Order Code RL30354
Monetary Policy and the Federal Reserve:
Current Policy and Conditions
August 22, 2008
Specialist in Macroeconomics
Government and Finance Division
Gail E. Makinen
Economic Policy Consultant
Government and Finance Division
Monetary Policy and the Federal Reserve:
Current Policy and Conditions
Monetary policy can be defined as any policy relating to the supply of money.
Since the agency concerned with the supply of money is the nation’s central bank, the
Federal Reserve, monetary policy can also be defined in terms of the directives,
policies, statements, and actions of the Federal Reserve, particularly those from its
Board of Governors that have an effect on national spending. The nation’s financial
press and markets pay particular attention to the pronouncements of the chairman of
the Board of Governors, the nation’s central banker. The reason for this attention is
that monetary policy can have important effects on aggregate demand and through
it on real Gross Domestic Product (GDP), unemployment, real foreign exchange
rates, real interest rates, the composition of output, etc.
It is paradoxical that these important effects, to the extent that they occur, are
essentially only short run in nature. Over the longer run, the major effect of monetary
policy is on the rate of inflation. Thus, while a more rapid rate of money growth may
for a time stimulate the economy, leading to a more rapid rate of real GDP growth
and a lower unemployment rate, over the longer run, these changes are undone and
the economy is left with a higher rate of inflation. In some societies where high rates
of inflation are endemic, more rapid rates of money growth fail to exercise any
stimulating effect and are almost immediately translated into higher rates of inflation.
Traditionally, two means have been used to measure the posture of monetary
policy. Since monetary policy involves the Federal Reserve’s contribution to aggregate demand or money spending, it would be logical to examine the growth rate of
the money supply. A growing money supply is important for the subsequent growth
in money spending or aggregate demand. Defining “the supply of money” has not
been easy. For the United States, three different collections of assets have been
defined as “money” and labeled M1, M2, and M3. Unfortunately, over the period
1990-2007, these aggregates have not been consistently linked to money spending
and, consequently, they are not the major focus of monetary policy.
Rather, the Federal Reserve executes monetary policy by setting a target for an
overnight interest rate called the federal funds rate. Low or falling rates are usually
taken as a sign of monetary ease; high or rising rates usually indicate monetary
tightness. Changes in the federal funds rates affect primarily short-term interest rates,
and through these changes, money spending.
Between January 3, 2001, and June 25, 2003, the target rate for federal funds
was reduced to 1% from 6½%. This policy was reversed beginning June 30, 2004.
In 17 equal increments ending on June 29, 2006, the target rate was raised to 5¼%.
No additional changes were made until September 18, 2007 when, in a series of
seven moves, the target was reduced to 2% on April 30. These reductions were
designed to ease credit market conditions and stimulate spending. This report will
be updated periodically as new data become available.
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
What is Monetary Policy? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Is Monetary Policy Important? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Monetary vs. Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Short Run vs. Longer Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Indicators of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Money Supply Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
The Recent and Current Posture of Monetary Policy . . . . . . . . . . . . . . . . . . . . . . 6
The Federal Reserve and the Monetary Aggregates . . . . . . . . . . . . . . . . . . . . . . 11
The Federal Reserve and the Discount Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
The Federal Reserve’s Mandate and Its Independence . . . . . . . . . . . . . . . . . . . . 12
Congressional Oversight and The Near-Term Goals of Monetary Policy . . . . . . 13
Appendix. Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
List of Figures
Figure 1. Yield on Selected Securities and Federal Funds . . . . . . . . . . . . . . . . . 10
List of Tables
Table 1. Recent Economic Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Table 2. The Growth Rates of the Monetary Aggregates . . . . . . . . . . . . . . . . . . . 9
Table 3. Growth in Major Components of M2 . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Table 4. Federal Reserve System Economic Projections . . . . . . . . . . . . . . . . . . . 14
Monetary Policy and the Federal Reserve:
Current Policy and Conditions
The behavior of the U.S. economy is affected significantly by the behavior of
monetary policy. And monetary policy over the past seven years has been supportive
of a continued and sustained economic expansion. Monetary policy changes typically
affect the economy with a 12- to 18-month lag.
