Monetary Policy and the Federal Reserve:
Current Policy and Conditions

Marc Labonte
Specialist in Macroeconomic Policy
March 31, 2010
Congressional Research Service
7-5700
www.crs.gov
RL30354
CRS Report for Congress
P
repared for Members and Committees of Congress

Monetary Policy and the Federal Reserve: Current Policy and Conditions

Summary
The Federal Reserve (Fed) defines monetary policy as the actions it undertakes to influence the
availability and cost of money and credit to help promote its congressionally mandated goals,
achieving a stable price level and maximum sustainable economic growth. 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 its sustainability, solvency, and integrity. This
role has become of great importance with the onset of the financial crisis in the summer of 2007.
Traditionally, the Fed has had 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 the proportion of deposits that
must be held either as vault cash or as a deposit at the Federal Reserve. 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 more traditional reliance on open market operations.
The Fed conducts open market operations by setting an interest rate target that it believes will
allow it to achieve price stability and maximum sustainable growth. 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 longer term interest rates.
Interest rates affect interest-sensitive spending – business capital spending on plant and
equipment, household spending on consumer durables, and residential investment.
In the short run, monetary policy can be used to stimulate or slow aggregate spending. While
monetary policy is charged with promoting maximum sustainable economic growth, it does so
only indirectly in the long run by maintaining a stable price level since the direct effect of
monetary policy is primarily on the rate of inflation. A low and stable rate of inflation through the
business cycle 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. Between January 3, 2001, and June 25, 2003, the target rate was reduced to 1% from
6½%. This policy was reversed on June 30, 2004, and 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 10 moves, the target was reduced to a range of 0% to 1/4% 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.
For more information on the Fed’s crisis-response actions, see CRS Report RL34427, Financial
Turmoil: Federal Reserve Policy Responses
, by Marc Labonte. Legislative changes to the Fed’s
duties and authority related to financial regulatory reform can be found in CRS Report R40877,
Financial Regulatory Reform: Systemic Risk and the Federal Reserve, by Marc Labonte.
Congressional Research Service

Monetary Policy and the Federal Reserve: Current Policy and Conditions

Contents
Introduction ................................................................................................................................ 1
How Does the Federal Reserve Execute Monetary Policy? .......................................................... 2
The Importance of Monetary Policy ............................................................................................ 4
Monetary vs. Fiscal Policy .................................................................................................... 4
Short Run vs. Longer Run..................................................................................................... 5
The Recent and Current Stance of Monetary Policy..................................................................... 5
Congressional Oversight and The Near-Term Goals of Monetary Policy..................................... 7
The Federal Reserve’s Mandate and Its Independence ................................................................. 8

Appendixes
Appendix A. Federal Reserve and the Discount Rate ................................................................. 10
Appendix B. Federal Reserve and the Monetary Aggregates ...................................................... 11

Contacts
Author Contact Information ...................................................................................................... 11
Acknowledgments .................................................................................................................... 12

