Monetary Policy and the Fed
Read this chapter to understand in more detail the monetary policy tools, process, and impacts on the U.S. economy. Review specific monetary policies and their effects from our recent history.
Monetary Policy in the United States
Goals of Monetary Policy
When we think of the goals of
monetary policy, we naturally think of standards of macroeconomic
performance that seem desirable - a low unemployment rate, a stable
price level, and economic growth. It thus seems reasonable to conclude
that the goals of monetary policy should include the maintenance of full
employment, the avoidance of inflation or deflation, and the promotion
of economic growth.
But these goals, each of which is desirable
in itself, may conflict with one another. A monetary policy that helps
to close a recessionary gap and thus promotes full employment may
accelerate inflation. A monetary policy that seeks to reduce inflation
may increase unemployment and weaken economic growth. You might expect
that in such cases, monetary authorities would receive guidance from
legislation spelling out goals for the Fed to pursue and specifying what
to do when achieving one goal means not achieving another. But as we
shall see, that kind of guidance does not exist.
The Federal Reserve Act
When
Congress established the Federal Reserve System in 1913, it said little
about the policy goals the Fed should seek. The closest it came to
spelling out the goals of monetary policy was in the first paragraph of
the Federal Reserve Act, the legislation that created the Fed:
"An
Act to provide for the establishment of Federal reserve banks, to
furnish an elastic currency, [to make loans to banks], to establish a
more effective supervision of banking in the United States, and for
other purposes".
In short, nothing in the legislation creating
the Fed anticipates that the institution will act to close recessionary
or inflationary gaps, that it will seek to spur economic growth, or that
it will strive to keep the price level steady. There is no guidance as
to what the Fed should do when these goals conflict with one another.
The Employment Act of 1946
The
first U.S. effort to specify macroeconomic goals came after World War
II. The Great Depression of the 1930s had instilled in people a deep
desire to prevent similar calamities in the future. That desire, coupled
with the 1936 publication of John Maynard Keynes's prescription for
avoiding such problems through government policy (The General Theory of
Employment, Interest and Money), led to the passage of the Employment
Act of 1946, which declared that the federal government should "use all
practical means . . . to promote maximum employment, production and
purchasing power". The act also created the Council of Economic Advisers
(CEA) to advise the president on economic matters.
The Fed might
be expected to be influenced by this specification of federal goals,
but because it is an independent agency, it is not required to follow
any particular path. Furthermore, the legislation does not suggest what
should be done if the goals of achieving full employment and maximum
purchasing power conflict.
The Full Employment and Balanced Growth Act of 1978
The
clearest, and most specific, statement of federal economic goals came
in the Full Employment and Balanced Growth Act of 1978. This act,
generally known as the Humphrey–Hawkins Act, specified that by 1983 the
federal government should achieve an unemployment rate among adults of
3% or less, a civilian unemployment rate of 4% or less, and an inflation
rate of 3% or less. Although these goals have the virtue of
specificity, they offer little in terms of practical policy guidance.
The last time the civilian unemployment rate in the United States fell
below 4% was 1969, and the inflation rate that year was 6.2%. In 2000,
the unemployment rate touched 4%, and the inflation rate that year was
3.4%, so the goals were close to being met. Except for 2007 when
inflation hit 4.1%, inflation has hovered between 1.6% and 3.4% in all
the other years between 1991 and 2011, so the inflation goal was met or
nearly met, but unemployment fluctuated between 4.0% and 9.6% during
those years.
The Humphrey-Hawkins Act requires that the chairman
of the Fed's Board of Governors report twice each year to Congress about
the Fed's monetary policy. These sessions provide an opportunity for
members of the House and Senate to express their views on monetary
policy.
Federal Reserve Policy and Goals
Perhaps the clearest
way to see the Fed's goals is to observe the policy choices it makes.
Since 1979, following a bout of double-digit inflation, its actions have
suggested that the Fed's primary goal is to keep inflation under
control. Provided that the inflation rate falls within acceptable
limits, however, the Fed will also use stimulative measures to attempt
to close recessionary gaps.
In 1979, the Fed, then led by Paul
Volcker, launched a deliberate program of reducing the inflation rate.
It stuck to that effort through the early 1980s, even in the face of a
major recession. That effort achieved its goal: the annual inflation
rate fell from 13.3% in 1979 to 3.8% in 1982. The cost, however, was
great. Unemployment soared past 9% during the recession. With the
inflation rate below 4%, the Fed shifted to a stimulative policy early
in 1983.
