Monetary Policy: How the Federal Reserve attempts to control the US economy

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Monetary Policy: How the Federal Reserve attempts to control the US economy
Monetary policy seeks to balance the economy, primarily by controlling the money supply. Bet_Noire/Getty Images
  • Monetary policy consists of actions taken by a nation's central bank to achieve and maintain economic growth and stability by controlling the amount of money available to banks, businesses, and consumers.
  • The Federal Open Market Committee (FOMC), the steering arm of the Federal Reserve, meets eight times a year to set US monetary policy.
  • Monetary policy is either contractionary (designed to slow down a hot economy and curb inflation) or expansionary (designed to speed up a cold economy and stimulate growth).

Monetary policy is the framework established by a nation's central bank to maintain economic growth and stability through the use of various tools designed to control the amount of money available to banks, businesses, and consumers.

"Monetary policy primarily controls inflation rates, especially if you look at the impact of the policy over a longer time span of several years," says Linda M. Hooks, head of the Department of Economics at Washington and Lee University in Lexington, Virginia. "In the shorter term of a year or two, monetary policy can help the economy to recover from a recession or slowdown. Monetary policy also has an impact on exchange rates, banks, and financial markets, and sets the foundation for sustained economic growth in the US economy."

In the US, the Federal Reserve System is the country's central bank and is responsible for setting and adjusting monetary policy. The Federal Reserve system was created by the US Congress with passage of the Federal Reserve Act of 1913. This act also granted authority to the Federal Reserve to set monetary policy. Although Congress has amended the Federal Reserve Act several times, the primary mandates of the Federal Reserve remain the same: "to promote maximum employment, stable prices, and moderate long-term interest rates in the US economy."

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Understanding how monetary policy works

In the US, monetary policy refers to the policies that the Federal Reserve makes to support a strong economy. The Federal Reserve's main tools are changing the quantity of money and influencing interest rates. At a more technical level, these policies usually involve buying and selling Treasury or other bonds.

The Federal Reserve determines monetary policy when its Federal Open Market Committee (FOMC) meets and deliberates to "review economic and financial conditions, determine the appropriate stance of monetary policy, and assess the risks to its long-run goals of price stability and sustainable economic growth," according to the Federal Reserve's site. Most countries around the world have a similar structure. An economy that is out of balance is either too hot (resulting in high inflation) or too cold (resulting in high unemployment). To rebalance the economy, the Federal Reserve - commonly referred to as the Fed - uses a variety of tools to control the supply of money.

When inflation - or the rising cost of goods and services - gets too high, the Fed may sell bonds, thereby decreasing the supply of money in the economy. Less money in the economy results in higher interest rates including the interest rate banks charge each other (federal funds rate). The Fed may also raise its discount rate or the interest it charges on funds loaned directly to banks. These moves also cause financial institutions to raise the interest rates they charge businesses and consumers, resulting in less borrowing, a slowing down of the economy, and ultimately lower inflation.

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Conversely, when the economy has cooled down so much that unemployment is unacceptably high, the central bank may buy bonds and other securities, increasing the money supply and lowering the Fed funds rate. It may also lower its discount rate, thereby encouraging businesses and consumers to borrow, putting more money into the economy, increasing hiring, and lowering unemployment.

Traditional tools used by the Fed to balance the economy

"The Federal Reserve's main goals," says Hooks, "involve changing the quantity of money and influencing interest rates." To accomplish this, the Fed has four main tools at its disposal.

  • Open market operations (OMO), through which the Fed traditionally buys and sells securities (bonds) in the open market to keep the federal funds rate at or near the target established by the Federal Open Market Committee (FOMC). A form of open market operations, known as Quantitative Easing (QE), used in times of crisis is discussed below.
  • The discount rate, or the interest rate the Fed charges commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank, can be raised to discourage borrowing and lowered to encourage it.
  • Reserve requirements refers to the dollar amount a depository institution is required to maintain by the Federal Reserve. Normally that amount is determined by applying the appropriate reserve requirement ratios specified in the Board's Regulation D (Reserve Requirements of Depository Institutions, 12 CFR Part 204) to an institution's reservable liabilities.
  • Interest on reserve balances was added to the Fed toolkit in 2008. This allows Federal Reserve Banks to pay interest on balances held by or on behalf of eligible institutions in Reserve Banks. The interest rate on reserve balances (IORB) is set and used by the Fed to conduct its monetary policy, especially as it pertains to the FOMC target range for the federal funds rate.

Quick tip: On March 26, 2020, the Federal Reserve reduced reserve requirement ratios to zero percent. This action eliminates manipulation of reserve requirements as a tool to achieve economic balance.

