Monetary Policy

What is monetary policy?

Simply put, monetary policy includes everything that a nation’s central bank does to influence the amount of money and credit available in the economy, thereby influencing economic growth. In the case of the United States, the central bank is called the Federal Reserve (or The Fed, for short). It has special control over producing and distributing money and credit. The goal of the Fed, as instructed by Congress, is to “promote maximum employment, stable prices, and moderate long-term interest rates.” One key to achieving these goals is to keep the economy moving along at a rate that is neither too slow nor too fast. Too slow and the economy can grow stagnant. Too fast and it could trigger high rates of inflation or a crash.

When the Fed is succeeding in its goals of maximum employment and stable prices, the result tends to be moderate long-term interest rates. The exact definitions of these goals have varied over time.

Maximum employment basically means that anyone who wants a job can get one, and it can vary depending on the structure and dynamics of the labor market. As a general rule of thumb, however, the Fed tends to aim for a longer-run unemployment rate of about 4 percent to achieve maximum employment.

Policymakers at the Fed have come to determine that stable prices can be achieved over the long-run with a two percent inflation rate. This means a two percent average over time, so after a period where inflation has been less than two percent, the Fed might strive to bump inflation up above two percent for a similar period of time.

How does it work?

Every day, consumers and businesses in the U.S. make about a half trillion dollars worth of non-cash payments through channels like debit cards, credit cards, electronic transfers, and checks. To make these payments possible, banks hold reserve balances with the Fed in order to easily transfer funds from one bank to another. Regulations also require banks to hold these balances to ensure that their finances are sound and their customers’ deposits are safe. Depending on needs and market conditions, banks sometimes need to borrow or may lend reserves to each other overnight. To borrow reserve balances overnight, banks pay an interest rate known as the federal funds rate. By changing the interest it pays on reserve balances that banks hold with it, the Fed can influence the federal funds rate. Changes in the federal funds rate can impact the broader economy in several ways. Because they are tied to the interest rates that banks and other lenders charge on short-term loans to businesses and consumers, they can affect floating-rate mortgages and credit lines. Long-term interest rates are determined more by expectations of what the federal funds rate will be over a period of time, so they aren’t affected as much by momentary changes to the federal funds rate. If the Fed gives banks and businesses a reason to believe federal funds rates will be higher or lower over time, however, it can impact economic decisions with longer planning horizons like consumers' purchases of houses, cars, and other big-ticket items, as well as businesses' investments in structures, machinery, and equipment.

Tools at its disposal

The Fed has three main tools at its disposal that it can use to influence the economy. They are reserve requirements, the discount rate, and open market operations.

Reserve requirements were established by the Federal Reserve Act of 1913. The law required that all commercial banks, savings banks, savings and loans, credit unions, and U.S. branches and agencies of foreign banks hold a certain percentage of deposits as either cash on hand or at a Reserve Bank. These institutions usually have an account with the Fed and keep reserve balances there to meet reserve requirements. By changing the reserve requirements, the Fed can effectively influence how much money banks and other financial institutions can loan out to customers. During the 2008 financial crisis, however, the Fed drastically increased the level of reserves in the banking system, ensuring that banks have much more money on hand than needed to meet reserve requirements. In 2020, the Fed dropped reserve requirements to zero in response to the COVID-19 pandemic, hoping to jump-start the economy by allowing banks to lend more to consumers and businesses.

The discount rate is what financial institutions are charged by the Fed to borrow money on a short-term basis – a transaction known as borrowing at the “discount window.” Its level is set above the federal funds rate target, which means that it provides a backup source of funding for banks and other depository institutions. In rare situations like the 2008 financial crisis, this discount window becomes a primary source of funds because the normal functioning of financial markets is disrupted.

Historically the Fed has tended to use open market operations to manage the economy more than any other tool. This means buying and selling U.S. Government Securities (usually Treasury bonds, bills, and notes to finance the federal government) on the open market, in order to align the federal funds rate with a target publicly set by the Federal Open Market Committee (FOMC). The FOMC is composed of 12 members. Seven of them are from the Board of Governors of the Federal Reserve System. The other five are made up of the president of the Federal Reserve Bank of New York and then four of the other 11 Reserve Bank presidents. Reserve Bank presidents serve one-year terms on a rotating basis.

If the FOMC lowered its targeted federal funds rate, the Fed would buy securities on the open market to raise available reserves. It can do this by crediting the reserve accounts of the banks it bought the securities from. This would add to the reserve balances of banks and allow for them to issue more loans, putting more money into the economy. The basic principles of supply and demand of available loans dictate that both short- and long-term interest rates would fall, encouraging economic activity through more consumer and business spending.

If the FOMC raised its target federal funds rate, the opposite would happen. The Fed would sell government securities and collect payments from banks by taking funds out of their reserve accounts. Fewer reserves means less money for banks to loan and a corresponding increase in interest rates, putting a damper on consumer and business spending and slowing economic activity. It also helps to slow inflation, however, because less money is being injected into the economy.

Why does it matter to you?

Many experts believe the Fed is limited in what it can do to shape economic growth. It doesn’t have all-powerful tools for fixing any economic problem. However the decisions the Fed makes do have an impact on the everyday lives of Americans. If you want to buy a government bond, for instance, the Fed’s monetary policy decisions affect the interest rate you will be paid. If you want to buy a new house, monetary policy affects the mortgage rate you’ll receive. If you want to take out a loan from a bank to buy a car, go to college, or start a business, the amount banks may be able to loan you and the interest rate of that loan are all affected by the Fed’s decisions.

On a much broader scale, the Fed is tasked with making sure the U.S. financial system is stable. It monitors banks to make sure that your savings deposits are safe and that banks don’t overstretch themselves and trigger another Great Depression. It also has influence over inflation and – ideally – is making prudent decisions that ensure long-term stability for your savings and investments. For example, it may seem like a quick and easy fix to economic woes to simply print a lot more money and inject it into the economy, but it comes with a cost, because the dollars you do have can’t buy you quite as many goods and services as they used to.