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What Is Monetary Policy?

September 11, 2019 · 6 minute read

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What Is Monetary Policy?

If you look at your social media feed, watch a news program on your phone, tablet, or television, or listen to a conversation at the coffee shop, you very well may hear people talking about the Federal Reserve monetary policy.

In fact, lately, it’s been big news. So, what is monetary policy and why does the Federal Reserve sometimes alter it?

In general, monetary policies focus on how a central bank or similar financial agency manages the supply of money—as well as the interest rates—in an economy, such as that of the United States. The Fed’s dual mandate is to maintain stable prices and to promote full employment, among other macroeconomic functions.

In the United States, the Federal Reserve System fulfills that role, serving as our country’s central bank. Specifically, the mission of the Federal Reserve System is to “foster the stability, integrity, and efficiency of the nation’s monetary, financial, and payment systems so as to promote optimal macroeconomic performance.”

The Federal Reserve monetary policy has three main economic goals. Congress has given it these goals to pursue, and it is to promote:

•  Maximum employment

•  Stable prices

•  Moderate long-term interest rates

Read on to learn more about the goals of monetary policy, the integral role that the Federal Reserve plays in this process, three major monetary policy challenges, and more.

Fed Monetary Policy

Focusing on the Federal Reserve monetary policy, rather than on agencies regulating economies in other nations, the agency notes that, by managing the level of the short-term interest rates in the country, this has an impact on the “availability and cost of credit.” In other words, its monetary policy has a direct impact because it sets a certain key interest rate for banks.

The Federal Reserve has a direct effect on short-term interest rates and an indirect one on longer-term rates, as well as on “currency exchange rates, and prices of equities and other assets and thus wealth. Through these channels, monetary policy influences household spending, business investment, production, employment, and inflation in the United States.”

The Federal Reserve System has a committee, the Federal Open Market Committee (FOMC), that meets several times a year to review key economic factors, watching for signs of recession or inflation, as just two of many factors. Using this information, it then sets what’s called the federal funds rate.

The federal funds rate is what banks charge one another on an overnight basis. 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 Federal Reserve.

This is the smallest amount of cash a bank must have on hand, either in its own vault or in one of the regional Federal Reserve banks.

If a bank doesn’t have enough to meet its reserves, it borrows the funds from a bank with excess cash—and the lending bank can benefit financially by loaning the funds, 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 in a vault, rather than lending it out.

Then, banks can decide to set their prime rates (the rates that they charge their best customers—those who are considered low risk) on the current federal funds rate. They aren’t required to do so, but it’s a common practice. So, if the federal funds rate goes up, your bank may decide to charge a higher interest rate on loans—if it goes down, a lower rate. Banks may add a lenders margin on top of the prime rate for consumer lending.

Why Does the Federal Reserve Alter Monetary Policy?

This raises the question of why the Fed doesn’t just leave well enough alone and not change the federal funds rate. Well, it makes these changes in response to the macroeconomic trends and concerns of the particular time period.

For example, the Federal Reserve, in the era of the housing bubble of 2008, lowered the federal funds rate to 0.25% to encourage banks to lend. This was part of the Fed’s strategy to mitigate the expanding financial crisis. In contrast to that rate, in 1980, the federal funds rate was 20%, the highest in our nation’s history.

Some reasons the Federal Reserve changes its rate include to decrease inflation or stimulate growth, or otherwise manage the macroeconomy in a way that is ideally beneficial to the country.

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How the Fed Monetary Policy Can Affect You

Although discussions about monetary policy on the news can sometimes veer to the theoretical, moves made by the Fed can have a significant impact on the personal finances of people in the U.S. As the federal funds rate changes, it’s likely that banks’ prime rates will change in response—which in turn affects what consumers are likely to be charged on mortgage loans, car loans, personal loans, credit cards, and so forth.

This can affect consumers who owe money on a variety of loan types, but this is often more the case for people who have short-term variable interest rate loans. As the federal funds rate and the prime interest rates at banks go up or down, so can the monthly loan payment. In addition, a credit card rate could be tied to the prime rate plus a certain percentage.

How the Fed Monetary Policy Can Affect the Economy

Rates set by the Federal Reserve and banks have an impact on the overall financial market. For example, 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.

As the Federal Reserve explains on its website, the country’s economy sometimes experiences inflation, which is when the prices of goods and services overall are rising. In more rare instances, the economy has been in a period of deflation when overall prices have fallen.

A sharp period of deflation occurred after World War I, as well as during the first several years of the Great Depression. Inflation was more rampant in the 1970s and early 1980s. Since then, consumer prices have stayed more stable.

Major Fed Monetary Policy Moves

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.

The Fed faced a significant challenge when World War I began, as it helped finance the war effort. This included overseeing the sale of war bonds and providing lower-interest loans to banks that purchased Treasury certificates. By the spring of 1918, about $10 billion in war bonds and Treasury certificates had been sold—in 2019 dollars, this would equal nearly $170 billion.

The Federal Reserve maintained low interest rates then, which led to more extensive borrowing. This in turn led to economic growth but also fueled inflation.

In that era, the Fed’s ability to manage inflation was limited to raising or lowering interest rates to member banks, which gave them fewer options in how to right the economy. In response to a greater need for inflation control, the Federal Reserve became independent from the Treasury Department to implement strategies to reduce post–World War I inflation.

Although 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—in 2002, a member of the Federal Reserve Board acknowledged that mistakes the board 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.

During this era, some policies were implemented that unintentionally hurt the economy. Other ideas, which may have helped, were not put into place. As an example of the first issue, the Fed raised interest rates in 1928 and 1929 to limit securities speculation.

Economic activity slowed and, because the “international gold standard linked interest rates and monetary policies among participating nations, the Fed’s actions triggered recessions in nations around the globe.” The Fed made the same error in judgment in 1931.

Here’s one more example. In 1973, President Richard Nixon stopped using the gold standard to support the U.S. dollar. When inflation rates tripled, the Federal Reserve 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, known as stop-go, didn’t effectively address the inflation and, in 1979, the Federal Reserve chair stopped using the stop-go policy. He raised rates and kept them higher to end inflation. In 1980, this might have contributed to the country’s recession, but the inflation problem was solved.

All three of these examples share some of the more turbulent economic times in our country’s history. If, though, you’re looking to refinance your existing home loan, monetary policy still has an effect on that interest rate as well.

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External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
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