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Non-traditional and crisis tools available to achieve monetary policy

The Fed has other means at its disposal to achieve economic stability when conditions demand. These tools are not part of the Fed's normal toolkit and are utilized only when there is an economic crisis.

  • Quantitative Easing (QE) occurs when the central bank buys long-term securities from the open market in order to increase the nation's money supply and encourage borrowing and investment. This is a form of OMO. QE can be dangerous since, without proper controls it can lead to high inflation without expected economic growth, a condition known as stagflation.
  • Public service announcements by the Fed provide "forward guidance" regarding policy actions and strategies the agency plans in the near future in order to help the economy through trying times. Forward guidance can be part of the Fed's normal operations as well, but often increases in times of crisis.
  • Reverse Repurchase Agreements (RRPs) provide a solution for financial institutions that are not allowed to earn interest on their reserves (see Interest on Reserve Balances above). Institutions affected include government-sponsored enterprise and Federal Home Loan Banks. RRPs allow the financial institution to buy securities from the Fed at one price and sell them back to the government at a higher price the next day. This is effectively an interest payment to the institution and, along with interest on reserve balances, helps control the Fed funds rate.
  • Use of the crisis era Term Asset Backed Securities Loan Facility (TALF) program facilitates lending to securities firms, major employers, small businesses, non-profits, state and municipal governments, and even loans to individuals by the Fed.

Quick tip: As of Sept. 7, 2021, the Fed's balance sheet, resulting from Quantitative Easing, was $8.36 trillion. For comparison, in March 2020, it was $4.31 trillion.

The role of the Federal Open Market Committee

The FOMC, made up of twelve members including the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, meets eight times a year to review economic and financial conditions.

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The role and importance of the FOMC cannot be understated. "When it meets and deliberates, the Fed's monetary policy is established," says Hooks. No wonder then that these meetings have the full, undivided attention of the entire financial world. Economists, financial analysts, and investors alike eagerly await not only the results of those discussions, but the discussions themselves, to pick up any clues they can as to which direction the Fed may move next.

What influences policy decisions?

Decisions made by the Fed, including the FOMC, aren't just pulled out of thin air. They are influenced by various macroeconomic factors including gross domestic product (GDP), inflation, and the consumer price index (CPI).

Quick tip: Currently the Federal Reserve has a target inflation rate of 2%. If inflation consistently runs above 2%, the FOMC will raise interest rates. Conversely, when inflation falls below 2%, that may result in a lowering of interest rates.

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Geopolitical developments are also monitored including oil embargos, the imposition (or lifting) of trade tariffs, and conflicts around the world that may impact the U.S. economy. The central bank may also consider concerns raised by specific interest groups, industries, and businesses as well as input from other parts of the government.

Types of monetary policies

Ultimately monetary policy is all about controlling the money supply. Within that framework, there are two types - contractionary and expansionary.

Contractionary monetary policy

In basic terms, contractionary monetary policy contracts or decreases the money supply. The main purpose of contractionary policy is to slow down a heated economy and lower inflation.

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Expansionary monetary policy

Expansionary monetary policy, as might be expected, is the opposite. This type of policy is designed to expand or increase the supply of money in an economy. Increasing the money supply results in economic growth, more spending, and lower unemployment.

Neither type of monetary policy is perfect, and either carried to extremes results in bad outcomes. It is the job of the Fed to balance the two.

Monetary policy vs. fiscal policy

Monetary policy involves manipulating interest rates as a primary means to control the money supply. This is done by the Federal Reserve.

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Fiscal policy, on the other hand, addresses taxes and government spending. Fiscal policy is determined by the government through legislation.

Together, monetary policy and fiscal policy help determine the state of the economy and the financial well-being of a country's citizens.

Monetary policyFiscal policy
Set by the Federal Reserve Controls the money supply Impacts individual finances Set by the government Controls taxes and spending Impacts individual finances

The financial takeaway

Monetary policy seeks to balance the economy, primarily by controlling the money supply. The Federal Reserve accomplishes this by manipulating interest rates to avoid both high inflation and high unemployment.

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"Monetary policy affects each of us," says Hooks. "Even though its aim is broad - the whole economy - its impact shows up at an individual level. If you pay more for most items today than you did a month ago, then inflation has affected you individually."

It's important to understand monetary policy and use that information to make financial decisions on an individual level. Cut back on spending during times of high inflation. Don't quit your job during times of high unemployment. At the same time, realize that actions taken by the Federal Reserve are designed to eventually right the ship. Be patient.

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