Congressional Research Service

Monetary Policy and the Federal Reserve: Current Policy and Conditions

Introduction
The Federal Reserve’s (Fed’s) responsibilities as the nation’s central bank fall into four main
categories: monetary policy, ensuring financial stability through the lender of last resort function,
supervision of bank holding companies, and providing payment system services to financial firms
and the government. This report will discuss the first two areas of responsibility.
The Fed defines monetary policy as the actions it undertakes to influence the availability and cost
of money and credit to promote the goals mandated by Congress: a stable price level and
maximum sustainable economic growth. Since the expectations of households as consumers and
businesses as the purchasers of capital goods exert an important influence on the major portion of
spending in the United States, and these expectations are influenced in important ways by the
actions of the Fed, a broader definition of monetary policy would include the directives, policies,
statements, forecasts of the economy, and other actions by the Fed, especially those made by or
associated with the chairman of its Board of Governors, the nation’s central banker.1
In addition, governments have traditionally assigned to a central bank the role of “lender of last
resort” to the nation’s financial system. This role means that the Federal Reserve is responsible
for ensuring the sustainability, solvency, and continued functioning of the nation’s financial
system as a whole, although this does not necessarily extend to any individual financial
institution. Thus, in times of financial stress or crisis, the Fed is responsible for ensuring that
financial intermediation does not come to a halt. Historically, Federal Reserve intervention has
been limited to the banking system. Indeed, the impetus for the founding of the Fed was an
outgrowth of the financial panic of 1907. During its nearly 100 year history, the Federal Reserve
has rarely been called upon to perform this role. It is now widely regarded as having failed to
perform it during the collapse of the U.S. banking system in the contraction of 1929-1933.
However, the financial crisis that began in the summer of 2007 with the bursting of the “housing
price bubble,” has placed this role front and center. The Fed has responded in the conventional
way by making massive additions of reserves available to depository institutions (primarily
commercial banks) through the purchase of U.S. Treasury securities and allowing banks to
discount large amounts of eligible paper. In addition, it has created a number of additional ways
to make credit available to a broader range of financial institutions as well as making loans
directly to non-financial firms. These innovations are still evolving and several are authorized
only in “unusual and exigent circumstances.”2
Thus, the Federal Reserve has a monetary policy function and a financial stability function. Its
monetary policy function is one of aggregate demand management. The availability and cost of
credit are used to manage aggregate demand in such a way as to promote a stable price level and

1 For a discussion of the important role played by expectations in formulation and execution of monetary policy, see
Santomero, Anthony M. “Great Expectations: The Role of Beliefs in Economics and Monetary Policy.” Business
Review,
Federal Reserve Bank of Philadelphia. Second Quarter 2004, pp. 1-6, and Sellon, Gordon H., Jr., “Expectations
and the Monetary Policy Transmission Mechanism”, Economic Review. Federal Reserve Bank of Kansas City, Fourth
Quarter 2004, pp. 4-42.
2 For a discussion of the current financial crisis, its origins, and the innovations by the Federal Reserve, see CRS Report
RL34730, Troubled Asset Relief Program: Legislation and Treasury Implementation, by Baird Webel and Edward V.
Murphyand CRS Report RL34427, Financial Turmoil: Federal Reserve Policy Responses, by Marc Labonte. For
historical perspective on Federal Reserve’s dealing in non-government debt, see Wheelock, David C. “Conducting
Monetary Policy Without Government Debt: The Fed’s Early Years. Review, Federal Reserve Bank of St. Louis.
May/June 2002, pp. 1-14.
Congressional Research Service
1

Monetary Policy and the Federal Reserve: Current Policy and Conditions

through it maximum sustainable growth. Its second function is as “lender of last resort” to the
nation’s financial system.
This report will examine the traditional execution of monetary policy. The “lender of last resort”
role since 2007 is examined in CRS Report RL34427, Financial Turmoil: Federal Reserve Policy
Responses
, by Marc Labonte. Legislative changes to the Fed’s duties and authority related to
financial regulatory reform can be found in CRS Report R40877, Financial Regulatory Reform:
Systemic Risk and the Federal Reserve
, by Marc Labonte.
How Does the Federal Reserve Execute Monetary
Policy?

