53 Monetary Policy
How the Fed Conducts Monetary Policy: Monetary Policy Objectives
The Fed’s mandate is that “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production , so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates .”(24)
The goals are often described as a “dual mandate” to achieve stable prices and maximum employment (full employment).
- In the short run , the Fed can face a tradeoff between policy that lowers the inflation rate but raises the unemployment rate, and policy that lowers the unemployment rate but raises the inflation rate.
- In the long run , the Fed’s goals are in harmony. Achieving stable prices, and keeping the inflation rate low and predictable is the source of maximum employment and moderate long-term interest rates. (10)
Low inflation rates mean that people make decisions without the confusion created by inflation. A low inflation rate also means low long-term interest rates ( nominal interest rate is real interest rate plus inflation rate).
Fed’s Operational Goals and FOMC:
- Operational “Maximum Employment” Goal: The Fed tracks the output gap , which is the percentage deviation of real GDP from potential GDP. A positive output gap leads to inflation; a negative output gap results in unemployment. The Fed tries to minimize the output gap.
- Operational “Stable Prices” Goal: The Fed pays attention to the core inflation rate , which is the annual percentage change in the Personal Consumption Expenditure deflator (PCE deflator) excluding the prices of food and fuel. (19)
Price stability can mean a core inflation rate between one and two percent. (25)
Responsibility for Monetary Policy
The FOMC makes monetary policy decisions at eight scheduled meetings a year. The Fed ( not the Congress or the President) has ultimate responsibility for monetary policy.
The Fed’s Decision-Making Strategy: Policy Instruments
A monetary policy instrument is a variable that the Fed can directly control or closely target and that influences the economy in desirable ways. The Fed, similar to most central banks, chooses to use a short-term interest rate as its monetary policy instrument. The interest rate the Fed targets is the federal funds rate, which is the interest rate at which banks can borrow and lend reserves in the federal funds market (that is, the market for overnight loans of reserves). Although the Fed can change the federal funds rate by any amount, it normally changes the federal funds rate one quarter of a percentage point at a time. (19)
The Fed can use two alternative decision-making strategies:
- Instrument rule : A decision rule, which sets the policy instrument at a level that is based on the current state of the economy.
- Targeting rule : A decision rule, which sets the policy in