Monetary policy of the United States
The monetary policy of the United States is the set of policies that the Federal Reserve follows to achieve its twin objectives of high employment and stable inflation.
The US central bank, the Federal Reserve System, colloquially known as "the Fed", was created in 1913 by the Federal Reserve Act as the monetary authority of the United States. The Federal Reserve's board of governors along with the Federal Open Market Committee are consequently the primary arbiters of monetary policy in the United States.
The U.S. Congress has established three key objectives for monetary policy in the Federal Reserve Act: maximizing employment, stabilizing prices, and moderating long-term interest rates. Because long-term interest rates remain moderate in a stable economy with low expected inflation, the last objective will be fulfilled automatically together with the first two ones, so that the objectives are often referred to as a dual mandate of promoting maximum employment and stable prices. The Fed operationalizes its objective of stable prices as following an inflation target of 2% annual inflation on average.
The Federal Reserve's main monetary policy instrument is its federal funds rate target. By adjusting this target, the Fed affects a wide range of market interest rates and in turn indirectly affects stock prices, wealth and currency exchange rates. Through these variables, monetary policy influences spending, investment, production, employment and inflation in the United States. These channels are collectively known as the monetary transmission mechanism. Effective monetary policy complements fiscal policy to support economic stability, dampening the impact of business cycles.
Besides conducting monetary policy, the Fed is tasked to promote the stability of the financial system and regulate financial institutions, and to act as lender of last resort. In addition,
the Fed should foster safety and efficiency in the payment and settlement system and promote consumer protection and community development.
Interest rates and transmission mechanism
Monetary policy works by stimulating or suppressing the overall demand for goods and services in the economy, which will tend to increase respectively diminish employment and inflation. The Federal Reserve's primary means to this end is adjusting the target for the Federal funds rate suitably. Changes in the Federal funds rate targets normally affect the interest rates that banks and other lenders charge on loans to firms and households, which will in turn impact private investment and consumption. Interest rate changes also affect asset prices like stock prices and house prices, which again influence households' consumption decisions through a wealth effect. Additionally, international interest rate differentials affect exchange rates and consequently US exports and imports. Consumption, investment and net exports are all important components of aggregate demand.Hence, by lowering the federal funds rate the Federal Reserve can stimulate aggregate demand, raising employment levels and inflation when inflation falls short of the 2% annual inflation target. Conversely, when inflation is too high, the Fed can tighten monetary policy by raising the federal funds rate, which will diminish economic activity and consequently dampen inflation. The various channels summarized above through which the Federal Reserve's actions affect the general interest rate level and consequently the overall economy are collectively referred to as the monetary transmission mechanism.
In some cases, the Fed may raise the FFR to the extent that the shorter term interest rates rise sufficiently to climb above their longer maturity bonds, causing an inverted yield curve. This scenario usually predates a recession, which is deflationary.
Implementation and policy tools
The Federal funds rate is a market interest rate, being the rate at which banks and credit unions lend reserve balances to each other overnight on an uncollateralized basis. The Fed consequently does not determine this rate directly, but has over time used various means to influence the rate. Until the 2008 financial crisis, the Fed relied on open market operations, i.e. selling and buying securities in the open market to adjust the supply of reserve balances so as to keep the FFR close to the Fed's target. However, since 2008 the actual conduct of monetary policy implementation has changed considerably, using instead various administered interest rates as the primary tools to steer short-term market interest rate towards the Fed's policy target, which from December 2008 has been expressed as a range of 25 basis points.The present implementation regime, which has evolved since the 2008 financial crisis, is referred to as an "ample-reserves regime" as opposed to the earlier limited-reserves regime. In 2019, the Fed announced that it would continue to use this implementation regime over the longer run. The Fed's central policy tools are the interest on reserve balances rate and the overnight reverse repurchase agreement offering rate. They are administered rates which the Fed pays on funds that commercial banks hold in their reserve balance accounts at the Fed and funds that large nonbank financial institutions deposit at the Fed, respectively. These rates set a floor on the rates at which banks are willing to lend excess cash to other private market participants. At the same time, the Fed operates a discount window in which it lends funds to banks at the discount rate, which puts a ceiling on the federal funds rate, as banks are unlikely to borrow elsewhere at a higher interest rate than the discount rate. Open-market operations are no longer used to steer the FR, but still form part of the over-all monetary policy toolbox, as they are used to always maintain an ample supply of reserves. The Fed began forward guidance in January 2012 to communicate policy intentions.
To sum up, the policy instruments in the current ample-reserves regime are:
- Interest on reserve balances - an administered interest rate paid on funds that commercial bankshold in their reserve balance accounts at the Fed
- Overnight reverse repurchase agreement facility - the Fed's offer to many large nonbank financial institutions to deposit funds at the Fed and earn interest
- Discount window - the Fed's lending to banks at the discount rate
- Open market operations - the Fed's buying and selling of securities to maintain an ample supply of reserves
Money supply
Monetary policy also generally affects the money supply. At times, changes in money supply measures have been closely related to important economic variables like GDP growth and inflation, and the Federal Reserve has earlier used these measures as an important guide in the conduct of monetary policy. In recent decades, however, these relationships have been quite unstable, and the importance of the money supply in this respect has consequently diminished over the years. Today, the Federal Open Market Committee reviews money supply data as just one part of a wide array of various financial and economic data which form the background for the Committee's monetary policy decisions,The economy's aggregate money supply is the total of
- M0 money, or monetary base - "dollars" in currency and bank money balances credited to the central bank's depositors, which are backed by the central bank's assets,
- plus M1, M2, M3 money - "dollars" in the form of bank money balances credited to banks' depositors, which are backed by the bank's assets and investments.
The Federal Reserve presently directly controls only the most narrow form of money, physical cash outstanding; the Federal Reserve indirectly influences the supply of other types of money. Until 2020, the Federal Reserve also used reserve requirements, enabling it to directly ensure a minimum of reserve balances of commercial banks, which together with outstanding cash makes up the monetary base. In March 2020, however, the Fed reduced reserve requirement ratios to zero, effectively abandoning this instrument and relying instead on interest rates on reserves to influence commercial banks' behavior.
Broad money includes money held in deposit balances in banks and other forms created in the financial system. Basic economics also teaches that the money supply shrinks when loans are repaid; however, the money supply will not necessarily decrease depending on the creation of new loans and other effects. Other than loans, investment activities of commercial banks and the Federal Reserve also increase and decrease the money supply. Discussion of "money" often confuses the different measures and may lead to misguided commentary on monetary policy and misunderstandings of policy discussions.