Monetary Policy and the Federal Reserve:
Current Policy and Conditions
Marc Labonte
Specialist in Macroeconomic Policy
July 1, 2014
Congressional Research Service
7-5700
www.crs.gov
RL30354
Monetary Policy and the Federal Reserve: Current Policy and Conditions
Summary
The Federal Reserve (the Fed) defines monetary policy as its actions to influence the availability
and cost of money and credit. Because the expectations of market participants play an important
role in determining prices and economic growth, monetary policy can also be defined to include
the directives, policies, statements, and actions of the Fed that influence future perceptions.
Traditionally, the Fed has implemented monetary policy primarily through open market
operations involving the purchase and sale of U.S. Treasury securities. The Fed traditionally
conducts open market operations by setting an interest rate target with the goal of fulfilling its
statutory mandate of “maximum employment, stable prices, and moderate long-term interest
rates.” The interest rate targeted is the federal funds rate, the price at which banks buy and sell
reserves on an overnight basis. Beginning in September 2007, in a series of 10 moves, the federal
funds target was reduced from 5.25% to a range of 0% to 0.25% on December 16, 2008, where it
has remained since.
With the federal funds target at the “zero lower bound,” the Fed has attempted to provide stimulus
through unconventional policies. The Fed has provided “forward guidance” on its expectations
for future rates, announcing that it “anticipates that, even after employment and inflation are near
mandate-consistent levels, economic conditions may, for some time, warrant keeping the target
federal funds rate below levels the Committee views as normal in the longer run.” The Fed has
also added monetary stimulus through unsterilized purchases of Treasury and government-
sponsored enterprise (GSE) securities. This practice is popularly referred to as quantitative easing
(“QE”), and it has caused the Fed’s balance sheet to increase to $4.4 trillion at the end of June
2014—five times its pre-crisis size. On September 13, 2012, the Fed began a third round of QE,
pledging to purchase GSE mortgage-backed securities and Treasury securities each month until
the labor market improves, as long as prices remain stable. In December 2013, the Fed began
tapering off (gradually reducing the rate of) its monthly asset purchases. If tapering maintains its
current trajectory, asset purchases will end in late 2014.
The purpose of targeting the federal funds rate, forward guidance, and QE is to influence private
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. Even if short-term interest rates reach zero, there is still scope for the Fed to influence
long-term rates, although economists dispute how great that influence has been. 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. Debate is
currently focused on the proper timing for ending unconventional policy measures and moving
away from the zero bound. Ending unconventional policy too soon could slow the return to full
employment, while ending it too late could result in undesirably high inflation.
Congress has delegated responsibility for monetary policy to the Fed, but retains oversight
responsibilities for ensuring that the Fed is adhering to its statutory mandate. H.R. 1174/S. 238,
H.R. 492, and S. 215 would switch to a single mandate of price stability. Congressional debate on
Fed oversight has focused on audits by the Government Accountability Office (GAO). The Dodd-
Frank Act enhanced the GAO’s ability to audit the Fed and required audits of its emergency
programs and governance. H.R. 24, H.R. 33, and S. 209 would remove all remaining statutory
restrictions on GAO audits.
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Monetary Policy and the Federal Reserve: Current Policy and Conditions
Contents
Introduction ...................................................................................................................................... 1
How Does the Federal Reserve Execute Monetary Policy? ............................................................ 3
Economic Effects of Monetary Policy in the Short Run and Long Run .................................... 6
Monetary vs. Fiscal Policy ........................................................................................................ 7
The Recent and Current Stance of Monetary Policy........................................................................ 9
Before the Financial Crisis ........................................................................................................ 9
The Early Stages of the Crisis and the “Zero Lower Bound” .................................................. 10
Direct Assistance During and After the Financial Crisis ......................................................... 10
Central Bank Liquidity Swaps .......................................................................................... 11
Unconventional Policy Measures at the Zero Bound After the Crisis ..................................... 12
Quantitative Easing and the Growth in the Balance Sheet and Bank Reserves ................ 13
Forward Guidance ............................................................................................................. 16
GAO Audits, Congressional Oversight, and Disclosure ................................................................ 17
The Federal Reserve’s Dual Mandate and Proposals for a Single Mandate of Price
Stability ....................................................................................................................................... 18
Regulatory Responsibilities ........................................................................................................... 19
Contacts
Author Contact Information........................................................................................................... 21
Acknowledgments ......................................................................................................................... 21
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Monetary Policy and the Federal Reserve: Current Policy and Conditions
Introduction
Congress has delegated responsibility for monetary policy to the Federal Reserve (the Fed), but
retains oversight responsibilities to ensure that the Fed is adhering to its statutory mandate of
“maximum employment, stable prices, and moderate long-term interest rates.”1 The Fed has
defined stable prices as a longer-run goal of 2% inflation. The Fed’s responsibilities as the
nation’s central bank fall into four main categories: monetary policy, provision of emergency
liquidity through the lender of last resort function, supervision of certain types of banks and other
financial firms for safety and soundness, and provision of payment system services to financial
firms and the government.2
The Fed’s monetary policy function is one of aggregate demand management—stabilizing
business cycle fluctuations. The Federal Open Market Committee (FOMC), consisting of 12 Fed
officials, meets periodically to consider whether to maintain or change the current stance of
monetary policy.3 The Fed’s conventional tool for monetary policy is to target the federal funds
rate, the overnight, inter-bank lending rate. It influences the federal funds rate through “open
market operations,” the purchase and sale of securities.
In December 2008, the Fed lowered the federal funds rate to a range of 0% to 0.25%, which is
referred to as the “zero lower bound” because the Fed cannot provide any further stimulus
through conventional policy. Since then, it has turned to unconventional policy to provide further
stimulus to the economy.4 The Fed has provided “forward guidance” on its expectations for future
rates, announcing that it “anticipates that, even after employment and inflation are near mandate-
consistent levels, economic conditions may, for some time, warrant keeping the target federal
funds rate below levels the Committee views as normal in the longer run.”5 This is a departure
from past practice—normally, the Fed begins to raise rates well before the economy returns to full
employment.
In addition, the Fed has attempted to stimulate the economy through several rounds of large-scale
asset purchases of Treasury securities and securities issued by government-sponsored enterprises
(GSEs) since 2009, popularly referred to as quantitative easing (“QE”). As a result of QE, the size
of the Fed’s balance sheet has increased to $4.4 trillion at the end of June 2014—five times its
pre-crisis size. Since September 2012, the Fed has pursued a program of large-scale monthly asset
purchases of Treasury securities and mortgage-backed securities (MBS) issued by the GSEs
(referred to as “QE3”).6 Unlike the previous two rounds of asset purchases, the Fed specified no
planned end date to its purchases, instead pledging to continue purchases until labor markets
improved, in a context of price stability. In December 2013, the Fed began tapering off (gradually
reducing the rate of) its monthly asset purchases. If tapering maintains its current trajectory, asset
purchases will end in late 2014. Barring a future change in course, this is seen as the first step
1 Section 2A of the Federal Reserve Act, 12 U.S.C. 225a.
2 For background on the makeup of the Federal Reserve, see CRS Report RS20826, Structure and Functions of the
Federal Reserve System, by Marc Labonte.