In 1990, when the economy slipped into a recession, the
Fed, with Alan Greenspan at the helm, engaged in aggressive open-market
operations to stimulate the economy, despite the fact that the inflation
rate had jumped to 6.1%. Much of that increase in the inflation rate,
however, resulted from an oil-price boost that came in the wake of
Iraq's invasion of Kuwait that year. A jump in prices that occurs at the
same time as real GDP is slumping suggests a leftward shift in
short-run aggregate supply, a shift that creates a recessionary gap. Fed
officials concluded that the upturn in inflation in 1990 was a
temporary phenomenon and that an expansionary policy was an appropriate
response to a weak economy. Once the recovery was clearly under way, the
Fed shifted to a neutral policy, seeking neither to boost nor to reduce
aggregate demand. Early in 1994, the Fed shifted to a contractionary
policy, selling bonds to reduce the money supply and raise interest
rates. Then Fed Chairman Greenspan indicated that the move was intended
to head off any possible increase in inflation from its 1993 rate of
2.7%. Although the economy was still in a recessionary gap when the Fed
acted, Greenspan indicated that any acceleration of the inflation rate
would be unacceptable.
By March 1997 the inflation rate had
fallen to 2.4%. The Fed became concerned that inflationary pressures
were increasing and tightened monetary policy, raising the goal for the
federal funds interest rate to 5.5%. Inflation remained well below 2.0%
throughout the rest of 1997 and 1998. In the fall of 1998, with
inflation low, the Fed was concerned that the economic recession in much
of Asia and slow growth in Europe would reduce growth in the United
States. In quarter-point steps it reduced the goal for the federal funds
rate to 4.75%. With real GDP growing briskly in the first half of 1999,
the Fed became concerned that inflation would increase, even though the
inflation rate at the time was about 2%, and in June 1999, it raised
its goal for the federal funds rate to 5% and continued raising the rate
until it reached 6.5% in May 2000.
With inflation under control,
it then began lowering the federal funds rate to stimulate the economy.
It continued lowering through the brief recession of 2001 and beyond.
There were 11 rate cuts in 2001, with the rate at the end of that year
at 1.75%; in late 2002 the rate was cut to 1.25%, and in mid-2003 it was
cut to 1.0%.
Then, with growth picking up and inflation again a
concern, the Fed began again in the middle of 2004 to increase rates. By
the end of 2006, the rate stood at 5.25% as a result of 17
quarter-point rate increases.
Starting in September 2007, the
Fed, since 2006 led by Ben Bernanke, shifted gears and began lowering
the federal funds rate, mostly in larger steps or 0.5 to 0.75 percentage
points. Though initially somewhat concerned with inflation, it sensed
that the economy was beginning to slow down. It moved aggressively to
lower rates over the course of the next 15 months, and by the end of
2008, the rate was targeted at between 0% and 0.25%. In late 2008
through 2011, beginning with the threat of deflation and then
progressing into a period during which inflation ran fairly low, the Fed
seemed quite willing to use all of its options to try to keep financial
markets running smoothly. The Fed attempted, in the initial period, to
moderate the recession, and then it tried to support the rather
lackluster growth that followed. In January 2012, the Fed went on record
to say that given its expectation that inflation would remain under
control and that the economy would have slack, it anticipated keeping
the federal funds rate at extremely low levels through late 2014.
What
can we infer from these episodes in the 1980s, 1990s, and the first
decade of this century? It seems clear that the Fed is determined not to
allow the high inflation rates of the 1970s to occur again. When the
inflation rate is within acceptable limits, the Fed will undertake
stimulative measures in response to a recessionary gap or even in
response to the possibility of a growth slowdown. Those limits seem to
have tightened over time. In the late 1990s and early 2000s, it appeared
that an inflation rate above 3% - or any indication that inflation
might rise above 3% - would lead the Fed to adopt a contractionary
policy. While on the Federal Reserve Board in the early 2000s, Ben
Bernanke had been an advocate of inflation targeting. Under that system,
the central bank announces its inflation target and then adjusts the
federal funds rate if the inflation rate moves above or below the
central bank's target. Mr. Bernanke indicated his preferred target to be
an expected increase in the price level, as measured by the price index
for consumer goods and services excluding food and energy, of between
1% and 2%. Thus, the inflation goal appears to have tightened even more -
to a rate of 2% or less. If inflation were expected to remain below 2%,
however, the Fed would undertake stimulative measures to close a
recessionary gap. Whether the Fed will hold to that goal will not really
be tested until further macroeconomic experiences unfold.