The Federal Reserve has traditionally relied on three means to conduct monetary policy and they
are used to alter the reserves available to depository institutions. These institutions are required to
maintain reserves in the form of vault cash (currency) or as a deposit at the Fed against their
deposit liabilities, primarily checking, saving, and time (CDs). The size of these reserves places a
ceiling on the amount of deposits that financial institutions can have outstanding and deposit
liabilities are related to the amount of assets these institutions can acquire. These assets are often
called “credit” since they represent loans made to businesses and households, among others.
If the Federal Reserve wishes to expand money and credit, it has three ways to do so. The primary
method is called open market operations and it involves the Fed buying and selling existing U.S.
Treasury securities (or those that have been already issued and sold to private investors). Should
it buy securities, it does so with the equivalent of newly issued currency (Federal Reserve notes).
This expands the reserve base and the ability of depository institutions to make loans and expand
money and credit. The reverse is true if the Fed decides to sell securities from its portfolio. The
Fed can also change reserve requirements, meaning that a given amount of reserves will now
support more or less deposits and, in the process, this will affect the lending capability of
financial institutions. (This tool is rarely used today.) Finally, the Fed permits certain depository
institutions to borrow from it directly on a temporary basis. That is, these institutions can
“discount” at the Fed some of their own assets to provide a temporary means for obtaining
reserves. Discounts are usually on an overnight basis. For this privilege they are charged an
interest rate called, appropriately, the discount rate. Direct lending, from the discount window and
other recently created lending facilities, was negligible until late 2007, but has been an important
source of reserves since then.3
Because the Fed defines monetary policy as the actions it undertakes to influence the availability
and cost of money and credit, this suggests two ways to measure the stance of monetary policy.
One is to look at the cost of money and credit as measured by the rate of interest relative to
inflation (or inflation projections), while the other is to look at the growth of money and credit
itself. Thus, one can look at either interest rates or the growth in the supply of money and credit
in coming to a conclusion about the current stance of monetary policy, that is, whether it is
expansionary, contractionary, or neutral.

3 For a more complete discussion of the role of the discount rate in Federal Reserve policy, see Appendix A.
Congressional Research Service
2

Monetary Policy and the Federal Reserve: Current Policy and Conditions

Since the great inflation of the 1970s, most central banks have preferred to formulate monetary
policy more in terms of the cost of money and credit rather than on their supply.4 The Federal
Reserve thus conducts monetary policy by focusing on the cost of money and credit as proxied by
an interest rate. In particular, it targets a very short term interest rate known as the federal funds
rate. This rate is determined in the overnight market for reserves of depository institutions. At the
end of a given period, usually a day, depository institutions must calculate how many dollars of
reserves they want to hold against their reservable liabilities (deposits).5 Some institutions may
discover a reserve shortage (too few reservable assets relative to those it wants to hold) while
others may have had reservable assets in excess of their wants. A market exists in which these
reserves can be bought and sold on an overnight basis. The interest rate in this market is called
the federal funds rate. It is this rate that the Fed uses as a target for conducting monetary policy. If
it wishes to expand money and credit, it will lower the target which encourages more lending
activity and, thus, demand in the economy. To support this lower target, the Fed must stand ready
to buy more U.S. Treasury securities. Conversely, if it wishes to tighten money and credit, it will
raise the target and remove as many reserves from depository institutions as are necessary to
accomplish its ends. This will require the sale of treasuries from its portfolio of assets.6
The federal funds rate is linked to the interest rates that banks and other financial institutions
charge for loans – or the provision of credit. Thus, while the Fed may directly influence only a
very short term interest rate, this rate influences other longer term rates. However, this
relationship is far from being on a one-to-one basis since the longer term market rates are
influenced not only by what the Fed is doing today, but what it is expected to do in the future and
what inflation is expected to be in the future. This highlights the importance of expectations in
explaining market interest rates. For that reason, there is a growing body of literature that urges
the Federal Reserve to be very transparent in explaining what its policy is and will be and making
a commitment to adhere to that policy. In fact, the Fed has responded to this literature and is
increasingly transparent in explaining its policies and what they are expected to accomplish.
Using market interest rates as an indicator of monetary policy is fraught with danger, however.
The interest rate that is essential to decisions made by households and businesses to buy capital
goods is what economists call the “real” interest rate. It is often proxied by subtracting from the
market interest rate the actual or expected rate of inflation. The real rate is largely independent of
the amount of money and credit since over the longer run, it is determined by the interaction of
saving and investment (or the demand for capital goods). The internationalization of capital
markets means that for most developed countries the relevant saving and investment that
determines the real interest rate is on a global basis. Thus, real rates in the United States depend
not only on our national saving and investment, but on the saving and investment of other
countries as well. For that reason national interest rates will be influenced by international credit
conditions and business cycles.

