The Road to Normal: New Directions in Monetary Policy

Decisions made by the Federal Reserve System (the Fed) about monetary policy matter in important ways for all people living in the United States. Indeed, because of the size of the U.S. economy and the close financial ties between the U.S. and the rest of the world, the stance of Fed monetary policy matters for everyone on the globe.

The important role of the Fed in affecting economic outcomes for all U.S. residents was recognized in the Employment Act of 1946 and a 1978 amendment to that act (often called the Humphrey-Hawkins amendment). Congress assigned the Fed a dual mandate: to achieve “price stability” and “maximum employment.” In its Statement of Longer-Run Goals and Monetary Policy Strategy, the Federal Open Market Committee—or the FOMC, the main policymaking body of the Fed—stated that its goal, consistent with its price stability mandate, is an annual 2 percent rate of inflation, as measured by the rate of change in the personal consumption expenditures (PCE) deflator. Maximum employment is evaluated more broadly: A range of labor market and other indicators is considered, including the unemployment rate, employment growth and the growth rate in real gross domestic product (GDP).

Conventionally, the Fed acts to set a target for the federal funds rate—a very short-term interest rate (on overnight borrowing between financial institutions); to achieve the target, the Fed intervenes in financial markets by issuing money—reserves and currency—in exchange for U.S. Treasury securities. The federal funds rate, or fed funds rate, then affects all interest rates, including those on U.S. Treasury debt, mortgages, corporate bonds, credit cards and auto loans. Thus, conventional monetary policy has a direct effect on all creditors and debtors—millions of households and businesses in the U.S. economy—simply through the effects of Fed actions on interest rates.

But there are additional effects. In controlling market interest rates, the Fed also influences aggregate spending, employment and inflation. Some of these effects are only temporary; some last for a long time. For example, there is wide agreement among economists that the effects of monetary policy on employment and the total output of goods and services produced and sold in the U.S. are only temporary—perhaps extending at most over a couple of years. But monetary policy can control inflation not just in the short run but also in the long run.

In response to the global financial crisis and the unusually slow recovery from the ensuing Great Recession, the Fed engaged in some unconventional monetary policies. These unusual policies consisted of a long period of close-to-zero interest rates, forward guidance and quantitative easing. Currently, the fed funds rate is much lower than it would be if the Fed were responding to macroeconomic conditions in the same way as it was prior to the Great Recession. As well, the Fed’s balance sheet is more than five times its size at the onset of the Great Recession, as the result of quantitative easing.

At its December 2015 meeting, the Fed embarked on a program of monetary policy normalization. What was abnormal about the policies of the previous seven or eight years? What exactly does normalization entail, and how long will it take? How will people be affected by normalization? The purpose of this article is to answer these questions and to ultimately weigh the arguments for and against normalization.

Glossary

Federal funds rate: the interest rate at which financial institutions that have reserve accounts with the Fed lend to each other overnight. This lending is unsecured, that is, the borrower does not post collateral. Often referred to as the fed funds rate. [ back to text ]

Forward guidance: the provision of promises by a central bank regarding its future actions, which, if deemed credible, can adjust people’s views of the future and influence their economic activities; an example is the promise to hold the federal funds rate near zero for an extended period of time. [ back to text ]

PCE deflator: a measure of the average level of prices in the economy, derived from aggregate consumer spending. The rate of change in the PCE (personal consumption expenditures) deflator is the key measure of inflation used by the Fed. [ back to text ]

Quantitative easing: the purchase of unconventional, long-term assets (for example, mortgage-backed securities and long-term Treasury securities) by a central bank in order to directly reduce long-term interest rates. [ back to text ]