The 1991-2001 economic expansion, the longest in American history, came to
an end in March 2001. Economic growth became sluggish during the second half of
2000 and remained sluggish through 2001. During that year, GDP contracted during
the first and third quarters. Growth resumed in the fourth quarter and has continued
through the first quarter of 2008 (for which data are now available). Prior to mid2000, the economy was growing at a rate that was thought to be unsustainable. To
curb growth, the Federal Reserve between mid-1999 and May 2000 raised the target
for the federal funds rate to 6½% from 4¾%. This tightening was too severe, for
economic growth slumped, industrial production declined and unemployment rose.
The Federal Reserve then began aggressively easing monetary policy. Between
January 3, 2001, and June 25, 2003, the target for the federal funds rate was reduced
to 1% from 6½%. Short-term interest rates generally followed the decline in the
target for the federal funds rate, whereas longer-term rates proven more resilient and
did fall as much. As the economy recovered and expanded, monetary policy was
gradually tightened. In 17 moves between June 30, 2004, and June 29, 2006, the
target was increased to 5¼%. No changes were made until September 18, 2007,
when target reduction began. In seven moves ending on April 30, 2008, the target
was reduced to 2%. This was designed to ease pressures in financial markets and
The growth rates of the various measures of money have been quite different
and do not always provide information on the shifts in monetary policy. The only
measure that has enjoyed a fairly consistent rate of growth is the monetary base that
is composed largely of circulating paper currency, much of which appears to be
abroad and is not necessarily related to economic conditions in the United States.
What is Monetary Policy?
Broadly speaking, monetary policy is any policy related to the supply of money.
As such, it would encompass various activities of the U.S. Treasury for those relating
to foreign exchange operations and the receipt and disposition of public funds can
affect the supply of money. The dominant influence on the U.S. money supply,
however, comes from the policies of the nation’s central bank, the Federal Reserve,
and particularly those policies originating with its Board of Governors.1 Thus, a
more realistic definition of monetary policy would be that it consists of the directives,
policies, pronouncements, and actions of the Federal Reserve that affect aggregate
demand or national spending. Among these, the dominant action consists of open
market operations. These involve the buying and selling of seasoned Treasury
securities by the Federal Reserve. When Treasury securities are purchased, the
Federal Reserve does so with newly created money. This money can serve as
reserves for the financial system and allows commercial banks and other depository
institutions to make new loans and investments, thereby expanding the money supply
and aggregate demand. The opposite happens when the Federal Reserve sells
Is Monetary Policy Important?
It has been said that “money matters” and the case for this statement can be
made in at least two different contexts. In one, monetary policy is compared with
fiscal policy and, given the current international financial system with flexible
exchange rates and a high degree of capital mobility between countries, the ability
of changes in the money supply to affect aggregate demand and the pace of GDP
growth and employment is great compared with fiscal policy. In the other context,
changes in the money supply have the potential to bring about major changes in the
growth of GDP and employment only in the short run. Paradoxically, this is not true
over the longer run. Over the more extended horizon, money supply growth has its
primary effect only on the rate of inflation. How fast GDP grows or what the
unemployment rate is, is largely independent of the amount of money or its growth
rate. A brief discussion of each of the two contexts summarized above follows.
Monetary vs. Fiscal Policy. The standard open economy macroeconomic
model makes a compelling case for the relative importance of monetary policy in a
world whose financial arrangements involve the use of flexible exchange rates and
where capital is highly mobile between countries. To see this, fiscal and monetary
expansion will be contrasted.
Allow the full employment budget deficit to rise (or the full-employment surplus
to fall) through either a tax rate cut or a rise in appropriated expenditures. While the
increase in this budget deficit (or fall in surplus) raises aggregate demand, it also
reduces national saving. The fall in the supply of saving relative to domestic
investment demand. This causes domestic interest rates to rise relative to those in
other financial centers. The rise in domestic interest rates makes U.S. financial assets
more attractive to foreigners. They, in turn, increase the demand for dollars in
foreign exchange markets to acquire the wherewithal to purchase U.S. assets. The
increased demand for dollars causes the dollar to appreciate. Dollar appreciation then
reduces the cost of foreign goods and services to Americans and raises the price of
American goods and services to foreigners. As a result, U.S. spending on imports
tends to rise and foreign spending on U.S. exports tends to fall. Thus, any
For institutional information on the Fed, see CRS Report RS20826, Structure and
Functions of the Federal Reserve System, by Pauline Smale.