4 For a discussion of why the Federal Reserve does not conduct monetary policy by targeting the monetary aggregates,
see Appendix B.
5 Depository institutions are obligated by law to hold some fraction of their deposit liabilities as reserves. In addition,
they are also likely to hold additional or excess reserves based on certain risk assessments they make about their
portfolios and liabilities. Until very recently these reserves were non-income earning assets. The Fed now pays interest
on both types of reserves. It is too early to assess how this shift in policy will affect bank reserve holdings.
6 For a technical discussion of how this is actually done, see Edwards, Cheryl L., “Open Market Operations in the
1990s,” Federal Reserve Bulletin, November 1997, pp. 859-872.
Congressional Research Service
3

Monetary Policy and the Federal Reserve: Current Policy and Conditions

The Importance of Monetary Policy
It has been said the “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 monetary policy to affect aggregate demand is great
compared with fiscal policy. In the other context, changes in monetary policy have the potential
to bring about major changes in the growth of GDP and employment only in the short run. Most
economists do not believe that this holds true over the longer run. Over the more extended
horizon, monetary policy has its primary effect on the rate of inflation. A brief discussion 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 causes domestic interest rates (both real and
market) 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 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 deficit.7
Monetary policy stimulus (as shown by a reduction in the target rate for federal funds) initially
serves to lower U.S. interest rates (both real and market) relative to those in other financial
centers. Foreign financial assets become more attractive to U.S. investors, the supply of dollars on
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.

7 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.
Congressional Research Service
4

Monetary Policy and the Federal Reserve: Current Policy and Conditions

The implication from the standard open economy macroeconomic model is that monetary policy
is more powerful than fiscal policy in influencing GDP growth and employment given current
international financial arrangements.8
Short Run vs. Longer Run
The analysis above suggests that a more expansive monetary policy can cause domestic demand
to expand. An examination of U.S. economic history will show that money and credit induced
demand expansions can have a positive effect on U.S. GDP growth and total employment. This
same history, however, also suggests that over the longer run, a more rapid rate of growth of
money and credit 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 a more rapid growth of money and credit. 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 the growth of money and credit 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, monetary policy can matter in the short run
but be fairly neutral for GDP growth and employment in the longer run.9
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, the
ability of more rapid rates of growth of money and credit to alter GDP growth and employment is
virtually nonexistent, if not negative.
The Recent and Current Stance of Monetary Policy
Following the 2001 recession, unemployment continued rising until mid-2003. Fearful that the
economy would slip back into recession, the Fed kept the federal funds rate extremely low.10 The
federal funds target reached a low of 1% by mid-2003. As the expansion gathered momentum and
prices began to rise, the federal funds target was slowly increased in a series of moves to 5¼% in
mid-2006. Short-term interest rates followed and by the end of 2006, the yield curve (the

8It might be thought that this highly stylized account of monetary and fiscal policy is irrelevant to a world whose
financial institutions and practices are undergoing rapid change. For a contrary view, see Sellon, Gordon H., Jr., “The
Changing U.S. Financial System: Some Implications for the Monetary Transmission Mechanism,” Economic Review,
Federal Reserve Bank of Kansas City, First Quarter 2002, pp. 5-36.
9Two interesting papers bearing on what monetary policy can accomplish by two former officials of the Federal
Reserve are Santomero, Anthony M. “What Monetary Policy Can and Cannot Do”, Business Review, Federal Reserve
Bank of Philadelphia, First Quarter 2002, pp. 1-4, and Mishkin, Frederic S. “What Should Central Banks Do?, Review,
Federal Reserve Bank of St. Louis, November/December 2000, pp. 1-14.
10 Historical and current targets for the federal funds rate can be found at http://www.federalreserve.gov/fomc/
fundsrate.htm.
Congressional Research Service
5

