two separate appointments: a term as governor (just like that of the other six governors) that lasts 14 years (unless the chairman initially takes the remainder of the term of another governor) and a four-year term as chairman (see here for Chairman Bernanke’s terms). Again, the chairman can remain chairman until a new chairman is nominated. The practical result is that Fed chairmen in recent years have worked closely with each new President; Chairman Greenspan was nominated initially by President Reagan and then renominated by Presidents Bush and Clinton. The current understanding in Washington appears to be that markets would be upset by the ouster of a Fed chairman who is doing well, making administrations reluctant to change. Chairman Bernanke’s handling of the current economic mess will likely determine whether he will be renominated when his term as Chairman expires in January 2010.

There is one important mandate that the Fed does not have: managing the external value of the Dollar. It is a curious relic of the 1951 Fed-Treasury accord that the Treasury is responsible for the Dollar

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, so that only the Secretary of the Treasury will speak about the Dollar’s value or order intervention in currency markets (which will be carried out by the Fed). Most economists believe that the value of the Dollar is largely determined by monetary policy, which is planned and executed by the Fed. But for legal/political reasons, the official authority is in the Treasury.

The Federal Reserve was created by Congress almost 100 years ago, when the economy and markets were very different from today. Creating a central bank was controversial at the time and the political compromises led to a peculiar structure (see here for the official version of the Fed’s history; there are numerous alternate versions of the Fed’s history

, including this one that is considerably more skeptical).

The Fed consists of 12 regional Federal Reserves that were established in the large financial centers of 1913; there is only one regional Fed in the western US (in San Francisco) while there are two in Missouri (St. Louis and Kansas City). You can see the map here.

The decision making body of the Fed is the Federal Open Market Committee (FOMC). When you hear that the Fed cut rates it is by a vote of the FOMC. There are two sorts of members of the FOMC: seven governors, selected by the President, who serve 14-year terms. Due to a conflict between the Democratic Congress and a Republican President there are currently several vacancies; Board members can remain on the Board until their replacements are named or until their full 14-year term is completed. Few board members serve a 14-year term, so a two-term President is likely to have the opportunity to name all seven Board members.

The remaining five members of the committee come from the 12 Presidents of the regional Federal Reserve Banks (on a rotating basis)

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, who are selected by the locally-based Directors of the Banks (see here

, at the bottom of the page, for the list of which Fed President serves when).

The crucial policymaking is done at meetings of the FOMC in a large conference room in the Eccles Building in Washington, DC. Sitting at the table are the Chairman of the Fed (Ben Bernanke), the Vice Chairman of the Fed (Donald Kohn), the other five governors, the President of the New York Fed (Timothy Geithner)

, who is somewhat confusingly the Vice Chairman of the FOMC, and the other eleven regional Fed Presidents, four of whom are voting members of the committee at any time (the other seven participate in the discussion but do not vote). Also in the room are a number of high-level Board and regional Fed officials and economists who make presentations to the committee on various topics.

Recent Fed Chairmen (Bernanke

, Greenspan and Volcker) have had a very important influence in Committee decision making. While there may be extensive debate on what the Fed should be doing, there are very few close votes. It has been said that three negative votes are sufficient to veto any policy decision, so in recent years most votes have been unanimous or with one or two members dissenting.

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The Fed is the US central bank. The US has a fairly complex history of central banking (see here for the official version); the Fed was officially created by Congress in 1913 but did not really get the independence that it enjoys today until 1951. The following essays address the structure of the Fed

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, the mandates (or objectives set by Congress) of the Fed, the tools with which the Fed tries to achieve those objectives and the methods with which the Fed communicates with the market,

• The Structure of the Fed
• The Many Mandates of the Fed
• The Policy Tools of the Fed
• How the Fed Communicates

[If you would like a brief review of ways to measure inflation and the most important U.S. monthly inflation indices you should read Understanding Inflation Data: An Introduction first and then return to this article that is about the PPI

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, the producer price index]

The PPI or the Producer Price Index is published by the Bureau of Labor Statistics (the BLS) an independent agency of the U.S. federal government. The BLS publishes PPI data in the middle of the month after the data were collected (data for June 2008 will be released on July 15; see here for the release schedule).

The PPI set of indexes measures price changes from the perspective of the seller, in comparison to the CPI that measures price changes from the consumer’s perspective. These two price indices may differ because of government subsidies

, sales or excise taxes and distribution costs.

