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Monetary Policy, Explained

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Now and then, you probably run across headlines like the following:

"Japan Keeps Monetary Policy Steady Amid Deflation Fight"

"Bernanke Warns of 'Premature Tightening' in Monetary Policy"

"Business Groups Back May Monetary Policy Decisions"

If you're like many people, they make you a bit uneasy, as you don't have a good handle on what "monetary policy" actually is. Let's remedy that, shall we? Understanding its basics can help you make sense of financial news and our national and global financial condition.

In a nutshell
America's monetary policy is set by the Federal Reserve, our central bank, which influences the amount of money and credit in our economy, and, therefore also influences interest rates, inflation, and our economy's health and performance.

The Federal Reserve (which you can now refer to as "the Fed," due to your increased savviness) aims to have our economy in excellent condition, which means having interest rates and inflation at moderate, reasonable rates, and unemployment low.

How does the Fed try to achieve these goals? With its "three instruments of monetary policy": open market operations, the discount rate, and reserve requirements.

3 instruments
Decisions about open market operations are made by the Federal Open Market Committee, and involve the Fed buying or selling securities such as Treasury bonds, notes, and bills. When it buys them, it pays by depositing money with a bank or securities dealer, and when it sells them, it deducts their value from the account(s) of the purchasing banks or securities dealers. In this way, the Fed is adding or removing money from the money supply. Money added can then be loaned out, ultimately to businesses and consumers, stimulating the economy and boosting interest rates. Money removed from the supply can slow down our economy, increasing interest rates, too. A rapid rise in the supply of money boosts inflation -- and vice versa -- and is another way that monetary policy affects our everyday lives. (The Fed would generally like to see inflation rates in the 2% to 3% range.)

The discount rate is the rate that Federal Reserve Banks charge other financial institutions for short-term loans. When the rate is low, banks are more likely to borrow, thus increasing the economy's money supply and stimulating growth. Conversely, a monetary policy involving rising rates will slow down the economy. The discount rate was in the news more than usual recently, when Senator Elizabeth Warren protested a planned doubling of interest rates for federal student loans to 6.8%, while banks were enjoying a 0.75% discount rate.

Reserve requirements involve the Fed telling banks what portion of deposits they must keep in their vaults or deposited at a Federal Reserve Bank. It's another monetary policy tool; when the requirements are hiked, banks are less able to lend, the cost of credit rises, and some brakes are applied to the economy. A drop in requirements aims for opposite effects.

The investing angle
Monetary policy affects us as investors, too, because rising interest rates make existing bonds (with their lower rates) less attractive and lead to falling bond prices. Thus, stocks can become more attractive to many -- though savings accounts and CDs also become attractive, when they're paying significant interest. Falling interest rates can boost the real estate market, as mortgages become more affordable. If rates are very low, as they are now, they can discourage people from saving, while encouraging people -- and businesses -- to borrow. Many companies, such as Apple, IBM, Nike, and Microsoft, have been tapping the bond market for some cheap capital.

Monetary policy is important for investing, but it also has a broader reach across the overall economy. A better understanding of monetary policy can make you a savvier citizen and a smarter investor.

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Selena Maranjian

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter...

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