Monetary policy is how a central bank or similar government organization manages the supply of money, interest rates, and overall economic growth. In the United States, the central bank is known as the Federal Reserve. The Fed has a dual mandate: first, to maintain stable prices, and second, to promote maximum employment. Monetary policy is one tool that the Fed has to try and accomplish those goals.
Key Points
• Monetary policy refers to the actions that may be taken to manage money supply, interest rates, and economic growth.
• The Fed’s policy changes may curb inflation, the rise in the costs of goods or services over time.
• Increases to the federal funds rates may increase the cost of borrowing for businesses and consumers, slowing down economic activity.
• Decreases to the federal funds rate may encourage borrowing and spending, stimulating the economy.
• While the Federal Reserve manages the monetary policy in the U.S., fiscal policy is determined by Congress and the presidential administration.
Overview of Fed Monetary Policy
The Federal Reserve sets the key interest rate in the U.S., called the federal funds rate, that influences the short-term rates other financial institutions use, impacting the availability and cost of credit.
The Fed also has an indirect effect on longer-term interest rates, currency exchange rates, and prices of bonds and stocks, as well as other assets. Through these channels, monetary policy can influence household spending, business investment, production, employment, and inflation.
A country’s economy sometimes experiences inflation, which is when the prices of goods and services overall are rising. The central bank can use monetary policy to tame inflation, mainly by raising interest rates, as it did in 2022 and 2023, and during the 1980s.
In some instances, the economy may have been in a period of deflation when overall prices have fallen. Then the central bank typically responds by loosening monetary policy, either by lowering interest rates or using the more extreme measure of buying assets directly. A sharp period of deflation occurred after World War I, as well as during the first several years of the Great Depression.
What Is the Fed Funds Rate?
The Federal Reserve System has a committee, the Federal Open Market Committee (FOMC), which meets several times a year to review key economic factors. The FOMC watches for signs of recession or inflation. It then sets what’s called the federal funds rate, which informs the interest rate banks charge one another for overnight loans.
It may seem counterintuitive that banks would loan money to each other, but here’s why they do. Banks are required to meet the reserve requirement set by the Fed. This is the least amount of cash a bank must have on hand, either in its own vault or in one of the regional Fed banks. Even when the Fed sets the reserve requirement ratio to 0% for depository institutions, which it did in response to the Covid-19 pandemic, banks are still incentivized to maintain adequate reserves.
When the overnight rates banks use to borrow money are lowered or raised, this in turn can lower or raise the rates businesses and consumers use to borrow. For example, during the housing bubble of 2008, the Fed lowered the federal funds rate to a range of 0% to 0.25% to encourage borrowing. This was part of the Fed’s strategy to mitigate the financial crisis. In contrast to that rate, in 1980, the federal funds rate was 20%, the highest in our nation’s history.
Rates set by the Fed have an impact on the overall financial market. When rates are low, it’s less expensive and easier to borrow, which can boost the market’s liquidity. Overall, when rates are low, the economy grows. When high, it typically retracts.
Recommended: Federal Reserve Interest Rates, Explained
How Monetary Policy Can Affect You
If a bank doesn’t have enough to meet its reserves, it borrows the funds from a bank with excess cash. The lending bank can benefit financially because it would earn interest in the amount of whatever the federal funds rate is that day.
This system helps ensure that each bank has enough cash on hand for its business needs that day, and it also caps that bank’s lending ability because the bank needs to keep a certain amount of cash on hand, rather than lending it out.
Moves made by the Fed can have a significant impact on ordinary people’s personal finances, as well. As the federal funds rate changes, it’s likely that banks’ prime interest rates — or the rates they charge their best, low-risk customers — will change in response, as well. So, if the federal funds rate goes up, your bank may decide to charge a higher interest rate on loans — or if it goes down, a lower rate.
This may affect what consumers are likely to be charged on mortgage loans, car loans, personal loans, and so forth. A credit card rate, as well, is typically tied to the prime rate plus a certain percentage.
At the same time, a rise in the federal funds rate could mean that banks may increase the APY you receive on a bank account, while a cut in the Fed’s rate could lead to a lower APY. An increase in the federal funds rate is typically an incentive to save, rather than spend.
In short, as the federal funds rate and the prime interest rates at banks go up or down, so, too, can both monthly loan payments and the interest received on deposits at financial institutions.
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Famous Fed Decisions
If you want information in significant detail, you can see meeting minutes from the Federal Reserve going back to 1936. You can also see the entire history of rate changes since 1954.
An entire book could be written about Federal Reserve policies and the Great Depression — a decade-long, deep economic downturn when production numbers plunged and unemployment figures skyrocketed. It’s been acknowledged that mistakes the Fed made contributed to this economic disaster.
During this time period, the Fed was largely decentralized, and leaders disagreed on how to address the growing economic challenges. Some policies were implemented that unintentionally hurt the economy. The Fed raised interest rates in 1928 and 1929 to limit securities speculation, and economic activity slowed. The Fed made the same error in judgment in 1931, at the start of the Great Depression.
In 1973, President Richard Nixon stopped using the gold standard to support the U.S. dollar. When inflation rates tripled, the Fed doubled its interest rates and kept increasing them until the rate reached 13% in July 1974. Then, in January 1975, it was significantly dropped to 7.5%.
This monetary policy didn’t effectively address the inflation, and in 1979, then Fed Chairman Paul Volcker raised rates and kept them higher to end inflation. This might have contributed to the country’s recession, but the inflation problem was solved.
Recommended: History of the Federal Reserve
Monetary Policy vs Fiscal Policy
Both monetary policy and fiscal policy are tools government organizations use to manage a nation’s economy. Monetary policy typically refers to the action of central banks, such as changes to interest rates that then affect money supply.
Meanwhile, fiscal policy typically refers to tax and spending by the federal government. In the U.S., fiscal policy is decided by Congress and the presidential administration.
For instance, when the Covid-19 pandemic wrought havoc on the U.S. economy in 2020, causing many businesses to shut down, U.S. fiscal policy generated stimulus packages that included supplemental unemployment benefits, stimulus checks, and small-business loans. These measures were intended to prop up the economy during a difficult time.
The Takeaway
Monetary policies are a key way that central banks try to influence a country’s economy. The main tools that central banks, like the U.S. Federal Reserve, use are interest-rate levels and money supply. On a macroeconomic level, monetary policy can be a powerful, important way to fend off recessions or tame inflationary pressure. On a microeconomic level, the monetary policy interest rates that a central bank sets also affect both loans that everyday consumers take from their banks and the interest rates they receive on their deposits and savings.
Understanding how monetary policy works can inform individuals’ strategies when it comes to spending, saving, and making bigger financial decisions.
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FAQ
What is the Federal Reserve’s dual mandate?
The Federal Reserve’s dual mandate is to both maintain stable prices — or, keep inflation in check — and to promote full or maximum employment in the economy.
How does monetary policy differ from fiscal policy?
Both monetary policy and fiscal policy are tools used by regulators to manage the economy, but monetary policy refers to tools used by the Fed or a central bank, such as interest rates, whereas fiscal policy refers to tools used by Congress or the executive branch, such as taxation and spending.
Who or what sets interest rates in the U.S.?
The Federal Reserve sets the federal funds rate in the U.S., which then has a broader impact on the availability and cost of credit for consumers. The rates set by the central bank directly impact the rates banks use to borrow from each other, which in turn affects the interest rates consumers may see, ultimately influencing economic activity in the country.
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