Monetary Policy and the Federal Reserve: Current Policy and Conditions

relationship between short- and long-term interest rates) became inverted, with shorter term rates
higher than longer term rates. 11
It is now argued by many economists that the financial crisis was, at least in part, due to Federal
Reserve policy to ensure that the then-ongoing expansion continued. In particular, critics now
claim that the low short-term rates prevailing from 2001 through 2004 caused an increased
demand for housing leading to a “price bubble.” The shift in financing housing from fixed to
variable rate mortgages made this sector of the economy increasingly vulnerable to movements in
short-term interest rates. One consequence of the tightening of monetary policy, critics now
claim, was to burst this “price bubble” (a bubble that was also due, in part, to lax lending
standards that were subject to regulation by the Fed and others). The net result was the onset of a
financial crisis affecting not only depository institutions, but other segments of the financial
sector involved with housing finance as the delinquency rates on home mortgages rose to record
numbers and the subsequent losses of financial institutions made national headlines. The
contagious nature of this development was soon obvious as other types of loans and credit
became adversely affected. This, in turn, spilled over into the broader economy as the lack of
credit soon had a negative effect on both production and aggregate demand. In December 2007,
the economy entered a recession.
As the magnitude of the financial crisis, as well as its international scope, became apparent, the
Fed responded to the expected economic slump by reducing the federal funds target and the
discount rate. Beginning on September 18, 2007, and ending on December 16, 2008, the target
was reduced from 5¼% to a range between 0% and ¼%.
What began to concern the monetary authorities is that liquidity provided to the banking system
was not reaching other parts of the financial system. It would appear that the traditional
transmission mechanism for monetary policy is not working. To circumvent this problem, the Fed
began to employ a little used emergency provision, Section 13(3) of the Federal Reserve Act,12
that allows it to make loans to other financial institutions and to non-financial firms as well.
The magnitude of direct lending has been large. Total borrowing from the Federal Reserve during
November 2007 was $366 million. In mid-November 2008, it reached a high of $725 billion.
Direct lending did not fall below $100 billion until March 2009. The worsening of the crisis in
September 2008 was accompanied by an unprecedented increase in the reserves of depository
institutions. They increased from about $44.6 billion in August 2008 to $167 billion at the end of
2008 to $1,139 billion at the end of 2009. This is clearly not a “business as usual” monetary
policy, but something quite extraordinary, sometimes referred to as “quantitative easing.”

11 Yield curve inversions pose potentially difficult problems for depository institutions since they squeeze their
profitability and possibly undermine their capital structure. The reason for this is that depository institutions generally
lend long and borrow short. Thus, their borrowing (their ability to attract and retain deposits which are the source of
their funds) costs are very sensitive to movements in short term interest rates. Since they lend long, only a fraction of
their assets, their new loans, are affected by movements in longer term rates. Thus, when short term rates rise relative to
long term rates, depository institutions find their costs rising sharply as they struggle to retain and attract deposits,
while the gross earnings from their assets rise only slowly – the classic case of a profit squeeze. In fact, if losses ensue,
they undermine the capital base of these institutions setting in motion the possibility of failure. In any case, an inverted
yield curve generally has negative effects on credit creation and is often a leading indicator of an impending economic
downturn (see CRS Report RS22371, The Pattern of Interest Rates: Does It Signal an Impending Recession?, by Marc
Labonte and Gail E. Makinen.
12 12 U.S.C. 343.
Congressional Research Service
6