3 Its policy decisions can be accessed at http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm.
4 See CRS Report R42962, Federal Reserve: Unconventional Monetary Policy Options, by Marc Labonte.
5 Federal Reserve, press release, June 18, 2014, http://federalreserve.gov/newsevents/press/monetary/20140618a.htm.
6 Federal Reserve, press release, September 13, 2012, http://www.federalreserve.gov/newsevents/press/monetary/
20120913a.htm.
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toward an eventual end to unconventional monetary policy and a higher federal funds rate. The
Fed has announced that “it likely will be appropriate to maintain the current target range for the
federal funds rate for a considerable time after the asset purchase program ends.... ”7
Before 2008, short-term interest rates had never reached the “zero lower bound.” Rates have
remained there for several years since, and most members of the FOMC currently believe that it
would not be appropriate to raise the federal funds target until 2015.8 By contrast, in the previous
two economic expansions, the Fed began raising rates less than three years after the preceding
recession ended. Debate is currently focused on the proper timing for ending unconventional
policy measures and moving away from the zero bound. Because the recent recession was
unusually severe, there is disagreement among economists both how much slack remains in the
economy today and how aggressive the Fed should be. Economists who currently argue that the
Fed should not discontinue unconventional policy prematurely believe there is a large output gap
(i.e., the difference between actual output and potential output) and point to the fact that inflation
was slightly below the Fed’s 2% goal throughout 2013 and the first quarter of 2014. In other
words, they justify the continued use of unconventional policy to stimulate the economy in terms
of both the Fed’s full employment mandate and price stability mandate. Economists who
currently argue that unconventional policy has been in place too long point out that the economic
recession ended in June 2009 and the economy has been growing steadily since (although GDP
declined in the first quarter of 2014). Further, the unemployment rate is no longer abnormally
high and has been on a downward trajectory since 2011. Finally, although inflation has remained
low thus far, unconventional policy has led to above-average growth in the money supply that
arguably poses a threat to price stability. In critics’ eyes, the economy is now functioning close
enough to normal that the risks of continued unconventional policy stimulus outweigh the
benefits.
Besides monetary policy, the Fed is also the “lender of last resort,” meaning that it ensures
continued smooth functioning of financial intermediation by providing banks and financial
markets with adequate liquidity. In response to the financial crisis, this role became prominent
again, as the Fed provided liquidity to banks through the discount window and other parts of the
financial system through emergency facilities. As financial conditions normalized, loans were
repaid with interest and emergency lending programs have been wound down, with the exception
of foreign central bank liquidity swaps.9
The Fed’s unprecedented response to the financial crisis has garnered renewed attention on the
Fed from Congress. On the one hand, the Fed was given new regulatory responsibilities in the
Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203) in an attempt to
prevent future crises. On the other hand, the Dodd-Frank Act shifted the Fed’s consumer
protection responsibilities to the newly created Consumer Financial Protection Bureau, placed
restrictions on the Fed’s emergency powers, allowed the Government Accountability Office
(GAO) to audit the Fed’s monetary and lending activities, and required the Fed to release detailed
lending records for the first time. Fed oversight and disclosure has remained a congressional
7 Federal Reserve, press release, June 18, 2014, http://federalreserve.gov/newsevents/press/monetary/20140618a.htm.
8 Economic Projections of Federal Reserve Board Members and Presidents, press release, June 2014,
http://federalreserve.gov/monetarypolicy/files/fomcprojtabl20140618.pdf.
9 Details of the lending facilities created by the Federal Reserve and other government agencies during the financial
crisis are discussed in CRS Report R41073, Government Interventions in Response to Financial Turmoil, by Baird
Webel and Marc Labonte.
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focus since then. In the 112th Congress, H.R. 459, which the House passed as amended on July
25, 2012, would have removed remaining restrictions on GAO’s audit authority, which prevent
GAO from analyzing monetary policy on policy grounds. Similar bills in the 113th Congress
include H.R. 24, H.R. 33, and S. 209. H.R. 1174/S. 238, H.R. 492, and S. 215 would switch to a
single mandate of price stability, removing the mandate of maximum employment. H.R. 1174/S.
238 would also limit the purchase of permissible securities other than Treasury securities to
“unusual and exigent circumstances,” which could last up to five years, increase the voting power
of the Fed’s regional bank presidents on the FOMC, and accelerate the lagged release of FOMC
meeting transcripts. H.R. 3928 would, among other things, change disclosure requirements, place
restrictions on employees, eliminate Fed regional bank directors chosen by the Board, and require
cost-benefit analysis of Fed rulemaking.
This report provides an overview of monetary policy and recent developments. It discusses issues
for Congress, including transparency and proposals to change the Fed’s mandate. It ends with a
brief overview of the Fed’s regulatory responsibilities.10
How Does the Federal Reserve Execute
Monetary Policy?
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 employment. Because the expectations of households as consumers and
businesses as 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, who is the nation’s central banker.
The Federal Reserve has traditionally relied on three instruments to conduct monetary policy.
Each works by altering the reserves available to depository institutions. These institutions are
required to maintain reserves against their deposit liabilities, primarily checking, saving, and time
certificates of deposit (CDs). These reserves can be held in the form of vault cash (currency) or as
a deposit at the Fed. The size of these reserves constrains 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.
The Federal Reserve has three ways to expand or contract money and credit. The primary method
is called open market operations and it involves the Fed buying 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.
10 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.
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The Fed can also change reserve requirements, controlling a portion of deposits that banks must
hold as vault cash or on deposit at the Fed, which affects the available liquidity within the market.
Currently, banks are required to hold 0% to 10% of their deposits in reserves, depending on the
size of the bank. This tool is used rarely—the percentage was last changed in 1998.11 To increase
control over the growth in the money supply at a time of rapid reserve growth, the Federal
Reserve began to pay interest on required and excess reserves in October 2008, reducing the
opportunity cost of holding that money as opposed to lending it out.
Finally, the Fed permits depository institutions to borrow from it directly on a temporary basis at
the discount window. 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. The
discount rate is set by the Fed at a small markup over the federal funds rate.12 Direct lending,
from the discount window and other recently created lending facilities, is negligible under normal
financial conditions, but was an important source of reserves during the financial crisis.
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.
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. 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. The FOMC meets every six weeks to choose a federal funds target and sometimes meets on
an ad hoc basis if it wishes to change the target between regularly scheduled meetings. The
FOMC is composed of the 7 Fed governors, the President of the New York Fed, and 4 of the other
11 regional Fed bank presidents selected on a rotating basis.
The federal funds rate is determined in the private market for overnight 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).13 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 private market
exists in which these reserves can be bought and sold on an overnight basis. The interest rate in
11 The deposit threshold is regularly adjusted for inflation. For current reserve requirements, see
http://www.federalreserve.gov/monetarypolicy/reservereq.htm.
12 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 at a penalty rate above the federal funds rate target.
However, during the financial crisis, the Fed encouraged banks to use the discount window.
13 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.
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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.14
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.15 In fact, the Fed has responded to this literature and is
increasingly transparent in explaining its policy measures and what these are expected to
accomplish.
Using market interest rates as an indicator of monetary policy is potentially misleading, 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 are influenced by international credit
conditions and business cycles.