expansionary effects on domestic demand from the larger budget deficit tends to be
offset in part or total by a reduced foreign trade surplus or a larger foreign trade
A more expansive monetary policy centering on a more rapid rate of growth of
the money supply initially serves to lower U.S. interest rates relative to those in other
financial centers. Foreign financial assets become more attractive to U.S. investors,
the supply of dollars to the foreign exchange markets rises as U.S. investors attempt
to acquire foreign currencies to buy foreign assets, and the dollar depreciates. Dollar
depreciation then makes foreign goods and services more expensive to Americans
and American goods and services cheaper to foreigners. As a result, the United
States spends less on imports and foreigners spend more on U.S. exports. A falling
foreign trade deficit or rising trade surplus thus reinforces any stimulus to domestic
demand that comes from lower U.S. interest rates.
The implication from the standard open economy macroeconomic model is that
monetary expansion is far more powerful than fiscal policy in influencing GDP
growth and employment given current international financial arrangements.
Short Run vs. Longer Run. The analysis above quite clearly shows that a
more rapid rate of growth of the money supply can cause domestic demand to
expand. An examination of U.S. economic history will show that money-induced
demand expansions can have a positive effect on U.S. GDP growth and total
employment. This same evidence, however, also suggests that over the longer run,
a more rapid rate of growth of the money supply is largely dissipated in a more rapid
rate of inflation with little if any lasting effect on real GDP and employment.
Economists have two explanations for this paradoxical behavior. First, they
note that, in the short run, many economies have an elaborate system of contracts
(both implicit and explicit) that makes it difficult in a short period for significant
adjustments to take place in wages and prices in response to more rapid money
growth. Second, they note that expectations for one reason or another are slow to
adjust to the longer run consequences of major changes in monetary policy. This
slow adjustment also adds rigidities to wages and prices. Because of these rigidities,
changes in money supply growth that change aggregate demand can have a large
initial effect on output and employment. Over the longer run, as contracts are
renegotiated and expectations adjust, wages and prices rise in response to the change
in demand and much of the change in output and employment is undone. Thus,
money can matter in the short run but be fairly neutral for GDP growth and
employment in the longer run.
It is noteworthy that in societies where high rates of inflation are endemic, the
short run may be very short indeed. During the final stages of very rapid inflations,
called hyperinflation, money’s ability to alter GDP growth and employment is
It is important to note that this explanation requires the full employment or structural
budget deficit to rise. Budget deficits produced by a fall in income, or cyclical deficits need
not produce these results.
Indicators of Monetary Policy
It is common to speak of monetary policy as being “easy” or being “tight” or
even of being “neutral.” What exactly do these terms mean and how does one
measure the posture of monetary policy?
Two basic measures of the posture of monetary policy are frequently used: the
growth rate of the money supply and market interest rates, particularly the federal
funds rate (the interest rate that one bank charges another for reserves that are lent on
an overnight basis). Unfortunately, as the following discussion makes clear, neither
of these two indicators provides an unambiguous measure of the posture of monetary
Money Supply Growth
Because the growth in aggregate demand depends heavily on the growth in the
supply of money, it would be logical to measure the posture of monetary policy by
the growth rate of the supply of money. Using this indicator, monetary policy is said
to be easy when, during a sustained period, the supply of money increases at a rate
that is high or rising relative to a recent trend. Alternatively, policy is said to be tight
when the rate of money growth is low or falling relative to a trend.
To measure the posture of monetary policy, the abstract concept “the supply of
money” must be given an empirical content. That is, the supply of money must be
defined in terms of an asset or group of assets that can be measured. Moreover, that
asset or group of assets must be stably or predictably related to aggregate demand or
money spending. The latter condition is important. It means that, when the supply
of money is changed, it will be possible to predict its effect on money spending.
