Monetary policy of the United States
The monetary policy of The United States is the set of policies which the Federal Reserve follows to achieve its twin objectives of high employment and stable inflation.[1]
The US central bank, The Federal Reserve System, colloquially known as "The Fed", was created in 1913 by the Federal Reserve Act as the monetary authority of the United States. The Federal Reserve's board of governors along with the Federal Open Market Committee (FOMC) are consequently the primary arbiters of monetary policy in the United States.
The U.S. Congress has established three key objectives for monetary policy in the Federal Reserve Act: maximizing employment, stabilizing prices, and moderating long-term interest rates. Because long-term interest rates remain moderate in a stable economy with low expected inflation, the last objective will be fulfilled automatically together with the first two ones, so that the objectives are often referred to as a dual mandate of promoting maximum employment and stable prices. The Fed operationalizes its objective of stable prices as following an inflation target of 2% annual inflation on average.[1]
The Federal Reserve's main monetary policy instrument is its Federal funds rate target. By adjusting this target, the Fed affects a wide range of market interest rates and in turn indirectly affects stock prices, wealth and currency exchange rates. Through these variables, monetary policy influences spending, investment, production, employment and inflation in the United States. These channels are collectively known as the monetary transmission mechanism. Effective monetary policy complements fiscal policy to support economic stability, dampening the impact of business cycles.
Besides conducting monetary policy, the Fed is tasked to promote the stability of the financial system and regulate financial institutions, and to act as lender of last resort.[2][3] In addition,
the Fed should foster safety and efficiency in the payment and settlement system and promote consumer protection and community development.[1]
The Federal funds rate is a market interest rate, being the rate at which banks and credit unions lend reserve balances to each other overnight on an uncollateralized basis. The Fed consequently does not determine this rate directly, but has over time used various means to influence the rate. Until the global financial crisis in 2008, the Fed relied on open market operations, i.e. selling and buying securities in the open market to adjust the supply of reserve balances so as to keep the FFR close to the Fed's target.[8] However, since 2008 the actual conduct of monetary policy implementation has changed considerably, using instead various administered interest rates (i.e., interest rates that are set directly by the Fed rather than being determined by the market forces of supply and demand[9]) as the primary tools to steer short-term market interest rate towards the Fed's policy target,[1] which from December 2008 has been expressed as a range of 25 basis points.[8]
The present implementation regime, which has evolved since the Financial Crisis, is referred to as an "ample-reserves regime" as opposed to the earlier limited-reserves regime. In 2019, the Fed announced that it would continue to use this implentation regime over the longer run.[9] The Fed's central policy tools are the interest on reserve balances rate (IORB) and the overnight reverse repurchase agreement offering rate (ON RRP rate). They are administered rates which the Fed pays on funds that commercial banks hold in their reserve balance accounts at the Fed and funds that large nonbank financial institutions deposit at the Fed, respectively. These rates set a floor on the rates at which banks are willing to lend excess cash to other private market participants. At the same time, the Fed operates a discount window in which it lends funds to banks at the discount rate (a third administered rate), which puts a ceiling on the federal funds rate, as banks are unlikely to borrow elsewhere at a higher interest rate than the discount rate. Open-market operations are no longer used to steer the FR, but still form part of the over-all monetary policy toolbox, as they are used to always maintain an ample supply of reserves.[1]
To sum up, the policy instruments in the current ample-reserves regime are:[1]
Reserve requirements, which have formerly been used as a policy tool to manipulate the money supply and in turn market interest rates, are no longer used as a policy tool, and indeed in March 2020 were effectively abolished when the Fed's reserve requirement ratios were set to zero.[9]
Monetary policy also generally affects the money supply. At times, changes in money supply measures have been closely related to important economic variables like GDP growth and inflation, and the Federal Reserve has earlier used these measures as an important guide in the conduct of monetary policy. In recent decades, however, these relationships have been quite unstable, and the importance of the money supply in this respect has consequently diminished over the years. Today, the Federal Open Market Committee reviews money supply data as just one part of a wide array of various financial and economic data which form the background for the Committee's monetary policy decisions,[10]
The economy's aggregate money supply is the total of
The money supply thus has different components, generally broken down into "narrow" and "broad" money, reflecting the different degrees of liquidity ('spendability') of each different type, as broader forms of money can be converted into narrow forms of money (or may be readily accepted as money by others, such as personal checks).[11] For example, demand deposits are technically promises to pay on demand, while savings deposits are promises to pay subject to some withdrawal restrictions, and Certificates of Deposit are promises to pay only at certain specified dates; each can be converted into money, but "narrow" forms of money can be converted more readily.
The Federal Reserve presently directly controls only the most narrow form of money, physical cash outstanding; the Federal Reserve indirectly influences the supply of other types of money. Until 2020, the Federal Reserve also used reserve requirements, enabling it to directly ensure a minimum of reserve balances of commercial banks, which together with outstanding cash makes up the monetary base (known also as M0).[11] In March 2020, however, the Fed reduced reserve requirement ratios to zero, effectively abandoning this instrument and relying instead on interest rates on reserves to influence commercial banks' behavior.[9][12]
Broad money includes money held in deposit balances in banks and other forms created in the financial system. Basic economics also teaches that the money supply shrinks when loans are repaid;[13][14] however, the money supply will not necessarily decrease depending on the creation of new loans and other effects. Other than loans, investment activities of commercial banks and the Federal Reserve also increase and decrease the money supply.[15] Discussion of "money" often confuses the different measures and may lead to misguided commentary on monetary policy and misunderstandings of policy discussions.[16]
A few of the uncertainties involved in monetary policy decision making are described by the federal reserve:[55]