The recent financial crisis underlines that open market operations alone can be insufficient at
times for meeting the Fed’s statutory mandate. Since the crisis, many economists and central
bankers have argued that a macroprudential approach to supervision and regulation is needed
(discussed in the section below entitled “Regulatory Responsibilities”), and this may affect
conduct of monetary policy to maintain maximum employment and price stability.16 Whereas
traditional open market operations managed to contain systemic risk following the bursting of the
“dot-com” bubble in 2000, direct lending by the Fed on a large scale was unable to contain
14 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; Benjamin Friedman and Kenneth Kuttner,
“Implementation of Monetary Policy: How Do Central Banks Set Interest Rates?”, National Bureau of Economic
Research, working paper, no. 16165, March 2011.
15 See, for example, 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.
16 Bank for International Settlements, “Monetary Policy in a World with Macro Prudential Policy,” speech by Jaime
Caruana on June 11, 2011, http://www.bis.org/speeches/sp110610.htm.
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systemic risk in 2008. This had led to a debate about whether the Fed should be aggressive in
using monetary policy against asset bubbles, even at the expense of meeting its mandate in the
short term. Traditionally, the Fed has expressed doubt that it could correctly identify or safely
neutralize bubbles using monetary policy.
Economic Effects of Monetary Policy in the Short Run and
Long Run
How do changes in short-term interest rates affect the overall economy? In the short run, an
expansionary monetary policy that reduces interest rates increases interest-sensitive spending, all
else equal. Interest-sensitive spending includes physical investment (i.e., plant and equipment) by
firms, residential investment (housing construction), and consumer-durable spending (e.g.,
automobiles and appliances) by households. As discussed in the next section, it also encourages
exchange rate depreciation that causes exports to rise and imports to fall, all else equal. To reduce
spending in the economy, the Fed raises interest rates, and the process works in reverse. 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. The extent to
which greater interest-sensitive spending results in an increase in overall spending in the
economy in the short run will depend in part on how close the economy is to full employment.
When the economy is near full employment, the increase in spending is likely to be dissipated
through higher inflation more quickly. When the economy is far below full employment,
inflationary pressures are more likely to be muted. 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. (Since
the crisis, the historical relationship between money growth and inflation has not held so far, as
will be discussed below.)
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 albeit with a policy lag of six to eight quarters before the
broader economy fully responds to monetary policy measures. 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.17
It is noteworthy that in societies where high rates of inflation are endemic, price adjustments are
very rapid. During the final stages of very rapid inflations, called hyperinflation, the ability of
17 Two 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.
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more rapid rates of growth of money and credit to alter GDP growth and employment is virtually
nonexistent, if not negative.
Monetary vs. Fiscal Policy
Either fiscal policy (defined here as changes in the structural budget deficit) or monetary policy
can be used to alter overall spending in the economy. However, there are several important
differences to consider between the two.
First, economic conditions change rapidly, and in practice monetary policy can be much more
nimble than fiscal policy. The Fed meets every six weeks to consider changes in interest rates,
and can call an unscheduled meeting any time in between. Large changes to fiscal policy typically
occur once a year at most. Once a decision to alter fiscal policy has been made, the proposal must
travel through a long and arduous legislative process that can last months before it can become
law, while monetary policy changes are made instantly.18
In addition to differences in implementation lags, both monetary and fiscal policy face lags due to
“pipeline effects.” In the case of monetary policy, interest rates throughout the economy may
change rapidly, but it takes longer for economic actors to change their spending patterns in
response. For example, in response to a lower interest rate, a business must put together a loan
proposal, apply for a loan, receive approval for the loan, and then put the funds to use. In the case
of fiscal policy, once legislation has been enacted, it may take some time for authorized spending
to be outlayed. An agency must approve projects and select and negotiate with contractors before
funds can be released. In the case of transfers or tax cuts, recipients must receive the funds and
then alter their private spending patterns before the economy-wide effects are felt. For both
monetary and fiscal policy, further rounds of private and public decision-making must occur
before “multiplier” or “ripple” effects are fully felt.
Second, political constraints have led to fiscal policy being employed mostly in only one
direction. Over the course of the business cycle, aggregate spending in the economy can be
expected to be too high as often as it is too low. This means that stabilization policy should be
tightened as often as it is loosened, yet increasing the budget deficit has proven to be much more
popular than implementing the spending cuts or tax increases necessary to reduce it. As a result,
the budget has been in deficit in all but five years since 1961. This has led to an accumulation of
federal debt that gives policy makers less leeway to potentially undertake a robust expansionary
fiscal policy, if needed, in the future. By contrast, the Fed is more insulated from political
pressures,19 and experience shows that it is as willing to raise interest rates as it is to lower them.
Third, the long-run consequences of fiscal and monetary policy differ. Expansionary fiscal policy
creates federal debt that must be serviced by future generations. Some of this debt will be “owed
to ourselves,” but some (presently, about half) will be owed to foreigners. To the extent that
expansionary fiscal policy “crowds out” private investment, it leaves future national income
lower than it otherwise would have been.20 Monetary policy does not have this effect on
18 To some extent, fiscal policy automatically mitigates changes in the business cycle without any policy changes
because tax revenue falls relative to GDP and certain mandatory spending (such as unemployment insurance) rises
when economic growth slows, and vice versa.
19 For more information, see CRS Report RL31056, Economics of Federal Reserve Independence, by Marc Labonte.
20 An exception to the rule would be a situation where the economy is far enough below full employment that virtually
(continued...)
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generational equity, though different levels of interest rates will affect borrowers and lenders
differently. Furthermore, the government faces a budget constraint that limits the scope of
expansionary fiscal policy—it can only issue debt as long as investors believe that the debt will
be honored—even if economic conditions require larger deficits to restore equilibrium.21
Fourth, openness of an economy to highly mobile capital flows changes the relative effectiveness
of fiscal and monetary policy. Expansionary fiscal policy would be expected to lead to higher
interest rates, all else equal, which would attract foreign capital looking for a higher rate of
return.22 Foreign capital can only enter the United States on net through a trade deficit. Thus,
higher foreign capital inflows lead to higher imports, which reduce spending on domestically
produced substitutes, and lower spending on exports. The increase in the trade deficit would
cancel out the expansionary effects of the increase in the budget deficit to some extent (in theory,
entirely). Expansionary monetary policy would have the opposite effect—lower interest rates
would cause capital to flow abroad in search of higher rates of return elsewhere. Foreign capital
outflows would reduce the trade deficit through an increase in spending on exports and
domestically produced import substitutes. Thus, foreign capital flows would (tend to) magnify the
expansionary effects of monetary policy.
Fifth, fiscal policy can be targeted to specific recipients. In the case of normal open market
operations, monetary policy cannot. This difference could be considered an advantage or
disadvantage. On the one hand, policy makers could target stimulus to aid the sectors of the
economy most in need, or most likely to respond positively to stimulus. On the other hand,
stimulus could turn out to be allocated on the basis of political or other non-economic factors that
reduce the macroeconomic effectiveness of the stimulus. As a result, both fiscal and monetary
policy have distributional implications, but the latter’s are largely incidental, whereas the former’s
can be explicitly chosen.
In cases where economic activity is extremely depressed, monetary policy may lose some of its
effectiveness. When interest rates become extremely low, interest-sensitive spending may no
longer be very responsive to further rate cuts. Furthermore, interest rates cannot be lowered below
zero. In this scenario, fiscal policy may be more effective. As is discussed in the next section,
some would argue that the U.S. economy experienced this scenario following the recent financial
crisis.
