Monetary Policy and the Federal Reserve: Current Policy and Conditions

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. This rate is linked to other short-term rates and these, along with future expectations, influence longer-term interest rates. Interest rates affect interest-sensitive spending such as business capital spending on plant and equipment, household spending on consumer durables, and residential investment. Through this channel, monetary policy can be used to stimulate or slow aggregate spending in the short run. In the long run, monetary policy mainly affects inflation. A low and stable rate of inflation promotes price transparency and, thereby, sounder economic decisions by households and businesses.

In addition, the Fed acts as a “lender of last resort” to the nation’s financial system, meaning that it ensures continued smooth functioning of financial intermediation by providing financial markets with adequate liquidity. In response to the financial crisis, direct lending became important once again, and the Fed created a number of new facilities to inject reserves, credit, and liquidity into the banking system, as well as making loans to firms that are not banks. 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.

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. In December 2012, the Fed pledged to maintain “exceptionally low rates” at least as long as unemployment is above 6.5% and inflation is low. With the federal funds target at the “zero lower bound,” the Fed has added additional monetary stimulus through purchases of Treasury and government-sponsored enterprise (GSE) securities. This practice is popularly referred to as quantitative easing (“QE”), and it has caused the size of the Fed’s balance sheet to quadruple since the financial crisis began, to $4 trillion at the end of 2013. On September 13, 2012, the Fed began a new 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. On December 18, 2013, the Fed announced that it would begin to taper off (gradually reduce the rate of) its monthly asset purchases. Debate is currently focused on the proper timing for ending unconventional policy measures and moving away from the zero bound.

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.