Monetary Policy

Monetary policy decisions impact the world's economy in a big way. Here's how central banks set monetary policy initiatives, and the underlying goals of all monetary policy decisions.

Nov 3, 2015 at 7:34PM

Monetary policy broadly defines the tools used by a central bank to control the money supply, encourage employment, and manage inflation. In the United States, the Federal Reserve -- also known as the Fed -- is tasked with making monetary policy decisions.

The Fed is said to have a "dual mandate" of maximizing employment and keeping prices stable. It does so by controlling interest rates by increasing or decreasing the supply of money in the economy.

Balancing employment and inflation is difficult. Generally, inflationary periods have been associated with higher employment, whereas deflationary periods have been associated with lower employment. The Federal Reserve must balance its goal to maximize employment without causing rampant inflation, and, at times, cool off inflation without causing unemployment.

Recent monetary policy actions and goals in the United States
The Federal Reserve has recently set a goal to target a rate of inflation of about 2% per year. That is, it seeks to manage inflation such that prices, as measured by the price index for personal consumption expenditures (basically, a basket of goods or service an ordinary American could expect to buy in any given year), rise no more than 2% per year.

In setting its inflation goal, the Federal Reserve also targets a level for unemployment, generally between 5.2-6%, which is considered "full employment." This is considered "full employment" because it is assumed there will always be some level of so-called "frictional unemployment" that results from workers being in between jobs or from statistical errors in calculating the unemployment rate.

We can observe how the Fed has responded to rising unemployment and recessions in the chart below, which shows the general level of short-term interest rates compared to the unemployment rate.

Rates Vs Unemployment

Notice how the Fed increases rates as the economy reaches "full employment" to stave off inflation, and how it decreases rates as unemployment spikes. The grey bars in the chart reflect recessionary periods -- three occasions in which the Fed quickly slashed rates to keep recessionary conditions from worsening.

How monetary policy changes are made
The Federal Reserve generally controls the level of interest rates in the United States by increasing or decreasing the money supply. It has many levers on which to pull, which include:

  1. Setting the federal funds rate -- This is the interest rate that banks charge one another for overnight loans of reserves held at the Federal Reserve. The Fed sets a "target" for the Fed funds rate and adds or subtracts from the money supply to create a supply and demand balance that results in the federal funds rate matching its target rate.
  2. Open market operations -- This is an all-encompassing term that describes actions taken by the Fed to increase or decrease the supply of money. In general, the Fed increases or decreases the money supply by buying or selling U.S. Treasuries (U.S. government debt) from so-called "primary dealers." Buying U.S. Treasuries increases the money supply, reducing interest rates. Selling U.S. Treasuries decreases the money supply, increasing interest rates.
    As an example, in 2011, the Federal Reserve enacted a program known as "Operation Twist" whereby it sold short-term U.S. debt to buy long-term U.S. debt. The goal was to push down long-term interest rates, thus encouraging individuals to make big purchases (like buying a home) and businesses to make big investments (like borrowing to build new factories, for example). Similarly, "quantitative easing" programs in which the Fed bought long-term U.S. Treasuries and government guaranteed mortgages were intended to reduce long-term interest rates. 
  3. Paying interest on excess reserves -- In 2006, the Fed was granted authority to pay interest on excess balances held by banks at the Federal Reserve. In 2008, it made use of this authorization, offering to pay banks 0.25% per year for holding excess reserves at the Federal Reserve. By paying banks interest on excess reserves, it can have more control over interest rates, specifically the federal funds rate. If the Fed pays 0.25% on excess reserves, as it currently does, banks have no incentive to lend to one another at any lower rate, thus keeping the federal funds rate closer to its target.

There are no hard and fast rules in monetary policy, and the Fed increasingly has more tools at its disposal to manage the money supply, and thus interest rates and employment. These three items above are not the end-all, be-all of the tools the Federal Reserve has to use, but they are perhaps the most relevant to controlling monetary policy decisions today.

The Federal Reserve's job of making monetary policy decisions is inherently hard. Critics contend that errors cost the economy in a major way, often pointing to the decision in the early 2000s to keep interest rates too low, for too long, thus stoking what would become a giant real estate bubble and collapse. Unfortunately, these observations can only be made in hindsight, making monetary policy perhaps the world's largest, and most consequential, economic guessing game.

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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