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.

Problems and Controversies of Monetary Policy

Choosing Targets

In attempting to manage the economy, on what macroeconomic variables should the Fed base its policies? It must have some target, or set of targets, that it wants to achieve. The failure of the economy to achieve one of the Fed's targets would then trigger a shift in monetary policy. The choice of a target, or set of targets, is a crucial one for monetary policy. Possible targets include interest rates, money growth rates, and the price level or expected changes in the price level.


Interest Rates

Interest rates, particularly the federal funds rate, played a key role in recent Fed policy. The FOMC does not decide to increase or decrease the money supply. Rather, it engages in operations to nudge the federal funds rate up or down.

Up until August 1997, it had instructed the trading desk at the New York Federal Reserve Bank to conduct open-market operations in a way that would either maintain, increase, or ease the current "degree of pressure" on the reserve positions of banks. That degree of pressure was reflected by the federal funds rate; if existing reserves were less than the amount banks wanted to hold, then the bidding for the available supply would send the federal funds rate up. If reserves were plentiful, then the federal funds rate would tend to decline. When the Fed increased the degree of pressure on reserves, it sold bonds, thus reducing the supply of reserves and increasing the federal funds rate. The Fed decreased the degree of pressure on reserves by buying bonds, thus injecting new reserves into the system and reducing the federal funds rate.

The current operating procedures of the Fed focus explicitly on interest rates. At each of its eight meetings during the year, the FOMC sets a specific target or target range for the federal funds rate. When the Fed lowers the target for the federal funds rate, it buys bonds. When it raises the target for the federal funds rate, it sells bonds.


Money Growth Rates

Until 2000, the Fed was required to announce to Congress at the beginning of each year its target for money growth that year and each report dutifully did so. At the same time, the Fed report would mention that its money growth targets were benchmarks based on historical relationships rather than guides for policy. As soon as the legal requirement to report targets for money growth ended, the Fed stopped doing so. Since in recent years the Fed has placed more importance on the federal funds rate, it must adjust the money supply in order to move the federal funds rate to the level it desires. As a result, the money growth targets tended to fall by the wayside, even over the last decade in which they were being reported. Instead, as data on economic conditions unfolded, the Fed made, and continues to make, adjustments in order to affect the federal funds interest rate.


Price Level or Expected Changes in the Price Level

Some economists argue that the Fed's primary goal should be price stability. If so, an obvious possible target is the price level itself. The Fed could target a particular price level or a particular rate of change in the price level and adjust its policies accordingly. If, for example, the Fed sought an inflation rate of 2%, then it could shift to a contractionary policy whenever the rate rose above 2%. One difficulty with such a policy, of course, is that the Fed would be responding to past economic conditions with policies that are not likely to affect the economy for a year or more. Another difficulty is that inflation could be rising when the economy is experiencing a recessionary gap. An example of this, mentioned earlier, occurred in 1990 when inflation increased due to the seemingly temporary increase in oil prices following Iraq's invasion of Kuwait. The Fed faced a similar situation in the first half of 2008 when oil prices were again rising. If the Fed undertakes contractionary monetary policy at such times, then its efforts to reduce the inflation rate could worsen the recessionary gap.

The solution proposed by Chairman Bernanke, who is an advocate of inflation rate targeting, is to focus not on the past rate of inflation or even the current rate of inflation, but on the expected rate of inflation, as revealed by various indicators, over the next year.

By 2010, the central banks of about 30 developed or developing countries had adopted specific inflation targeting. Inflation targeters include Australia, Brazil, Canada, Great Britain, New Zealand, South Korea, and, most recently, Turkey and Indonesia. A study by economist Carl Walsh found that inflationary experiences among developed countries have been similar, regardless of whether their central banks had explicit or more flexible inflation targets. For developing countries, however, he found that inflation targeting enhanced macroeconomic performance, in terms of both lower inflation and greater overall stability.