The United States does not have a unique asset or group of assets that the
Federal Reserve defines as money. Rather, three collections of assets have been
recognized as money and are designated as M1, M2, and M3 (for a definition of each,
see the appendix).3 They are constructed such that M3 includes M2, and M2 includes
M1. It is possible for the growth of one or two of the aggregates to rise or fall when
the growth of the other aggregate or aggregates falls or rises (a common reason for
this is that wealth owners can shift dollars from one type of account to another such
as when they shift from passbook savings, an account included in M2 but not M1,
into checking accounts on which interest is paid, an account included in both M1 and
M2). When these divergent movements take place, as they frequently have during
the past 12 years in the United States (see Table 2), it is difficult to characterized
Nevertheless, it might be possible to find that one aggregate is better than
another in explaining subsequent movements in aggregate demand. During much of
Some analysts have argued that the Fed should target a broader measure of financial
conditions than the money supply, such as stock prices. See CRS Report RL33666, Asset
Bubbles: Economic Effects Policy Options for the Federal Reserve, by Marc Labonte. In
March 2006, the Federal Reserve ceased publication of data on M3.
the post-World War II period, M1 had the most stable relationship to aggregate
demand. The Federal Reserve, however, beginning in the 1970s, set target growth
rate ranges for all three aggregates. Unfortunately, during the late 1970s, the stable
relationship between M1 and aggregate spending broke down and the Federal
Reserve, while still reporting movements in this aggregate, no longer sets growth rate
ranges for it. During the 1990s, the stable relationship between M2 and aggregate
spending also broke down. Beginning in July 2000, the Fed discontinued setting
monitoring ranges for M2 and M3. Legislation requiring it to do so expired.
(Although M3 was never strongly related to aggregate demand, its movement bore
little relationship to subsequent movements in demand during the 1990s and, as noted
in footnote 3, data on it were discontinued in 2006.)
Thus, the United States has had three definitions of money that appear to
provide little information about the posture of monetary policy. Moreover, an
extensive amount of recent research on the stability issue has yet to yield a collection
of new assets that performs consistently better, that is, provide consistently superior
information on the posture of monetary policy.4
A logical reason for focusing on interest rates in judging monetary policy is that
they are an important link through which changes in the money supply are
transmitted to the real economy. That is, changes in money supply growth lead to
changes in market interest rates and these changes then influence households in their
decisions to buy homes, automobiles, appliances, and the like, and businesses in their
decisions regarding inventories and plant and equipment purchases.
The interest rate relevant for these decisions is not the market rate but the real
rate or market rate less the expected rate of inflation. Rising real rates are interpreted
as a sign of tight monetary policy while falling real rates supposedly signal a move
toward an easier monetary policy. Caution should be used, however, in making this
interpretation of the movement in real rates. The reason is that market interest rates
respond both to shifts in the supply and demand for money.5
Those who use interest rates as guides to the posture of monetary policy appear
to implicitly assume that shifts in the supply of money dominate movements in the
relevant interest rates. Thus, a more rapid rate of growth of the money supply should
drive down market interest rates, especially short-term rates. Given expectations
about future inflation, the fall in market rates is taken as a fall in real rates and a
For a discussion of these studies and the issues involved, see CRS Report RL31416,
Monetary Aggregates: Their Use in the Conduct of Monetary Policy, by Marc Labonte and
Gail E. Makinen.
The real rate of interest is determined by the interaction of saving and investment. Thus,
change in the national saving rate or the desire to invest (i.e., add to the national capital
stock) can affect the real rate independent of anything the Federal Reserve does. Such
changes to the real rate can further complicate the use of interest rates as an indicator of the
posture of monetary policy.
signal that monetary policy has eased; and, conversely, for a rise in market and real
Market interest rates, however, can fall for two other reasons even when the
supply of money (or its growth rate) is held constant. First, any fall in income
reduces the demand for money and, as a result, market interest rates and real rates
will fall. Second, should the public come to expect a lower inflation rate, inflation
expectations should also fall. With this decline, market interest rates should also fall.
However, real interest rates should not fall and may even rise in the short run. Thus,
the fall in market rates should not stimulate economic activity.
An important interest rate for the Federal Reserve is the federal funds rate,
which is essentially an overnight rate that one depository institution charges another
when reserves are lent — reserves being necessary to back the deposit liabilities
financial institutions have on their books. If the Federal Reserve wishes to expand
the reserves of depository institutions thereby enhancing their lending capabilities,
it will supply reserves to this market. The increased supply will drive down the
federal funds rate and monetary policy can be said to have eased.