Monetary Policy and the Federal Reserve: Current Policy and Conditions

Quantitative easing can be defined as increasing the reserves of the banking system beyond the
amount needed to meet the Fed’s interest rate target.
With direct lending falling as financial conditions normalize, the Fed found other tools to
maintain the current level of liquidity in the financial system. On March 17, 2009, the FOMC
announced plans for a massive purchase of agency and Treasury securities in excess of $1.0
trillion to further ease credit market conditions and stimulate spending. (Agency securities are
here defined as securities of Fannie Mae, Freddie Mac, and Ginnie Mae.) These purchases were
completed by the end of March 2010. Once the economy returns to normal, the task facing the
Fed will be to remove this huge amount of credit from the financial system quickly enough to
prevent inflation from taking hold.
It should not go unnoticed that a potential complication for the conduct of monetary policy
emerges when the federal funds rate is at or near zero, its floor, as it is now. A zero federal funds
rate does not constrain the Federal Reserve from supplying additional reserves and liquidity to the
financial system, as the Fed is now doing through purchases of Treasury and agency securities.
Whether the additional reserves will be lent out, resulting in lower market interest rates and an
expansion of new spending, as posited in the text book explanation of how monetary policy
works, is another story. Recent experience is not reassuring, as excess bank reserves held at the
Fed have remained unusually high.13
Congressional Oversight and The Near-Term
Goals of Monetary Policy

Congress has delegated monetary policy decisions to the Fed but retains oversight
responsibilities. The primary form of congressional oversight of the Federal Reserve is 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 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
Humphrey-Hawkins 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 publicly
provide additional forecasts. They now appear quarterly.

13 For a recent discussion of this issue by the president of the Federal Reserve Bank of St. Louis, see Bullard, Thomas.
Effective Monetary Policy in a Low Interest Rate Environment, The Henry Thornton Lecture, Cass Business School,
London (March 24, 2009).
Congressional Research Service
7

Monetary Policy and the Federal Reserve: Current Policy and Conditions

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.14 The Federal Reserve
system is quasi-public 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
countries with independent central banks are more likely to have low inflation rates and better
economic performance.15
As a practical matter, the Fed’s mandate can be seen as a further source of political independence
by giving it broad policy discretion. 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 instrument 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.16 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 is focused on keeping inflation low would deliver better economic results and improve
transparency and oversight.17 Opponents, including former Chairman Greenspan, say that the

14For more information, see CRS Report RL31056, Economics of Federal Reserve Independence, by Marc Labonte.
15For 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 E. Makinen.
16See CRS Report 98-16, Should the Federal Reserve Adopt an Inflation Target?, by Marc Labonte.
17 In a recent speech, Fed Vice Chairman Donald Kohn reports that the Fed Governors and Reserve Bank presidents
continue “to discuss whether an explicit numerical objective for inflation would be beneficial. Under current
circumstances, those benefits would include underscoring our understanding that our legislative mandate for promoting
price stability encompasses both preventing inflation from falling too low in the near term and from rising too far as the
economy recovers.” See Monetary Policy in the Financial Crisis, a Conference in Honor of Dewey Daane, Nashville,
Tennessee, April 18, 2009.
Congressional Research Service
8

Monetary Policy and the Federal Reserve: Current Policy and Conditions

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
an overly volatile business cycle. Various forms of inflation targeting have been adopted abroad.18
Another policy proposal that has gained prominence during the financial crisis is a removal of the
statutory restrictions on Government Accountability Office (GAO) audits of the Fed. Currently,
GAO cannot audit Fed actions related to monetary policy, including emergency lending
activities.19 Various proposals have been put forth to remove all audit restrictions or audit
restrictions related to emergency lending. Another goal of some has been to require the Fed to
disclose the identities of borrowers, which are currently kept confidential. Proponents of these
proposals cite the need for more information to aid Congress in its oversight duties, while
opponents predict that audits would have a negative effect on Fed independence and disclosing
borrowers could cause runs on those institutions.20