Of course, using monetary and fiscal policy to stabilize the economy are not mutually exclusive
policy options. But because of the Fed’s independence from Congress and the Administration, the
two policy options are not always coordinated. If compatible fiscal and monetary policies are
chosen by Congress and the Fed, respectively, then the economic effects would be more powerful
than if either policy were implemented in isolation. For example, if stimulative monetary and
fiscal policies were implemented, the resulting economic stimulus would be larger than if one
policy were stimulative and the other were neutral. But if incompatible policies are selected, they
(...continued)
no crowding out takes place because the stimulus to spending generates enough resources to finance new capital
spending.
21 The analogous constraint on monetary policy is that after a certain limit, expansionary monetary policy would
become highly inflationary. But from the current starting point of price stability, problems with inflation would
presumably only occur after a point where the economy had returned to full employment.
22 For more information, see CRS Report RL31235, The Economics of the Federal Budget Deficit, by Brian W.
Cashell.
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could partially negate each other. For example, a stimulative fiscal policy and contractionary
monetary policy may end up having little net effect on aggregate demand (though there may be
considerable distributional effects). Thus, when fiscal and monetary policy makers disagree in the
current system, they can potentially choose policies with the intent of offsetting each other’s
actions.23 Whether this arrangement is better or worse for the economy depends on what policies
are chosen. If one actor chooses inappropriate policies, then the lack of coordination allows the
other actor to try to negate its effects.
The Recent and Current Stance of Monetary Policy
Until financial turmoil emerged in 2007, a consensus had emerged among economists that a
relatively stable business cycle could be maintained through prudent and nimble changes to
interest rates via transparently communicated and signaled open market operations. That
consensus would break down as the financial crisis worsened, and the Fed took increasingly
unconventional and unprecedented steps to restore financial stability.
Before the Financial Crisis
As the U.S. economy was coming out of the short and shallow 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.24 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.
It is now argued by some economists that the financial crisis was, at least in part, due to Federal
Reserve policy to ensure that the then-ongoing expansion continued.25 In particular, critics now
claim that the low short-term rates were kept too low for too long after the 2001 recession had
ended, and this caused an increased demand for housing that resulted in a “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 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. An
alternative perspective, championed by Ben Bernanke and others, was that the low mortgage rates
that helped fuel the housing bubble were mainly caused by a “global savings glut” over which the
Fed had little control.26 One consequence of the tightening of monetary policy later in the decade,
critics now claim, was to burst this “price bubble.”
23 It is important to take this possibility into consideration when evaluating the potential effects of fiscal policy on the
business cycle. Because the Fed presumably chooses (and continually updates) a monetary policy that aims to keep the
economy at full employment, the Fed would need to alter its policy to offset the effects of any stimulative fiscal policy
changes that moved the economy above full employment. Thus, the actual net stimulative effect of a fiscal policy
change (after taking into account monetary policy adjustments) could be less than the effects in isolation.
24 Historical and current targets for the federal funds rate can be found at http://www.federalreserve.gov/fomc/
fundsrate.htm.
25 In a Wall Street Journal opinion article, six economists are polled regarding if the Fed was to blame for creating the
housing bubble that in part led to the recent financial crisis, and five of six responded that the Fed in some degree was
to blame. See David Henderson, “Did the Fed Cause the Housing Bubble?,” Wall Street Journal, March 27, 2009.
26 See Ben Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit,” speech at the Virginia
Association of Economists, March 10, 2005.
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The Early Stages of the Crisis and the “Zero Lower Bound”
The bursting of the housing bubble led to the onset of a financial crisis that affected both
depository institutions and other segments of the financial sector involved with housing finance.
As the delinquency rates on home mortgages rose to record numbers, financial firms exposed to
the mortgage market suffered capital losses and lost access to liquidity. 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 spillover effects from the housing slump to the financial system, as well as its international
scope, became apparent, the Fed responded by reducing the federal funds target and the discount
rate.27 Beginning on September 18, 2007, and ending on December 16, 2008, the federal funds
target was reduced from 5¼% to a range between 0% and ¼%, where it currently remains.
Economists call this the “zero lower bound” to signify that once the federal funds rate is lowered
to zero, conventional open market operations cannot be used to provide further stimulus.
The decision to maintain a target interest rate near zero is unprecedented. First, short-term interest
rates have never been reduced to zero before in the history of the Federal Reserve.28 Second, the
Fed has waited much longer than usual to begin tightening monetary policy in this recovery. For
example, in the previous two expansions, the Fed began raising rates less than three years after
the preceding recession ended.
Direct Assistance During and After the Financial Crisis
With liquidity problems persisting as the federal funds rate was reduced, it appeared that the
traditional transmission mechanism linking monetary policy to activity in the broader economy
was not working. It also began to concern the monetary authorities that the liquidity provided to
the banking system was not reaching other parts of the financial system. Using only traditional
monetary policy tools, additional monetary stimulus cannot be provided once the federal funds
rate has reached its zero bound. To circumvent this problem, the Fed decided to use non-
traditional methods to provide additional monetary policy stimulus.
First, the Federal Reserve introduced a number of emergency credit facilities to provide increased
liquidity directly to financial firms and markets. The first facility was introduced in December
2007, and several were added after the worsening of the crisis in September 2008. These facilities
were designed to fill perceived gaps between open market operations and the discount window.
The loans primarily provided by these facilities were designed to provide short-term loans backed
by collateral that exceeded the value of the loan.29 A number of the recipients were non-banks that
27 For a detailed account of the Fed’s role in the financial crisis, see CRS Report RL34427, Financial Turmoil: Federal
Reserve Policy Responses, by Marc Labonte.
28 The Fed did not target the federal funds rate as its monetary policy instrument until the late 1980s or early 1990s.
(See Daniel Thornton, “When Did the FOMC Begin Targeting the Federal Funds Rate?,” Federal Reserve Bank of St.
Louis, working paper 2004-015B, May 2005, http://research.stlouisfed.org/wp/2004/2004-015.pdf.) Data on the federal
funds rate back to 1914 is not available. Since 1914, the Fed had not set its discount rate (the rate charged at the Fed’s
discount window) as low as 0.5% before 2008.
29 See CRS Report R41073, Government Interventions in Response to Financial Turmoil, by Baird Webel and Marc
(continued...)
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are outside the regulatory umbrella of the Federal Reserve; this marked the first time that the Fed
lent to non-banks since the Great Depression. The Fed began to employ a seldom used emergency
provision, Section 13(3) of the Federal Reserve Act,30 that allows it to make loans to other
financial institutions and to non-financial firms as well. The Fed justified emergency lending on
the grounds that it falls under its mandate to “promote effectively the goals of maximum
employment, stable prices, and moderate long-term interest rates.”31
The Fed provided assistance through liquidity facilities, which included both the traditional
discount window and the newly created emergency facilities previously mentioned, and through
direct support to two specific institutions, AIG and Bear Stearns.32 The magnitude of this
assistance has been large. Total assistance from the Federal Reserve at the beginning of August
2007 was approximately $234 million provided through liquidity facilities, with no direct support
given. In mid-December 2008, it reached a high of $1.6 trillion, with a near high of $108 billion
given in direct support. From that point on, it fell steadily. Assistance provided through liquidity
facilities fell below $100 billion in February 2010, when many facilities were allowed to expire,
and support to specific institutions fell below $100 billion in January 2011.33 Central bank
liquidity swaps, discussed in the next section, are the only facility created during the crisis that is
still active. With one exception, all assistance through expired facilities has been fully repaid with
interest, and eventual repayment in that case is expected.34
Central Bank Liquidity Swaps
The Fed’s central bank liquidity swap lines, or temporary reciprocal currency agreements, are the
only lending facility introduced during the recent financial crisis that is still active. The first swap
lines were created in December 2007. Overall, 10 central banks have drawn on the swap lines at
some point, and 4 more were eligible to—but did not—use the swap lines.35 In October 2008, the
Fed made the swap lines with certain countries unlimited in size. The swap lines expired in
February 2010, but were subsequently reopened in May 2010 with the Bank of Canada, the Bank
of England, the European Central Bank (ECB), the Bank of Japan, and the Swiss National Bank
in response to the eurozone crisis. The Fed has extended the expiration date of the swap lines
several times, and in October 2013, it converted them to permanent standing arrangements.