Conversely, when the Federal Reserve wishes to tighten lending, it will
withdraw reserves from this market causing the funds rate to rise. Thus, a falling
funds rate is often taken to signal an easing of monetary policy, a rising rate the
tightening of policy, and a constant rate, a neutral or “stand fast” policy. However,
this is not always the case and each movement can have unintended consequences.
This arises because the Federal Reserve, through the federal funds rate, only
controls the supply of reserves. It does not control the demand for reserves. That is
in the domain of financial institutions and is governed by their outlook for economic
activity. A constant federal funds rate, for example, may not be a neutral policy.
Suppose that financial institutions become pessimistic about the future and cut back
their demand for reserves. Reserve growth declines as does lending and economic
activity. During the period these advents are transpiring, the Federal Reserve keeps
the funds rate constant. The effect on the economy is not neutral.
How long this would continue before it became apparent to the Federal Reserve
that the economy had shifted is open to conjecture. After some period of time, data
would reveal the falloff in the growth of the reserves of depository institutions and
the monetary aggregates. Misinterpretations such as this are most costly when an
economy is at a critical turning point.
The Recent and Current Posture of Monetary Policy
The behavior of several important performance characteristics of the U.S.
economy since the early 1980s is shown in Table 1. An early period of interest is
GDP growth from 1994 to 2000. At that time, growth rates of from 4% to 5% were
regarded as unsustainable. These rates likely played an important role in causing the
Federal Reserve to tighten monetary policy. And this tightening played an important
role in bringing to an end the longest economic expansion in U.S. history (March
1991 to March 2001), as well as setting in motion the current expansion. As noted
above, there are two ways to measure the posture of monetary policy: the growth of
the monetary aggregates and interest rates.
Table 1. Recent Economic Performance
Source: U.S. Departments of Labor and Commerce.
a. Real growth and inflation are measured on a fourth quarter over fourth quarter basis. For 2008,
growth is the annualized rate over the first half year.
b. Inflation is measured by the implicit price deflator for GDP on a fourth quarter over fourth quarter
c. The unemployment rates subsequent to 1994 are not strictly comparable with those of previous
years. Annual averages for all years. Unemployment rate for 2008 is average of first 7months.
The behavior of the aggregates is shown in Table 2. The first impression is that
they do not tell a consistent story. Indeed, focusing on Aggregate Reserves alone
may lead one to wonder how this long expansion period ever got underway since they
contracted during most of the period 1994-2002, whereas the Monetary Base, M2,
and M3 grew positively in each year (a definition of each aggregate is given in the
appendix). All, however, is not what it seems. The decline in Aggregate Reserves
actually allowed for considerable monetary expansion. This occurred because
individuals and businesses allowed their demand deposit balances to run off (see
Table 3). This decline in demand deposit balances set free bank reserves. Since not
all of these reserves were removed from the banking system, reserve contraction was
compatible with expanding the lending capacity of banks. (The increase in aggregate
reserves in 2001 was temporary and designed to forestall a possible liquidity crisis
in the immediate aftermath of the September 11 terrorist attacks.) The shift to
positive reserve growth during 2003 and 2004 reflects the fall in the federal funds
target during those years. The contraction of reserves during 2005 and 2006 reflects
the increase in the target for federal funds that began in November 2004. Their rise
over the past 12 months is compatible with the observed lowering of the target.
The behavior of the Monetary Base could account for both the recovery that
began in the fourth quarter of 2001 and the subsequent expansion of the economy.
However, this may be due to chance since approximately 90% of the Base consists
of paper currency (and coin) in circulation, much of which apparently does not
circulate within the United States.6 Thus, its behavior may depend on conditions in
foreign countries rather than reflect economic developments in the United States.
Similarly, problems exist with the three M’s in explaining both the beginning
of the expansion of 1991-2001 and 2002, and their continuations.
A general conclusion from the behavior of the aggregates is that, while they
might yield some useful information about the economic expansion, they do not
provide consistent information on the posture of monetary policy. Consequently,
they are not used by the Federal Reserve in the conduct of monetary policy. Rather,
the posture of monetary policy is best inferred from interest rates, particularly
movements in the federal funds rate.