18See CRS Report RL31702, Price Stability (Inflation Targeting) as the Sole Goal of Monetary Policy: The
International Experience
, by Marc Labonte and Gail E. Makinen.
19 Currently, GAO can (and does) audit the Fed’s regulatory and payment system duties. S. 896, which was signed into
law on May 20, 2009 (P.L. 111-22), allows GAO audits of “any action taken by the Board under ... Section 13(3) of the
Federal Reserve Act with respect to a single and specific partnership or corporation.” This would allow GAO audits of
the Maiden Lane facilities and the asset guarantees of Citigroup and Bank of America, but would maintain audit
restrictions on non-emergency activities and broadly accessed emergency lending facilities.
20 The current legislative status of these proposals can be found in CRS Report R40877, Financial Regulatory Reform:
Systemic Risk and the Federal Reserve
, by Marc Labonte.
Congressional Research Service
9

Monetary Policy and the Federal Reserve: Current Policy and Conditions

Appendix A. Federal Reserve and the Discount Rate
The Federal Reserve has preferred to conduct monetary policy primarily through its target for the
federal funds rate. This method has allowed the Federal Reserve to adopt an activist stance 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 Fed at this rate
through the Fed’s discount window. The Board can either grant or deny the loan. The initiation of
the loan, however, is at the discretion of the borrowing financial institution. In this sense, the Fed
is passive in the process. Although the discount rate has long been a tool of central banking, the
discount window has not been used much in the United States over the past several decades until
market turmoil in 2008 gave it a more prominent role. 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 Fed.21 In conducting monetary policy, the
Board has moved the discount rate in sympathy with the federal funds target.
Until 2003, the discount rate was set slightly below the federal funds target, and the Fed used
moral suasion to discourage healthy banks from profiting from this low rate. To reduce the need
for moral suasion, 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, following the
financial crisis, the Fed has not discouraged banks in their use of the discount window.

21A certain stigma was once attached to using the discount window to obtain reserves. Since banks “borrow” from their
depositors to acquire assets, it was thought to be a sign of unsound banking to also borrow from the Federal Reserve.
Congressional Research Service
10

Monetary Policy and the Federal Reserve: Current Policy and Conditions

Appendix B. Federal Reserve and the Monetary
Aggregates

Because the amount of money in circulation is an important determinant of money spending, it
might appear to some as curious that the Fed does not target the money supply in the conduct of
monetary policy. Such a target has not been popular with the Fed. However, the Fed did define
several measures of money (designating them, ultimately, as M1, M2, and M3), published data on
them on a monthly basis, and set growth rate ranges for each on a annual basis.
Early on, the Fed encountered problems with its defined measures of money. These monetary
aggregates were not stably and predictably related to money spending (in the technical language
of the economist, the demand for these measures of money was unstable). Hence, their usefulness
as a target for monetary policy was questionable and deemed inferior to using an interest rate
target. This the Fed ultimately recognized, and the Fed de-emphasized the importance of the
aggregates in the 1990s.22 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 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.”23

Author Contact Information

Marc Labonte

Specialist in Macroeconomic Policy
mlabonte@crs.loc.gov, 7-0640


22For a discussion of their usefulness in the conduct of monetary policy, see CRS Report RL31416, Monetary
Aggregates: Their Use in the Conduct of Monetary Policy
, by Marc Labonte; Dotsey, Michael, Carl Lanta, and
Lawrence Santucci, “Is Money Useful in the Conduct of Monetary Policy? Quarterly Review, Federal Reserve Bank of
Richmond, Vol. 86, No. 4 (Fall 2000), pp. 23-48, and Meyer, Laurence H. “The 2001 Homer Jones Memorial Lecture,”
Washington University, St. Louis, Missouri, March 28, 2001. When this lecture was given, Laurence Meyer was a
governor of the Federal Reserve.
23Monetary Policy Report to the Congress, February 15, 2006, p. 22.
Congressional Research Service
11

Monetary Policy and the Federal Reserve: Current Policy and Conditions

Acknowledgments
This report was originally authored by Gail E. Makinen, formerly of the Congressional Research
Service.

Congressional Research Service
12