(...continued)
Labonte.
30 12 U.S.C. 343.
31 Federal Reserve Act, Section 2A, 12 U.S.C. 225a.
32 In 2011, the Dodd-Frank Act (P.L. 111-203) changed Section 13(3) to rule out direct support to specific institutions
in the future.
33 Data from “Recent Balance Sheet Trends,” Credit and Liquidity Programs and the Balance Sheet,
http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm. Values include totals from credit extended
through Federal Reserve liquidity facilities and support for specific institutions.
34 One expired facility, the Term Securities Lending Facility, still has a small amount of long-term loans outstanding.
The Fed expects that all assistance through this facility will be repaid with interest once the loans mature in March
2015. For more information, see http://www.federalreserve.gov/monetarypolicy/talf.htm.
35 U.S. Government Accountability Office, Federal Reserve System: Opportunities Exist to Strengthen Policies and
Processes for Managing Emergency Assistance, GAO-11-696, July 21, 2011, Appendix IX, http://www.gao.gov/
new.items/d11696.pdf.
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Under a swap with, say, the ECB, the ECB temporarily receives U.S. dollars and the Fed
temporarily receives euros. After a fixed period of time (up to three months), the transaction is
reversed. Interest on swaps is paid to the Fed at 0.5 percentage points above the U.S. dollar
overnight index swap rate (OIS), a private borrowing rate. The temporary swaps are repaid at the
exchange rate prevailing at the time of the original swap, meaning that there is no downside risk
for the Fed if the dollar appreciates in the meantime (although the Fed also does not enjoy upside
gain if the dollar depreciates). Except in the unlikely event that the borrowing country’s currency
becomes unconvertible in foreign exchange markets, there is no credit risk involved because the
swap is with other central banks (the foreign central bank bears losses if the private bank it lends
the dollars to defaults). The Fed has reported no losses under the program. The swaps were
created under the section of the Federal Reserve Act providing authority for open market
operations (Section 14); they did not require the emergency authority found in Section 13(3) of
the Federal Reserve Act.36
Swaps outstanding peaked at $583 billion in December 2008 and fell to zero by March 2010.
After reestablishment in May 2010, small amounts were drawn from May 2010 to March 2011.
They were then unused between March and August 2011. Swaps outstanding increased suddenly
in December 2011, averaging more than $100 billion from late December to February 2012. Their
use has since declined, and less than $1 billion has been outstanding since August 2013. To date,
most of the swaps have been with the European Central Bank; the Bank of Japan has been the
second-largest counterparty.
Swap lines are intended to provide liquidity to private banks in non-domestic denominations.
Because banks lend long-term and borrow short-term, a solvent bank can become illiquid,
meaning it cannot borrow in private markets to meet short-term cash flow needs. For example,
many European banks have borrowed in dollars to finance dollar-denominated transactions.
Normally, foreign banks could finance their dollar-denominated borrowing through the private
inter-bank lending market. As some banks have become reluctant to lend to each other through
this market, central banks at home and abroad have taken a much larger role in providing banks
with liquidity directly. Normally, banks can only borrow from their home central bank, and
central banks can only provide liquidity in their own currency. The Fed’s swap lines allow foreign
central banks to provide needed liquidity to their country’s banks in dollars. News articles
indicate that access to dollar liquidity deteriorated for European banks when the eurozone crisis
has worsened.37 Initially, the swap lines were designed to provide foreign central banks with
access to U.S. dollars. In April 2009, the swap lines were modified so that the Fed could access
foreign currency to provide to its banks as well; to date, the Fed has not done so.
Unconventional Policy Measures at the Zero Bound After the Crisis
With the federal funds rate at its zero bound since December 2008 and direct lending falling as
financial conditions began to normalize in 2009, the Fed was faced with the decision of whether
to try to provide additional monetary stimulus through unconventional measures. Since then, it
has done so through two unconventional tools—large-scale asset purchases (“quantitative
easing”) and “forward guidance.”
36 Prior to the crisis, currency swaps had been used sporadically dating back to 1962, including after September 11,
2011. See William Dudley, Testimony Before the Committee on Oversight and Government Reform, U.S. House of
Representatives, December 16, 2011.
37 See, for example, “The Dash for Cash,” The Economist, December 3, 2011, p. 85.
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Quantitative Easing and the Growth in the Balance Sheet and Bank Reserves
As direct lending declined, the Fed’s first decision was whether to maintain the elevated level of
liquidity in the financial system now that assistance through its liquidity facilities was declining.
To prevent a removal of monetary stimulus while the economy was still fragile, the Fed decided
to keep the liquidity in place, and in March 2009, the Fed announced plans to purchase $300
billion of Treasury securities, $200 billion of Agency debt (later revised to $175 billion), and
$1.25 trillion of Agency mortgage-backed securities. These purchases were completed by the end
of March 2010.38
This was clearly not a “business as usual” monetary policy, but something quite extraordinary,
sometimes referred to as “quantitative easing.”39 While there may not be a universally accepted
definition of quantitative easing, this report defines it as actions to further stimulate the economy
through growth in the Fed’s balance sheet once the federal funds rate has reached the “zero
bound.”
Beginning in November of 2010, the Federal Reserve, dissatisfied with the high level of
unemployment, took steps to encourage economic growth by purchasing an additional $600
billion of Treasury securities and continuing the practice of replacing maturing securities. The
purchases were made at a pace of $75 billion a month and were completed in about eight months.
The Fed has focused on purchasing securities with maturities between 2½ and 10 years in length.
This policy became popularly known as “QE2.” According to the Fed, these actions were taken to
promote a stronger pace of economic recovery because progress to date toward the Fed’s policy
objectives had been “disappointingly slow.”40
After the completion of QE2, the Fed took no further monetary policy actions for about six
months. On September 21, 2011, the Fed announced the Maturity Extension Program, which has
been popularly coined “Operation Twist” after a similar 1961 program.41 Under this program, the
Fed purchased $667 billion in long-term Treasury securities and sold an equivalent amount of
short-term Treasury securities from its portfolio. Unlike “quantitative easing,” the Maturity
Extension Program had no effect on the size of the Fed’s balance sheet, bank reserves, or the
monetary base. The Maturity Extension Program expired at the end of 2012, at which point, the
Fed announced that it would continue to purchase $45 billion of long-term Treasury securities
each month, but would no longer offset those purchases through the sale of short-term Treasury
securities.
