Book Description

Congress has delegated responsibility for monetary policy to the nation's central bank, the Federal Reserve (the Fed), but retains oversight responsibilities for ensuring that the Fed is adhering to its statutory mandate of "maximum employment, stable prices, and moderate long-term interest rates." To meet its price stability mandate, the Fed has set a longer-run goal of 2% inflation. The Fed's control over monetary policy stems from its exclusive ability to alter the money supply and credit conditions more broadly. Normally, the Fed conducts monetary policy by setting a target for the federal funds rate, the rate at which banks borrow and lend reserves on an overnight basis. It meets its target through open market operations, financial transactions traditionally involving U.S. Treasury securities. Beginning in September 2007, the federal funds target was reduced from 5.25% to a range of 0% to 0.25% in December 2008, which economists call the zero lower bound. By historical standards, rates were kept unusually low for an unusually long time to mitigate the effects of the financial crisis and its aftermath. In December 2015, the Fed began raising interest rates and expects to gradually raise rates further. The Fed influences interest rates to affect interest-sensitive spending, such as business capital spending on plant and equipment, household spending on consumer durables, and residential investment. In addition, when interest rates diverge between countries, as is the case now, it causes capital flows that affect the exchange rate between foreign currencies and the dollar, which in turn affects spending on exports and imports. Through these channels, 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. While the federal funds target was at the zero lower bound, the Fed attempted to provide additional stimulus through unsterilized purchases of Treasury and mortgage-backed securities (MBS), a practice popularly referred to as quantitative easing (QE). Between 2009 and 2014, the Fed undertook three rounds of QE. The third round was completed in October 2014, at which point the Fed's balance sheet was $4.5 trillion-five times its pre-crisis size. Although QE has ended, the Fed has maintained the balance sheet at its current level since, with the intention of beginning later this year to gradually reduce it to a more normal size. The Fed has raised interest rates in the presence of a large balance sheet through the use of two new tools-by raising the rate of interest paid to banks on reserves and by engaging in reverse repurchase agreements (reverse repos) through a new overnight facility. The Fed "expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run." Thus, although rates are being raised, the Fed plans to maintain an unusually stimulative monetary policy for the time being. In terms of its mandate, the Fed believes that unemployment has reached the rate that it considers consistent with maximum employment (although other labor market indicators suggest some slack remains), but inflation has generally remained below the Fed's 2% goal since 2013 by the Fed's preferred measure. Debate is currently focused on how quickly the Fed should raise rates. Some contend the greater risk is that raising rates too slowly will cause inflation to become too high or cause financial instability, whereas others contend that raising rates too quickly will cause inflation to remain too low and choke off the expansion.