Monetary Policy: Goals, Tools, and How It Affects the Economy

What Is Monetary Policy?

Monetary policy is the set of decisions a central bank uses to influence interest rates, credit conditions, financial markets, and ultimately economic activity and inflation. In the United States, monetary policy is set by the Federal Reserve, principally through the Federal Open Market Committee (FOMC).

Congress has directed the Federal Reserve to promote maximum employment, stable prices, and moderate long-term interest rates. In practice, the first two are commonly called the Fed's dual mandate. The FOMC judges that 2 percent inflation over the longer run, measured by the annual change in the personal consumption expenditures (PCE) price index, is most consistent with price stability.

The Federal Reserve's Objectives

Maximum Employment

Maximum employment is not a fixed unemployment-rate target. The level of employment that can be sustained without undermining price stability changes over time and cannot be measured precisely, so the FOMC considers a broad set of labor-market indicators.

Stable Prices

The FOMC's longer-run inflation objective is 2 percent as measured by the PCE price index. Stable and well-anchored inflation expectations make it easier for households and businesses to make long-term saving, borrowing, hiring, and investment decisions.

Moderate Long-Term Interest Rates

The Federal Reserve Act also refers to moderate long-term interest rates. In practice, durable price stability and a well-functioning economy help create conditions in which long-term rates can remain moderate.

The Main Policy Tool: The Federal Funds Rate

In normal circumstances, the FOMC's primary way of tightening or easing monetary policy is changing the target range for the federal funds rate.

A higher target range generally tightens financial conditions by raising the cost of short-term money and influencing expectations for future interest rates. A lower target range generally eases financial conditions and can support borrowing, spending, and investment.

The observed effective federal funds rate is a market rate, not simply a number fixed by the FOMC. The Federal Reserve implements its target using tools such as the interest rate paid on reserve balances (IORB), overnight reverse repurchase agreements, and open-market or standing repo operations. For the distinction between the target range and the observed market rate, see Federal Funds Rate.

Other Monetary Policy Tools

Interest on Reserve Balances

In the current ample-reserves framework, IORB is a central tool for controlling short-term rates. Banks compare the return available on reserve balances with alternative short-term lending opportunities, so changes in IORB influence money-market rates.

Open Market and Repo Operations

The Federal Reserve Bank of New York conducts operations in securities and repo markets to implement FOMC directives, support rate control, and maintain an ample supply of reserves.

Balance Sheet Policy and Quantitative Easing

When short-term rates are near their effective lower bound or financial conditions require additional support, the Fed can purchase longer-term Treasury and agency securities. Large-scale asset purchases can put downward pressure on longer-term yields and ease broader financial conditions. Reducing or allowing the balance sheet to run off can work in the opposite direction.

See Quantitative Easing for more detail.

Forward Guidance and Communication

FOMC statements, projections, minutes, speeches, and other communication can influence expectations about the future path of policy. Because financial markets price expected future conditions, communication can affect current yields and asset prices even before the policy rate changes.

Reserve Requirements: Mostly a Historical Tool in the Current Framework

Older explanations of monetary policy often list reserve requirements as a routine tool. The Federal Reserve reduced reserve requirement ratios to zero percent in March 2020, eliminating reserve requirements for depository institutions. The Fed retains legal authority in this area, but reserve requirements are not a central active tool in the current ample-reserves operating framework.

How Monetary Policy Reaches the Economy

Monetary policy works through several connected channels rather than one direct switch.

1. Short-term rates: Changes in the policy stance influence overnight and money-market rates.
2. Longer-term yields: Expectations for future policy affect Treasury and other longer-term interest rates.
3. Credit conditions: Bank loans, corporate debt, mortgages, and consumer credit respond to market rates and risk conditions.
4. Asset prices and exchange rates: Changes in discount rates and relative returns can affect equities, bonds, currencies, and other assets.
5. Spending and investment: Borrowing costs and financial conditions influence household purchases and business investment.
6. Employment and inflation: Those changes in demand eventually affect labor markets and prices, usually with uncertain and variable lags.

Because many other forces also affect the economy, monetary policy cannot precisely control growth, employment, or inflation from month to month.

Expansionary vs. Restrictive Monetary Policy

Easier or expansionary policy generally means a lower policy-rate range or other actions intended to ease financial conditions. It is commonly used when economic activity is weak or inflation is running below the desired path.

Tighter or restrictive policy generally means a higher policy-rate range or other actions intended to restrain financial conditions. It is commonly used when inflation is too high or demand appears unsustainably strong.

The FOMC does not mechanically choose one stance from a single data point. It evaluates incoming data, the economic outlook, and risks to both sides of its mandate.

Unconventional Policy Since the Global Financial Crisis

The 2008 financial crisis and the 2020 pandemic showed that central banks sometimes need tools beyond ordinary short-term rate changes. The Federal Reserve used large-scale asset purchases, emergency lending facilities, forward guidance, and other measures when financial markets were impaired or the policy rate was near zero.

These tools can support market functioning and economic activity, but they also have tradeoffs and are generally treated differently from routine adjustments to the federal funds target range.

Sources

• Federal Reserve: Monetary Policy — Goals and How It Works
• Federal Reserve: Statement on Longer-Run Goals and Monetary Policy Strategy
• Federal Reserve: Interest on Reserve Balances FAQ
• Federal Reserve: Reserve Requirements
• Federal Reserve: Open Market Operations

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