On September 13, 2012, in light of continuing high unemployment and inflation slightly below its
long-term target, the Fed announced it would restart large-scale asset purchases (popularly
38 In this context, Agency securities and MBS are primarily securities issued by Fannie Mae and Freddie Mac, with
some securities issued by the Federal Home Loan Banks and Ginnie Mae. The amounts announced in March 2009
included Agency securities and MBS that the Fed began purchasing in late 2008.
39 See CRS Report R42962, Federal Reserve: Unconventional Monetary Policy Options, by Marc Labonte.
40 Federal Reserve, “Federal Open Market Committee,” press release, November 3, 2010,
http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm.
41 The original Operation Twist was devised as a way to stimulate the economy given that monetary policy was
constrained by the need to maintain the gold standard. Since such a constraint does not exist today under the current
market-determined exchange rate, the Fed could have stimulated the economy through expansionary monetary policy
instead, although at the zero bound, this would have been limited to unconventional forms of stimulus, such as
quantitative easing.
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referred to as “QE3”), pledging to purchase $40 billion of government-sponsored enterprise
(GSE) mortgage-backed securities (MBS) per month. Coupled with its monthly purchases of
Treasury securities, QE3 is a modestly higher monthly purchase rate than QE2. Unlike the
previous two rounds of asset purchases, the Fed specified no planned end date to its purchases,
instead pledging to continue purchases until labor markets improved, in a context of price
stability.42 Some economists have argued that pledging to pursue a policy for “as long as it takes”
is more effective than announcing a limited and predetermined duration, although it has an
unclear effect on market uncertainty.43
In December 2013, the Fed began to gradually taper off its asset purchases. At each subsequent
FOMC meeting (which typically occur every six weeks), the Fed has reduced its asset purchases
by $10 billion, divided evenly between MBS and Treasury securities. Smaller asset purchases can
still be considered an expansionary monetary policy, but one that adds less stimulus to the
economy than previously. If the current rate of tapering is maintained, asset purchases will end in
late 2014.
To understand the effect of quantitative easing on the economy, it is first necessary to describe its
effect on the Fed’s balance sheet. The loans and other assistance provided by the Federal Reserve
to banks and non-bank institutions are considered assets on the Fed’s balance sheet because they
represent money owed to or assets owned by the Fed. This assistance and its holdings of Treasury
securities, MBS, and GSE debt comprise most of the assets on the Fed’s balance sheet.
From the time its first emergency lending facility was introduced in December 2007 until the
crisis worsened in September 2008, the Fed “sterilized” the effects of lending on its balance sheet
by selling Treasury securities. After September 2008, the Fed allowed its balance sheet to grow,
and between September and November 2008, it more than doubled in size, increasing from under
$1 trillion to over $2 trillion. The increase in assets during this time took the form of direct
assistance to the financial sector through emergency liquidity facilities. From November 2008 to
November 2010, the overall size of the Fed’s balance sheet did not vary much; however, its
composition changed. The amount of Fed loans fell until it was less than $50 billion at the end of
2010, while holdings of securities rose from under $500 billion in November 2008 to over $2
trillion in November 2010. The purchases of $600 billion in Treasury securities increased the
balance sheet from $2.3 trillion in November 2010 to $2.9 trillion mid-2011. It remained around
that level until September 2012, when it began rising for the duration of QE3. It was about $4
trillion at the end of 2013 and $4.4 trillion at the end of June 2014, or about five times larger than
it was before the crisis.
This increase in the Fed’s assets must be matched by a corresponding increase in its liabilities on
its balance sheet, which mostly takes the form of currency, bank reserves, and cash deposited by
the U.S. Treasury at the Fed. Bank reserves increased from about $46 billion in August 2008 to
$820 billion at the end of 2008. Since October 2009, bank reserves have exceeded $1 trillion,
reaching $2.7 trillion by the end of June 2014.44 The increase in bank reserves can be seen as the
42 Federal Reserve, Press Release, September 13, 2012, http://www.federalreserve.gov/newsevents/press/monetary/
20120913a.htm.
43 Michael Woodford, “Methods of Policy Accommodation at the Interest-Rate Lower Bound,” working paper, August
2012, available at http://www.kansascityfed.org/publicat/sympos/2012/mw.pdf?sm=jh083112-4.
44 See H.3. Federal Reserve Statistical Releases, Aggregate Reserves of Depository Institutions and the Monetary Base
at http://www.federalreserve.gov/releases/h3/Current.
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inevitable outcome of the increase in assets held by the Fed because they, in effect, financed the
Fed’s asset purchases and loan programs. Reserves increase because the loans or proceeds from
asset purchases are credited to the recipients’ reserve accounts at the Fed.
Whether the additional reserves will be lent out by banks, resulting in lower market interest rates
and an expansion of new spending, as posited in the textbook explanation of how monetary policy
works, is another story. Recent experience is not reassuring, as the large volume of reserves added
to the banking system by the Fed have remained as excess bank reserves, without commensurate
increases in lending or other activities by banks. Some economists fear that the response of banks
to additional reserves is a sign that the economy has entered a “liquidity trap,” where total
spending in the economy (aggregate demand) is unresponsive to additional monetary stimulus.
This phenomenon could help explain why the unprecedented growth in the monetary base (the
portion of the money supply controlled by the Fed) since 2008 has not translated into higher
inflation to date. Critics fear that it is simply a matter of time before quantitative easing leads to
high inflation, and argue that these long-term risks outweigh any modest short-term benefits of
QE.45 In particular, there is concern that the Fed’s “exit strategy” for returning to conventional
monetary policy is untested and may not prove successful. Because the current size of the balance
sheet is inconsistent with a market-determined federal funds rate above zero, the Fed must either
sell assets or find other ways to raise interest rates, such as raising the rate that it pays to banks
for holding reserves.46
By contrast, the Fed has argued that quantitative easing has successfully stimulated the economy,
mainly through lower long-term interest rates.47 Fed Chair Janet Yellen has defended these
policies, arguing that the evidence has shown that the financial securities purchases by the
Federal Reserve have proven effective in easing financial conditions and stimulating economic
activity. With unemployment remaining high and expectations that inflation will be low over the
medium run, she argues that the accommodative stance of the Fed regarding their monetary
policy is appropriate to achieve the Fed’s mandate and that the economic costs have thus far
proven small.48 Some critics have questioned whether quantitative easing has been effective,
given economic growth remains sluggish.
Another concern is that by purchasing MBS, the Fed is allocating credit to the housing sector,
putting the rest of the economy at a disadvantage compared with that sector. Arguments in favor
of MBS purchases are that housing was the sector of the economy most in need of stabilization,
given the nature of the crisis (this argument becomes less persuasive as the housing market
continues to rebound); MBS markets are more liquid than most alternatives, limiting the potential
45 See, for example, “An Open Letter to Chairman Bernanke,” November 15, 2010, http://economics21.org/
commentary/e21s-open-letter-ben-bernanke.
46 The Fed’s exit strategy has been laid out in a number of speeches by Fed officials, such as testimony of Ben
Bernanke, “Federal Reserve’s Exit Strategy,” testimony before U.S. Congress, House Committee on Financial
Services, February 10, 2010, http://www.federalreserve.gov/newsevents/testimony/bernanke20100210a.htm.
