Introduction to U.S. Economy: Monetary Policy
Updated June 4, 2024
Introduction to U.S. Economy: Monetary Policy
The Federal Reserve (Fed), the nation’s central bank, is
Monetary Policy and the Economy
responsible for monetary policy. This In Focus explains
Changes in the FFR target lead to changes in interest rates
how monetary policy works. Typically, when the Fed wants
throughout the economy, although these changes are mostly
to stimulate the economy, it makes policy more
less than one-to-one. Changes in interest rates affect overall
expansionary by reducing short-term interest rates. When it
economic activity by changing the demand for interest-
wants to make policy more contractionary or tighter, it
sensitive spending (goods and services that are bought on
raises rates. Since March 2022, the Fed has tightened
credit). The main categories of interest-sensitive spending
monetary policy in an attempt to reduce inflation. For
are business physical capital investment (e.g., plant and
background on the Fed and its other responsibilities, see
equipment), consumer durables (e.g., automobiles,
CRS In Focus IF10054, Introduction to Financial Services:
appliances), and residential investment (new housing
The Federal Reserve.
construction). All else equal, higher interest rates reduce—
and lower rates increase—interest-sensitive spending.
Federal Open Market Committee
Monetary policy decisions are made by the Federal Open
Interest rates also influence the demand for exports and
Market Committee (FOMC), whose voting members are the
imports by affecting the value of the dollar. All else equal,
Fed’s seven governors, the New York Federal Reserve
higher interest rates increase net foreign capital inflows as
Bank president, and four other Reserve Bank presidents,
U.S. assets become more attractive relative to foreign
who vote on a rotating basis. The FOMC is chaired by the
assets. To purchase U.S. assets, foreigners must first
Fed chair. FOMC meetings are regularly scheduled every
purchase U.S. dollars, pushing up the value of the dollar.
six weeks, but the chair sometimes calls unscheduled
When the value of the dollar rises, the price of foreign
meetings. After these meetings, the FOMC statement
imports declines relative to U.S. import-competing goods,
announcing any changes to monetary policy is released.
and U.S. exports become more expensive relative to foreign
goods. As a result, net exports (exports less imports)
Statutory Goals
decrease. When interest rates fall, all of these factors work
In 1977, the Fed was mandated to set monetary policy to
in reverse and net exports increase, all else equal.
promote the goals of “maximum employment, stable prices,
and moderate long-term interest rates” (12 U.S.C. §225a).
Business investment, consumer durables, residential
The first two goals are referred to as the dual mandate. The
investment, and net exports are all components of gross
dual mandate provides the Fed with discretion on how to
domestic product (GDP). Thus, if expansionary monetary
interpret maximum employment and stable prices and how
policy causes interest-sensitive spending to rise, it increases
to set monetary policy to achieve those goals. There are no
GDP in the short run. This increases employment, as more
formal repercussions when goals are not met.
workers are hired to meet increased demand for goods and
services. An increase in spending also puts upward pressure
Since 2012, the FOMC has explained how it carries out its
on inflation. Contractionary monetary policy has the
mandate in its Statement on Longer-Run Goals. It defines
opposite effect on GDP, employment, and inflation. The
stable prices as 2% inflation, measured as the annual
Fed chooses whether to make monetary policy
percent change in the personal consumption expenditures
expansionary or contractionary based on how employment
price index. In the FOMC’s view, maximum employment
and inflation are performing compared to its statutory
“is not directly measurable and changes over time owing
goals—expansionary policy can boost employment but
largely to nonmonetary factors that affect the structure and
risks spurring inflation, while contractionary policy can
dynamics of the labor market.” The Fed aims to meet its
constrain inflation but risks decreasing employment.
inflation target on average over time, offsetting periods of
inflation below 2% with periods above 2%.
Most economists believe that although monetary policy can
permanently change the inflation rate, it cannot
Federal Funds Rate
permanently change the level or growth rate of GDP,
In normal economic conditions, the Fed’s primary
because long-run GDP is determined by the economy’s
instrument for setting monetary policy is the federal funds
productive capacity (the size of the labor force, capital
rate (FFR), the overnight interest rate in the federal funds
stock, and so on). If monetary policy pushes demand above
market, a private market where banks lend to each other.
what the economy can produce, then inflation should
The FOMC sets a target range for the FFR that is 0.25
eventually rise to restore equilibrium. The Fed can
percentage points wide and uses its tools (discussed below)
preemptively change interest rates to take into account the
to keep the actual FFR within that range. (The current FFR
lags between a change in monetary policy and its effect on
target can be found here.)
economic conditions.