The BLS calculates the prices of about 100,000 prices from 25,000 estabishments every month (see here for the BLS handbook explaining the methods used to assemble the data). There are three separate reports:

• Prices by industry (see here for the most recent table): there are price indexes for 600 industries, ranging from manufacturing to services and health care.
• Prices by commodity (see here for the most recent table): there are price indexes for 2000 commodity groups.
• Prices by stage of processing (see here for the most recent table): there are price indexes for finished goods, intermediate goods and crude goods, with and without food and energy.

The PPI weights prices using data from the 1997 economic census (see here) and some 2002 data.

The PPI does not attract the same degree of attention as the CPI

, partially since it is not used as frequently by policy makers. In the past, the PPI was regularly published a few days before the CPI and was viewed as a forecast of consumer prices; now the CPI published before the PPI around half the time. Even so, the BLS appears to spend considerable energy improving the report. The BLS believes that the PPI is more of a work in progress, in transition from a report that measured the prices of goods to a report that will measure the entire domestic output prices of goods and services.

The most interesting use of the PPI (in this economist’s view) is as a way to view the transmission of inflation through the economy, the so-called “pass through”. By looking at the stage of production indices you can see whether increases in commodity prices in crude goods result in increases in prices of finished goods. A great puzzle of recent years has been the lack of pass through

, meaning that increases in the prices of oil and food have not, so far, resulted in increases in finished goods prices.

One of the biggest problems facing an economic analyst is the lack of timeliness of published data. Most economic numbers are published a month or two after the data are collected, due to the difficulty in collecting and assembling the data (for example

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, the CPI measures the prices of 80,000 goods and the employment report surveys 60,000 households and 160,000 businesses; both reports are released between three weeks and a month after the surveys are conducted). Measuring what people have done in an economy of 300,000,000 residents is hard work. It is much simpler to contact a small group of Americans and ask them how they are feeling.

The reports on how Americans are feeling are called surveys of consumer confidence or sentiment. There are two main measures of consumer sentiment, the Conference Board and the University of Michigan. The Conference Board publishes (among other data) the Consumer Confidence Survey (available by subscription, see here for a sample issue) that asks 5,000 households by mail how they are feeling (see here for a description of the Conference Board methodology, which I can no longer find on their website). The University of Michigan Survey Research Center (see here for past data and survey description, registration required) does 500 telephone interviews asking people in the mainland U.S. (residents of Alaska and Hawaii are excluded) about their perception of the current and future state of the economy.

The obvious advantage of these data is that they can be published almost immediately. The obvious disadvantage is that the data are measuring what people say and not what they are doing. While both entities have published studies demonstrating the usefulness of their data, there are numerous skeptics (see here for one) who argue that at best confidence surveys reflect the current economic situation but are not good at predicting the future. An earlier, more careful study (see here) finds some evidence that the Conference Board data can be useful at predicting consumer spending (but note that one of the co-authors is a former employee of the Conference Board, see here). But more recent studies (see here) are considerably more skeptical. Recent Conference Board data (see here) show that confidence was at a relatively high level as recently as July 2007, just before the subprime problems affected markets and the price of petroleum started to climb.

There is a third confidence measure published by the Washington Post/ABC News that appears weekly that does not attract as much attention as the two monthly surveys. The survey does telephone interviews with 1000 randomly selected adults (see here for details) and data are released every Tuesday evening at 5pm. You can examine past polling data here or see a table of past data here. If you look at the historical data, you will find out that the answer to the question “Would you describe the state of the nation’s economy these days as excellent

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, good, not so good, or poor?” is generally “not so good” or “poor”. From 1986 to 2007, there were only five years when a majority of respondents described the economy as excellent or good

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, from 1997 to 2001. While there are numerous problems in the US, this view seems overly pessimistic.

There are other measures of how consumers feel about the economy (available here; there are also a large number of polls on more traditional topics such as politics) but these days markets seem to attach little weight to these surveys.

The media report the confidence data as if they represent important news; see here for a newspaper article about the July 2007 surge in the Conference Board consumer confidence index. While forecasting the economy is always difficult, economists who believed that “[the] rebound in confidence suggests economic activity may gather a little momentum in the coming months” probably made worse forecasts than economists who ignored the report.