47 For a thorough discussion and defense of the Fed’s recent actions, see Chairman Ben Bernanke, “Monetary Policy
Since the Onset of the Crisis,” speech at the Federal Reserve Bank of Kansas City Economic Symposium, August 31,
2012, available at http://www.federalreserve.gov/newsevents/speech/bernanke20120831a.htm. See also Thomas
Bullard, Effective Monetary Policy in a Low Interest Rate Environment, The Henry Thornton Lecture, Cass Business
School, London, March 24, 2009.
48 Board of Governors of the Federal Reserve System, “Challenges Confronting Monetary Policy,” speech by Janet L.
Yellen on March 4, 2013, http://www.federalreserve.gov/newsevents/speech/yellen20130302a.htm.
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for the Fed’s purchases to be disruptive; and that there are few other assets that the Fed is legally
permitted to purchase, besides Treasury securities.49
The Fed’s securities holdings earn interest that the Fed uses to fund its operations. (The Fed
receives no appropriations from Congress.) The Fed’s income exceeds its expenses, and it remits
most of its net income to the Treasury, which uses it to reduce the budget deficit. While the
increase in, first, lending and, then, holdings of mortgage-related securities increased the potential
riskiness of the Fed’s balance sheet, its ex-post effect was to more than double the Fed’s net
income and remittances to Treasury. Remittances to Treasury rose from $35 billion in 2007 to $79
billion in 2010, and were $78 billion in 2013. However, if the Fed increases interest paid on
reserves in future years as part of the exit strategy, remittances could be significantly lower.
Forward Guidance
Another tool that the Fed has used recently in an attempt to achieve additional monetary stimulus
at the zero bound is to pledge to keep the federal funds rate low for an extended period of time,
which has been called “forward guidance” or “forward commitment.” The Fed believes that this
will stimulate economic activity because businesses, for example, will be more likely to take on
long-term investment commitments if they are confident that rates will be low over the life of a
loan. Over time, this forward guidance became more detailed and explicit. In September 2012, the
Fed extended its expected time frame for “exceptionally low levels for the federal funds rate”
from late 2014 to mid-2015. In December 2012, the Fed replaced the date threshold with an
economic threshold: it pledged to maintain an “exceptionally low” federal funds target at least as
long as unemployment is above 6.5% and inflation is low.
It is difficult to pinpoint how effective the forward guidance tool has been, in part because it
depends on how credible the market finds the commitment. A problem with this approach is that
economic conditions may unexpectedly change, so this commitment is only a contingent one.
This occurred in 2013 to 2014, when the unemployment rate fell unexpectedly rapidly without a
commensurate improvement in broader labor market or economic conditions.50 Had the Fed
followed its existing forward guidance, the fall in the unemployment rate would have led to a
tightening of policy sooner than intended. Instead, as the unemployment rate neared 6.5% in
March 2014, the Fed replaced the specific unemployment threshold in its forward guidance with a
vaguer statement—“The Committee currently anticipates that, even after employment and
inflation are near mandate-consistent levels, economic conditions may, for some time, warrant
keeping the target federal funds rate below levels the Committee views as normal in the longer
run.”51 This statement provides less clarity to market participants about the path of future rates
than the previous statement, but is less likely to need to be modified.
This statement represents a more aggressively stimulative policy stance than normal. Typically,
the Fed employs below normal interest rates when the economy is operating below full
employment, normal interest rates near full employment, and above normal interest rates when
the economy is overheating. Because of lags between changes in interest rates and their economic
effects, the Fed may pre-emptively change its monetary policy stance before the economy reaches
49 H.R. 1174/S. 238 would allow the Fed to purchase MBS only if two-thirds of the FOMC finds that there are unusual
and exigent circumstances and limits the Fed’s holdings of MBS to a maximum of five years.
50 See CRS Report R43476, Returning to Full Employment: What Do the Indicators Tell Us?, by Marc Labonte.
51 Federal Reserve, press release, June 18, 2014, http://federalreserve.gov/newsevents/press/monetary/20140618a.htm.
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the state that the Fed is anticipating. By contrast, in this case, the Fed is pledging to keep interest
rates below normal even after the economy is approaching full employment. Normally, such a
stance would risk resulting in high inflation. In this case, the Fed views low inflation as a greater
risk than high inflation.
GAO Audits, Congressional Oversight, and
Disclosure
Critics of the Federal Reserve have long argued for more oversight, transparency, and disclosure.
Criticism intensified following the extensive assistance provided by the Fed during the financial
crisis. More specifically, critics have focused on the Government Accountability Office (GAO)
audits of the Fed and the disclosure of details on the identities of borrowers and the terms of those
loans.
Some critics have downplayed the degree of Fed oversight and disclosure that already takes
place. For oversight, the Fed has been required by statute to report to and testify before the House
and Senate committees of jurisdiction semi-annually since 1978. 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.52 In addition, these
committees periodically hold more focused hearings on Fed topics. On January 25, 2012, the Fed
began publishing its forecasts for its federal funds rate target, and announced a longer-run goal of
2% for inflation. The Fed hopes that greater transparency about its intentions will strengthen
understanding of its actions by financial market participants, thereby making its actions more
effective.
Contrary to popular belief, GAO has conducted audits of the Fed since 1978, subject to statutory
restrictions. In addition, the Fed’s financial statements are audited by private-sector auditors. The
Dodd-Frank Act (P.L. 111-203) required in an audit of the Fed’s emergency activities during the
financial crisis, released in July 2011, and an audit of Fed governance, released in October 2011.
The effective result of the audit restrictions remaining in law is that GAO cannot evaluate the
economic merits of Fed policy decisions. In the 112th Congress, the House passed H.R. 459 on
July 25, 2012, which would have removed all statutory restrictions on GAO audits. Similar bills
in the 113th Congress include H.R. 24, H.R. 33, and S. 209.
For disclosure, the Fed has publicly released extensive information on its operations, mostly on a
voluntary basis. For example, it has long released a weekly summary of its balance sheet.
Historically, the Fed had never released information on individual loans, such as the names of
borrowers or amounts borrowed, however. In December 2010, as a result of the Dodd-Frank Act,
the Fed released individual lending records for emergency facilities, revealing borrowers’
identities. Going forward, individual records for discount window and open market operation
transactions will be released with a two-year lag. In addition, Freedom of Information Act
lawsuits filed by Bloomberg and Fox News Network resulted in the release of individual lending
records for the discount window (the Fed’s traditional lending facility for banks).
52 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).
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Although oversight and disclosure are often lumped together, they are separate issues and need
not go together. Oversight relies on independent evaluation of the Fed; disclosure is an issue of
what internal information the Fed releases to the public. Contrary to a common misperception, a
GAO audit would not, under current law, result in the release of any confidential information
identifying institutions that have borrowed from the Fed or the details of other transactions.
A potential consequence of greater oversight is that it could undermine the Fed’s political
independence, which is discussed in the next section. The challenge for Congress is to strike the
right balance between a desire for the Fed to be responsive to Congress and for the Fed’s
decisions to be somewhat immune from political calculations. A potential drawback to greater
disclosure is that publicizing the names of borrowers could potentially stigmatize them in a way
that causes runs on those borrowers or causes them to shun access to needed liquidity. Either
outcome could result in a less stable financial system. A potential benefit of publicizing borrowers
is to safeguard against favoritism or other conflicts of interest.