The movement of selected U.S. Treasury yields and the federal funds rate is
shown in Figure 1. The sharp decline in the rate that began in 2000 played a major
role in initiating the cyclical upswing that began in November 2001 As the
expansion began to take hold, the Federal Reserve kept the target rate below 2% for
some three years (much of the time at 1%) from November 2001 through November
2004. This was done for several reasons. Initially, the recovery and subsequent
expansion was weak. GDP growth was accompanied by relatively little growth in job
creation. Second, there was fear of a major economic fallout from 9/11 (the target
was moved from 3% to1¾% in three months). Finally, during 2003, the Federal
Reserve began to fear that the U.S. would experience price deflation similar to that
For a detailed discussion, see CRS Report RL30904, Why is the Amount of Currency in
Circulation Rising?, by Marc Labonte and Gail Makinen.
experienced by Japan.7 However, as the growth rate accelerated, the unemployment
rate fell, and the fear of deflation ebbed, the Fed tightened policy. Between June 30,
2004, and June 29, 2006, the target was increased 17 times and then stood at 5¼%.
During the summer of 2007, a major disturbance to financial markets centering on
sub-prime mortgages and falling housing prices emerged and continued into 2008.
To deal with this and a related slowing in domestic spending, the Fed began to ease
monetary policy. On September 18, October 31, and December 11, 2007, and
January 22 and 30, March 18, and April 30, 2008, the target was reduced
incrementally to 2% from 5¼%, where it now remains.8
Table 2. The Growth Rates of the Monetary Aggregates
(annual rate of change)
07: 07-08: 07
Source: Board of Governors of the Federal Reserve System.
a. Data on M3 ceased to be published in March 2006.
See Alan Greenspan. The Age of Turbulence. Penguin Press. New York (2007): pp. 228229.
The Fed also undertook a number of new initiatives to provide liquidity to the financial
system. These are discussed in CRS Report RL34427, Financial Turmoil: Federal Reserve
Policy Responses, by Marc Labonte.
Figure 1. Yield on Selected Securities and Federal Funds
Source: Board of Governors of the Federal Reserve System.
Table 3. Growth in Major Components of M2
(annualized rates of change)
07: 07-08: 07
Source: Board of Governors of the Federal Reserve System.
a. Consists principally of savings accounts (including money market deposit accounts) and time
certificates of deposits.
Note also that, while short-term interest rates move in sympathy with the federal
funds rate, longer-term rates often do not. The divergence is especially noticeable
during 1996, 1997, 1999, and 2001 to 2007. This should help dispel the notion that
the Federal Reserve can set interest rates wherever it wishes.
The Federal Reserve and the Monetary Aggregates
In its report to Congress, dated July 20, 1993, the Board of Governors expressed
considerable uncertainty about the usefulness of M2 and M3 as measures of money.
The uncertainty arose from the perverse movement in the velocity or turnover rates
of these aggregates during the previous three years.
For this reason, the Board of Governors decided to de-emphasize both M2 and
M3 in its decision-making. While the board continued to set growth rate ranges for
each aggregate, it concluded:
With considerable uncertainty persisting about the relationship of the monetary
aggregates to spending, the behavior of the aggregates relative to their annual
ranges will likely be of limited use in guiding policy ... and the Federal Reserve
will continue to utilize a broad range of financial and economic indicators in
assessing its policy stance.
This position was reaffirmed by the board during subsequent Monetary Policy
(formerly called Humphrey-Hawkins) hearings. However, in the Monetary Policy
Report submitted to Congress on July 20, 2000, the Board of Governors stated:
At its June meeting, the FOMC did not establish ranges for the growth of money
and debt in 2000 and 2001. The legal requirement to establish and to announce
such ranges had expired, and owing to uncertainties about the behavior of the
velocities of debt and money, these ranges for many years have not provided
useful benchmarks for the conduct of monetary policy. Nevertheless, the FOMC
believes that the behavior of money and credit will continue to have value for
gauging economic and financial conditions....
