Monetary policy and the Federal Reserve: current policy and conditions.(Congressional Research Service)(Report)

 Contents  Introduction  How Does the Federal Reserve Execute Monetary Policy? The Importance of Monetary Policy    Monetary vs. Fiscal Policy    Short Run vs. Longer Run The Recent and Current Stance of Monetary Policy Congressional Oversight and The Near-Term Goals of Monetary Policy The Federal Reserve's Mandate and Its Independence  Appendixes  Appendix A. Federal Reserve and the Discount Rate Appendix B. Federal Reserve and the Monetary Aggregates 

March 31, 2010

Summary

The Federal Reserve (Fed) defines monetary policy as the actions it undertakes to influence the availability and cost of money and credit to help promote its congressionally mandated goals, achieving a stable price level and maximum sustainable economic growth. Since the expectations of market participants play an important role in determining prices and growth, monetary policy can also be defined to include the directives, policies, statements, and actions of the Fed that influence how the future is perceived. In addition, the Fed acts as a "lender of last resort" to the nation's financial system, meaning that it ensures its sustainability, solvency, and integrity. This role has become of great importance with the onset of the financial crisis in the summer of 2007.

Traditionally, the Fed has had three means for achieving its goals: open market operations involving the purchase and sale of U.S. Treasury securities, the discount rate charged to banks who borrow from the Fed, and reserve requirements that governed the proportion of deposits that must be held either as vault cash or as a deposit at the Federal Reserve. Historically, open market operations have been the primary means for executing monetary policy. Recently, in response to the financial crisis, direct lending has become important once again and the Fed has created a number of new ways for injecting reserves, credit, and liquidity into the banking system, as well as making loans to firms that are not banks. As financial conditions normalize, the Fed is moving back to a more traditional reliance on open market operations.

The Fed conducts open market operations by setting an interest rate target that it believes will allow it to achieve price stability and maximum sustainable growth. 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, in turn, influence longer term interest rates. Interest rates affect interest-sensitive spending--business capital spending on plant and equipment, household spending on consumer durables, and residential investment.

In the short run, monetary policy can be used to stimulate or slow aggregate spending. While monetary policy is charged with promoting maximum sustainable economic growth, it does so only indirectly in the long run by maintaining a stable price level since the direct effect of monetary policy is primarily on the rate of inflation. A low and stable rate of inflation through the business cycle promotes price transparency and, thereby, sounder economic decisions by households and businesses.

The Fed has frequently changed the federal funds target to match changes in expected economic conditions. Between January 3, 2001, and June 25, 2003, the target rate was reduced to 1% from 61/2%. This policy was reversed on June 30, 2004, and in 17 equal increments ending on June 29, 2006, the target rate was raised to 5%%. No additional changes were made until September 18, 2007, when, in a series of 10 moves, the target was reduced to a range of 0% to 1/4% on December 16, 2008, where it now remains. Since then, the Fed has added liquidity to the financial system beyond what is needed to meet its federal funds target through direct lending and, more recently, purchases of Treasury and government sponsored enterprise (GSE) securities. This practice is sometimes referred to as quantitative easing.

For more information on the Fed's crisis-response actions, see CRS Report RL34427, Financial Turmoil: Federal Reserve Policy Responses, by Marc Labonte. Legislative changes to the Fed's duties and authority related to financial regulatory reform can be found in CRS Report R40877, Financial Regulatory Reform: Systemic Risk and the Federal Reserve, by Marc Labonte.

Introduction

The Federal Reserve's (Fed's) responsibilities as the nation's central bank fall into four main categories: monetary policy, ensuring financial stability through the lender of last resort function, supervision of bank holding companies, and providing payment system services to financial firms and the government. This report will discuss the first two areas of responsibility.

The Fed defines monetary policy as the actions it undertakes to influence the availability and cost of money and credit to promote the goals mandated by Congress: a stable price level and maximum sustainable economic growth. Since the expectations of households as consumers and businesses as the purchasers of capital goods exert an important influence on the major portion of spending in the United States, and these expectations are influenced in important ways by the actions of the Fed, a broader definition of monetary policy would include the directives, policies, statements, forecasts of the economy, and other actions by the Fed, especially those made by or associated with the chairman of its Board of Governors, the nation's central banker. (1)

In addition, governments have traditionally assigned to a central bank the role of "lender of last resort" to the nation's financial system. This role means that the Federal Reserve is responsible for ensuring the sustainability, solvency, and continued functioning of the nation's financial system as a whole, although this does not necessarily extend to any individual financial institution. Thus, in times of financial stress or crisis, the Fed is responsible for ensuring that financial intermediation does not come to a halt. Historically, Federal Reserve intervention has been limited to the banking system. Indeed, the impetus for the founding of the Fed was an outgrowth of the financial panic of 1907. During its nearly 100 year history, the Federal Reserve has rarely been …