For more information, see CRS Report R42079, Federal Reserve: Oversight and Disclosure
Issues, by Marc Labonte.
The Federal Reserve’s Dual Mandate and Proposals
for a Single Mandate of Price Stability
The Fed’s current statutory mandate calls for it to “promote effectively the goals of maximum
employment, stable prices, and moderate long-term interest rates.”53 Although this mandate
includes three goals, it is often referred to by economists as a “dual mandate” of maximum
employment and stable prices. Some economists have argued that this mandate should be
replaced with a single mandate of price stability.
Often the proposal for a single mandate is paired with a more specific proposal that the Fed
should adopt an inflation target. Under an inflation target, the goal of monetary policy would be
to achieve an explicit, numerical target or range for some measure of price inflation. Inflation
targets could be required by Congress or voluntarily adopted by the Fed as a way to pursue price
stability, or a single mandate could be adopted without an inflation target. Alternatively, an
inflation target could be adopted under the current mandate. In January 2012, the Fed voluntarily
introduced a “longer-run goal for inflation” of 2%, which some might consider an inflation target.
In the 113th Congress, H.R. 1174/S. 238 and S. 215 would strike the goal of maximum
employment from the mandate, leaving a single goal of price stability, and require the Fed to
adopt an inflation target. Were a single mandate to be adopted in the United States, it would
follow an international trend that has seen many foreign central banks adopt single mandates or
inflation targets in recent decades.
Arguments made in favor of a price stability mandate are that it would better ensure that inflation
was low and stable; increase the predictability of monetary policy for financial markets; narrow
the potential to pursue monetary policies with short-term political benefits but long-term costs;
remove statutory goals that the Fed has no control over in the long run; limit policy discretion;
53 This mandate was added to statute by The Federal Reserve Act of 1977 (P.L. 95-188, 91 Stat. 1387).
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and increase transparency, oversight, accountability, and credibility. Defenders of the current
mandate argue that the Fed has already delivered low and stable inflation for the past two
decades, unemployment is a valid statutory goal since it is influenced by monetary policy in the
short run, and discretion is desirable to respond to unforeseen economic shocks.
Discontent with the Fed’s performance in recent years has led to calls for legislative change. It is
not clear that a single mandate would have altered its decision making, however. A case could
also be made that changing the mandate alone would not significantly alter policymaking,
because Fed discretion, transparency, oversight, and credibility are mostly influenced by other
factors, such as the Fed’s political independence. Criticizing the Fed for the depth and length of
the recession arguably leads to the prescription that monetary policy should have been more
stimulative, which points to greater weight on the employment part of the dual mandate. Whether
or not the Fed allowed the housing bubble to inflate, it is not clear that a single mandate would
have changed matters because the housing bubble did not result in indisputably higher inflation
(which measures the change in the prices of goods and services, not assets). Some economists
believe that the Fed’s recent policy of “quantitative easing” (large-scale asset purchases) will
result in high inflation. Inflation has not increased to date, but even if these economists are
correct, the Fed has discretion to pursue policies it believes are consistent with its mandate. It has
argued that quantitative easing was necessary to maintain price stability by avoiding price
deflation, and it could still make this argument under a single mandate. Chair Yellen has testified
that she is in favor of the current mandate, and does not believe a single mandate would have led
to different monetary policy decisions in recent years because inflation has been too low.54
For more information, see CRS Report R41656, Changing the Federal Reserve’s Mandate: An
Economic Analysis, by Marc Labonte.
Regulatory Responsibilities
The Fed has distinct roles as a central bank and a regulator. Its main regulatory responsibilities
are as follows:
• Bank regulation. The Fed supervises bank holding companies (BHCs)
and thrift holding companies (THCs), which include all large and
hundreds of small depositories, for safety and soundness.55 The Dodd-
Frank Act (P.L. 111-203) requires the Fed to subject BHCs with more
than $50 billion in consolidated assets to enhanced supervision (i.e.,
stricter standards than similar firms are subjected to) in an effort to
mitigate the systemic risk they pose.56 The Fed is also the prudential
regulator of U.S. branches of foreign banks and state banks that have
elected to become members of the Federal Reserve System. Often in
concert with the other banking regulators,57 it promulgates rules and
54 Fed Chair Janet Yellen, testimony before the Senate Banking, Housing and Urban Affairs Committee, Hearing on
Federal Reserve Semi-Annual Monetary Policy Report to Congress, February 27, 2014.
55 The Fed was assigned regulatory responsibility for THCs as a result of the Dodd-Frank Act, which eliminated the
Office of Thrift Supervision.
56 For more information, see CRS Report R42150, Systemically Important or “Too Big to Fail” Financial Institutions,
by Marc Labonte.
57 The federal financial regulatory system is charter based. Other types of depositories are regulated by the OCC and
(continued...)
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supervisory guidelines that apply to banks in areas such as capital
adequacy, and it examines depository firms under its supervision to
ensure that those rules are being followed and those firms are conducting
business prudently.
• Prudential supervision of non-bank systemically important financial
institutions. The Dodd-Frank Act allows the Financial Stability
Oversight Council (FSOC)58 to designate non-bank financial firms as
systemically important. Designated firms are supervised by the Fed for
safety and soundness.
• Regulation of the payment system. The Fed regulates the retail and
wholesale payment system for safety and soundness. It also operates
parts of the payment system, such as inter-bank settlements and check
clearing. The Dodd-Frank Act subjects payment, clearing, and settlement
systems designated as systemically important by the FSOC to enhanced
supervision by the Fed (along with the SEC and CFTC, depending on the
type of system).
• Margin requirements. The Fed sets margin requirements on the
purchases of certain securities, such as stocks, in certain private
transactions. The purpose of margin requirements are to mandate what
proportion of the purchase can be made on credit.
Through these regulatory responsibilities, as well as its lender of last resort activities and its
participation on the FSOC (whose mandate is to identify risks and respond to emerging threats to
financial stability), the Fed attempts to mitigate systemic risk and prevent financial instability.
The Fed has also restructured its internal operations to facilitate a macroprudential approach to
supervision and regulation.59
H.R. 3928 would, among other things, require cost-benefit analysis of Fed rulemaking and
increase disclosures of the Fed’s stress testing.
(...continued)
FDIC. A BHC is typically regulated by the Fed at the holding company level and the other banking regulators at the
bank subsidiary level. For more info, see CRS Report R43087, Who Regulates Whom and How? An Overview of U.S.
Financial Regulatory Policy for Banking and Securities Markets, by Edward V. Murphy.
58 The FSOC is an interagency council consisting of financial regulators and headed by the Treasury Secretary. For
more information, see CRS Report R42083, Financial Stability Oversight Council: A Framework to Mitigate Systemic
Risk, by Edward V. Murphy.
59 Chairman Ben Bernanke, “Implementing a Macroprudential Approach to Supervision and Regulation,” speech at the
47th Annual Conference on Bank Structure and Competition, Chicago, Illinois, Federal Reserve, May 5, 2011,
http://www.federalreserve.gov/newsevents/speech/bernanke20110505a.htm.
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Author Contact Information
Marc Labonte
Specialist in Macroeconomic Policy
mlabonte@crs.loc.gov, 7-0640
Acknowledgments
This report was originally authored by Gail E. Makinen, formerly of the Congressional Research
Service.
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