Even this view of the usefulness of the aggregates has changed. The Board of
Governors announced in November 2005 that beginning in March 23, 2006, it would
no longer publish data on M3. In the words of the Board: “... publication of M3 was
judged to be no longer generating sufficient benefit in the analysis of the economy
or of the financial sector to justify the costs of publication.”9
The Federal Reserve and the Discount Rate
The Federal Reserve has preferred to conduct monetary policy by setting a target
for the federal funds rate. This method has allowed the Federal Reserve to adopt an
activist posture in the conduct of monetary policy. The Board of Governors controls
another interest rate, the discount rate. Financial institutions can borrow on a
temporary basis directly from the Federal Reserve at this rate. The Board can either
Monetary Policy Report to the Congress, February 15, 2006, p. 22.
grant or deny the loan. The initiation of the loan, however, is at the discretion of the
borrowing financial institution. In this sense, the Federal Reserve is passive in the
process. Although the discount rate has long been a tool of central banking, it has
fallen into disuse in the United States over the past several decades. Financial
institutions prefer to borrow overnight in the federal funds market because they can
obtain what they need without having to subject their borrowing needs to the purview
of the Federal Reserve. On the downside, borrowing federal funds is generally on an
overnight basis where as borrowing at the discount window is for a longer period.
In conducting monetary policy, the Board has, in the past, moved the discount rate
in sympathy with the federal funds target. For much of the past decade, the discount
rate was set slightly below the federal funds target.
To discourage financial institutions from borrowing at the discount window,
lending rules were altered in early 2003. Since that time, the discount rate has been
set above the federal funds rate target and is now a penalty rate. However, a change
in the discount rate independent from a change in the federal funds target can send
a powerful message to financial markets. For example, on August 17, 2007, the
Board of Governors, concerned about the adequacy of liquidity in national financial
markets, reduced the discount rate for primary credit to 4¾% from 5¼%. Later, on
September 18, October 31, December 11, 2007, January 22 and 30, March 18, and
April 30, 2008, when the federal funds target was reduced, the discount rate was also
reduced replicating past behavior by the Federal Reserve (in addition, on March16,
2008, the discount rate was lowered without any change in the federal funds target).
The Federal Reserve’s Mandate
and Its Independence
The Constitution grants Congress the power to “coin money, and regulate the
value thereof....” However, operational responsibility for making U.S. monetary
policy has been delegated by Congress to the Fed. Congress is still responsible for
oversight, setting the Fed’s mandate and approving the President’s nominations for
the Fed’s Board of Governors, but several institutional features grant it significant
“independence” from the political process.10 The Federal Reserve system is quasipublic in structure: it is owned by its member banks. The governors are appointed
to staggered 14-year terms, and can only be removed by Congress for cause. It is
self-funded and does not receive appropriations. While it must follow its
congressional mandate, it has been granted broad discretion to interpret and carry out
that mandate as it sees fit on a day-to-day basis. Most economists argue that good
monetary policy depends on independence because it reduces the temptation to raise
inflation in the long run in order to lower unemployment in the short run.
Researchers have made cross-country comparisons to try to make the case that
For more information, see CRS Report RL31056, Economics of Federal Reserve
Independence, by Marc Labonte.
countries with independent central banks are more likely to have low inflation rates
and better economic performance.11
As a practical matter, the Fed’s mandate can be seen as a further source of
political independence. The Federal Reserve Act of 1977 (P.L. 95-188, 91 Stat.
1387) charged the Fed with “the goals of maximum employment, stable prices, and
moderate long-term interest rates.” Note that the Fed controls none of these three
indicators directly; it controls only overnight interest rates. Because it has only one
tool at its disposal and three goals, there will be times when the goals will be at odds
with each other, and the Fed will have to choose to pursue one at the expense of the
other two. Critics have argued that the ambiguity inherent in the current mandate
makes for less than optimal transparency and accountability. It may also strengthen
political independence if it allows the Fed to deflect congressional criticism by
pointing, at any given time, to whatever goal justifies its current policy stance.
