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Monday, October 24, 2011

Monetary Policy and the Federal Reserve: Current Policy and Conditions

Marc Labonte
Specialist in Macroeconomic Policy

The Federal Reserve (Fed) defines monetary policy as the actions it undertakes to influence the availability and cost of money and credit. Since the expectations of market participants play an important role in determining prices and growth, monetary policy can also be defined to include the directives, policies, statements, and actions of the Fed that influence how the future is perceived. In addition, the Fed acts as a “lender of last resort” to the nation’s financial system, meaning that it ensures continued smooth functioning of financial intermediation by providing financial markets with adequate liquidity. This role has become of great importance following the onset of the recent financial crisis.

Traditionally, the Fed has three means for achieving its goals: open market operations involving the purchase and sale of U.S. Treasury securities, the discount rate charged to banks who borrow from the Fed, and reserve requirements that governed vault cash or deposits with the Fed as a proportion of deposits. Historically, open market operations have been the primary means for executing monetary policy. Recently, in response to the financial crisis, direct lending has become important once again and the Fed has created a number of new ways for injecting reserves, credit, and liquidity into the banking system, as well as making loans to firms that are not banks. As financial conditions normalize, the Fed is moving back to a reliance on open market operations.

The Fed traditionally conducts open market operations by setting an interest rate target that it believes will allow it to achieve price stability and maximum sustainable employment. The interest rate targeted is the federal funds rate, the price at which banks buy and sell reserves on an overnight basis. This rate is linked to other short-term rates and these, in turn, influence longerterm interest rates. Interest rates affect interest-sensitive spending such as business capital spending on plant and equipment, household spending on consumer durables, and residential investment. Through this channel, monetary policy can be used to stimulate or slow aggregate spending in the short run. In the long run, monetary policy mainly affects inflation. A low and stable rate of inflation promotes price transparency and, thereby, sounder economic decisions by households and businesses.

The Fed has frequently changed the federal funds target to match changes in expected economic conditions. Beginning September 18, 2007, in a series of 10 moves, the target was reduced from 5.25% to a range of 0% to 0.25% on December 16, 2008, where it now remains. Since then, the Fed has added liquidity to the financial system beyond what is needed to meet its federal funds target through direct lending and, more recently, purchases of Treasury and government sponsored enterprise (GSE) securities. This practice is sometimes referred to as quantitative easing, which has tripled the size of the Fed’s balance sheet since financial turmoil began. A second round of quantitative easing began in November 2010. In September 2011, the Fed announced a plan to buy $400 billion of long-term Treasury securities and sell an equivalent amount of short-term Treasury securities, a proposal some have referred to as “Operation Twist.”

Congress has delegated responsibility for monetary policy to the Fed, but retains oversight responsibilities to ensure that the Fed is adhering to its statutory mandate “maximum employment, stable prices, and moderate long-term interest rates.” H.R. 245 would switch to a single mandate of price stability. The Dodd-Frank Act enhanced the GAO’s ability to audit the Fed, and required a review of its emergency programs. H.R. 459/H.R. 1496/S. 202 would remove all remaining restrictions on GAO’s audit powers. H.R. 1512 would remove the regional Fed bank presidents from the Federal Open Market Committee.

Date of Report: October 1
2, 2011
Number of Pages:
Order Number: R
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