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Introduction to U.S. Economy: Monetary Policy
The Fed generally tries to avoid policy surprises, and
liquidity from the financial system. Unlike the FFR, the Fed
FOMC members regularly communicate their views on the
sets the IOR and the reverse repo rate directly. The IOR and
future direction of monetary policy to the public. The Fed
repo rate anchor the FFR because these short-term funding
describes its monetary policy plans as “data dependent,”
sources are relatively substitutable.
meaning plans would be altered if actual employment or
Before the crisis, monetary policy was conducted
inflation deviate from its forecast. Data is volatile, however,
differently. The Fed did not have authority to pay interest
and truly data-dependent policymaking would lead to
on bank reserves until 2008, so it could not target the FFR
sudden shifts in policy. In practice, the Fed likes to avoid
by setting the IOR. Instead, the Fed directly intervened in
surprises as much as possible, so large-scale shifts in course
the federal funds market through open market operations
are relatively infrequent.
that added or removed reserves from the federal funds
The Fed’s Balance Sheet
market. Open market operations could be conducted by
buying or selling Treasury securities, but were typically
Like any company, the Fed holds assets on its balance sheet
conducted through repos. (As noted above, the Fed still
that are equally matched by the sum of its liabilities and
capital. The Fed’s assets are primarily Treasury securities,
purchases Treasury securities and uses repos, but it no
longer does so to target the FFR. Whereas previously the
mortgage-backed securities, loans it has made, repurchase
Fed would offer the amount of repos needed to meet its
agreements (repos), and other assets acquired from
FFR target, market participants now choose how much repo
emergency programs. Its liabilities are primarily currency,
lending or borrowing to enter into with the Fed.)
reverse repos, bank reserves, and money that Treasury
holds at the Fed. When the Fed purchases assets or makes
Before the crisis, the Fed could target the FFR through
loans, its balance sheet gets larger, which is matched by
direct intervention in the federal funds market because
growth in reverse repos and bank reserves. Capital comes
reserves were scarce—banks held only enough reserves to
from stock issued to private banks that are “member banks”
slightly exceed the reserve requirements set by the Fed.
and the funds in its surplus account. As discussed in the
Now, banks hold trillions of dollars of reserves, despite the
next section, the Fed’s balance sheet grew significantly
fact that the Fed eliminated reserve requirements in 2020.
from 2008 to 2014 and from 2020 to 2022 in response to
The overall level of reserves is the result of Fed actions—
the financial crisis and the pandemic, respectively. Since
primarily QE—that have increased the Fed’s balance sheet
June 2022, the balance sheet has been gradually shrinking.
and are not a choice by banks.
For more information, see CRS In Focus IF12147, The
Fed’s Balance Sheet and Quantitative Tightening.
After the Fed ended QE in 2014, it decided to maintain
abundant reserves instead of fully shrinking its balance
Unconventional Tools at the
sheet and returning to its pre-crisis monetary framework.
Zero Lower Bound
With reserves so abundant, adding or removing reserves
Twice in its history—during the 2007-2009 financial crisis
could not raise the FFR above zero in the absence of IOR
and the COVID-19 pandemic—the Fed lowered the FFR
and the reverse repo facility. In 2021, the Fed added a
target range to 0-0.25% (called the zero lower bound) in
standing repo lending facility to make it easier to keep the
response to unusually serious economic disruptions.
FFR from exceeding its target.
Because the zero lower bound prevented the Fed from
The Money Supply and Inflation
providing as much conventional stimulus as desired to
Historically, money supply growth has been a predictor of
mitigate these crises, it turned to unconventional monetary
the inflation rate. The logic behind this relationship is that
policy tools in an effort to reduce longer-term interest rates.
inflation is caused by “too much money chasing too few
Under quantitative easing (QE), it purchased trillions of
goods.” The money supply grew at historically high levels
dollars of Treasury securities and mortgage-backed
during the pandemic but shrank more recently. The money
securities in an effort to directly lower their yield. Under
supply grew relatively rapidly during QE partly because of
forward guidance, it pledged to keep the FFR low for an
rapid growth in the monetary base, which consists of bank
extended period of time, with the hope that reducing
reserves and currency and is controlled by the Fed. Besides
investor expectations of future short-term rates will reduce
the pandemic, money supply growth and inflation have not
long-term rates today. It also used large-scale repos,
moved together closely in recent decades. Although faster
equivalent to short-term loans, to directly pump more
money supply growth would typically cause inflation to
liquidity into the financial system.
rise, all else equal, IOR gives the Fed a means to “tie up”
bank reserves so that they do not potentially cause inflation.
In addition, the Fed has responded to these crises by using
Congress and Monetary Policy
its lender-of-last-resort powers to establish temporary
emergency facilities to stabilize the financial system. For its
Congress has delegated responsibility for monetary policy
actions in the pandemic, see CRS Report R46411, The
to the Fed but retains oversight responsibilities. For
Federal Reserve’s Response to COVID-19: Policy Issues.
example, Title 12, Section 225b, of the U.S. Code requires
the Fed to semi-annually produce a written report and
The Post-Crisis Policy Framework
testify on monetary policy to the House Financial Services
Following the 2007-2009 financial crisis, the Fed changed
Committee and the Senate Banking, Housing, and Urban
how it conducted monetary policy. The Fed now maintains
Affairs Committee.
the FFR target primarily by setting the interest rate it pays
banks on reserves held at the Fed (IOR) and by using a
Marc Labonte, Specialist in Macroeconomic Policy
standing (i.e., on demand) reverse repo facility to drain
IF11751
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Introduction to U.S. Economy: Monetary Policy
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