The most popular alternative to the current mandate is to replace it with a single
mandate of price stability. Under this proposal, the Fed would typically be given (or,
under the version mooted by Chairman Bernanke, give itself) a numerical inflation
target, and would then be required to set monetary policy with the goal of meeting
the target on an ongoing basis.12 Proponents of inflation targeting say that maximum
employment and moderate interest rates are not meaningful policy goals because
monetary policy has no long-term influence over either one. They argue a mandate
that focused on keeping inflation low would deliver better economic results and
improve transparency and oversight. Opponents, including former Chairman
Greenspan, say that the flexibility inherent in the current system has served the
United States well in the past 25 years, delivering both low inflation and economic
stability, and there is little reason to fix a system that is not broken. They argue that
some focus on employment is appropriate given that monetary policy has powerful
short-term effects on it, and that too great a focus on inflation could lead to a overly
volatile business cycle. Inflation targeting has been widely adopted abroad, although
foreign inflation targeters seem to target inflation less strictly in practice than some
of its proponents may have hoped.13
Congressional Oversight and The Near-Term
Goals of Monetary Policy
The primary form of congressional oversight of the Federal Reserve are the
semi-annual hearings with the Senate Committee on Banking, Housing, and Urban
Affairs and the House Committee on Financial Services. At these hearings, which
For a review of the research and criticisms, see CRS Report RL31955, Central Bank
Independence and Economic Performance: What Does the Evidence Show?, by Marc
Labonte and Gail Makinen.
See CRS Report 98-16, Should the Federal Reserve Adopt an Inflation Target?, by Marc
Labonte and Gail Makinen.
See CRS Report RL31702, Price Stability (Inflation Targeting) as the Sole Goal of
Monetary Policy: The International Experience, by Marc Labonte and Gail Makinen.
take place in February and July, the Fed Chairman presents the Fed’s Monetary
Policy Report to the Congress, testifies, and responds to questions from committee
members. These hearings and reporting requirements were established by the Full
Employment Act of 1978 (P.L. 95-523, 92 Stat 1897), also known as the HumphreyHawkins Act, and renewed in the American Homeownership and Economic
Opportunity Act of 2000 (P.L. 106-569).
The semiannual Monetary Policy Report presents a review of recent economic
and monetary policy developments, as well as economic projections for three years.
Since monetary policy plays an important role in determining economic outcomes,
these projections can be viewed as the Fed’s perceptions of how today’s monetary
policy stance will influence future economic conditions. To increase the transparency
of monetary policy, the Fed in 2007 began to provide additional forecasts. They now
appear quarterly. The most recent, from the Monetary Policy Report of July 15,
2008, representing the views of the Board of Governors and the 12 Reserve Bank
Presidents, is presented in Table 4. These are contrasted with the projections made
for similar variables by the Federal Reserve last April.14
Table 4. Federal Reserve System Economic Projections
Growth of real GDP
1.0 to 1.6
2.0 to 2.8
2.5 to 3.0
0.3 to 1.2
2.0 to 2.8
2.6 to 3.1
5.5 to 5.7
5.3 to 5.8
5.0 to 5.6
5.5 to 5.7
5.2 to 5.7
4.9 to 5.5
3.8 to 4.2
2.0 to 2.3
1.8 to 2.0
3.1 to 3.4
1.9 to 2.3
1.8 to 2.0
Core PCE inflation
2.2 to 2.4
2.0 to 2.2
1.8 to 2.0
2.2 to 2.4
1.9 to 2.1
1.7 to 1.9
Source: Table in the Monetary Policy Report, July 15, 2008.
a. These projections use the price index for Personal Consumption Expenditures obtained from the
Gross Domestic Product accounts. The Core PCE is the PCE less food and energy.
These projections represent the “central tendency” for each variable, which means that
in computing the averages in the table the three highest and lowest projections for each
variable are excluded.
M1 is the sum of the following:
1. Currency held by the public
2. Outstanding traveler’s checks of nonbank issuers
3. Demand deposit balances
4. Negotiable Order of Withdrawal (NOW and Super-NOW) accounts and other
M2 is the sum of the following:
2. Time and savings deposits in amounts under $100,000
3. Individual holdings in money market mutual funds
4. Money market deposit accounts (MMDAs).
M3 was the sum of the following:
2. Time deposits at commercial banks in amounts of $100,000 or more
3. Term repurchase agreements
4. Institution-only money market mutual funds
5. Term Eurodollars held by U.S. residents in Canada and the U.K.
6. Overnight retail purchase agreements (Repos)
7. Overnight Eurodollars held by U.S. residents.
Nonfinancial debt is the sum of the following sectors’ outstanding debt:
1. U.S. government
2. State and local governments
3. Nonfinancial domestic businesses