Understanding the Role of Monetary Policy in the Economy

Wheelock: That's a very good and important question.

Fundamentally, monetary policy can influence the price level—the rate of inflation, the aggregate price level in an economy. And it is appropriate to provide a more expansionary monetary policy when there's evidence that inflation is falling or will fall below the desirable level.

In the Fed’s case, we target a 2% rate of inflation. For example, recently there was evidence in the Treasury market that expected inflation had fallen. In circumstances like that, an easing of monetary policy is an attempt to stimulate the economy in such a way as to help bring the inflation rate and expected inflation back to target.

Again, in the long run, monetary policy only really affects the inflation rate, the price level. But in the short run, it can influence the “real” side of the economy as well, and therefore have an influence on employment and GDP growth and so forth.

And so, in an event where it seems that the economy may be weakening or might slow down—particularly in context where inflation expectations are going down—policymakers may recalibrate monetary policy to a more accommodative or expansionary level in order to cushion that decline, or hopefully give it a boost back to the Fed’s legislated goals of price stability and maximum sustainable employment.

By the same token, if you see signs of overheating—inflation rising, maybe financial speculation running away such that it might cause problems in the economy down the road—it would be appropriate to calibrate monetary policy to a tighter stance, to try to resist that.

Wheelock: In the United States, the Federal Reserve targets the federal funds rate, and that is the primary tool that the Fed uses to implement monetary policy. This is a market-determined rate; it is determined by the supply and demand for federal funds—essentially, the deposits that banks have with the Federal Reserve—in the overnight market.

The Federal Reserve has an objective, or a target, for this market-determined rate. It uses other administered rates, such as interest on excess reserves, in order to try to encourage the fed funds rate to get as close to the target as possible.

If the federal funds rate is falling, then in some sense, the cost of funds for banks is falling. So banks are able to pass that along to borrowers in the form of lower interest rates on car loans or mortgage loans, and so forth.

It’s important to note, though, that short-term rates—such as rates on short-term Treasury bills and securities, or money market rates—are more closely tied to the federal funds rate than the rates on longer-term loans.

Wheelock: Regarding employment, the classic textbook argument is that if a central bank wants to try to boost employment, it uses its tools to try to encourage lower interest rates, which will stimulate borrowing. That will enable more consumers to buy cars and houses, and it will encourage firms to invest in new plants and equipment or to build up their inventories. In so doing, they’ll likely hire workers, which will tend to lower the unemployment rate.

That’s the textbook Econ 101 version. In practice, it’s not quite so neat and simple, but that’s the basic idea.

So while there may be ways a central bank can help boost employment in the short run, in the long run, monetary policy is only going to affect the inflation rate. Unemployment and things in the real economy are going to be determined by the technology, the amount of labor, even the weather—things that are not under the direct influence of monetary policy.

Wheelock: As we saw for a long time after the 2007-09 financial crisis, when the federal funds rate was effectively at zero, the Fed employed so-called unconventional policy tools.

This included forward guidance, which involves giving guidance to the public about where the Fed expects monetary policy to be over time—for example, how long it expects to keep the federal funds rate at zero. By communicating like that, the Fed can have an influence on longer-term interest rates in the economy, thereby having an effect even when it is not currently adjusting the federal funds rate.

Of course, the Fed has also engaged in the quantitative easing, or QE, programs where it bought large volumes of longer-term government securities and mortgage-backed securities. And there's evidence that those were effective in terms of influencing markets and the economy. Quantitative easing is a type of open market operation, an injection of reserves into the banking system that can influence the supply of credit.

As the March 15 FOMC statement said, the Committee will keep monitoring the implications of incoming information for the economic outlook, including information related to public health, and it will use its tools and act as appropriate to support the economy.

Wheelock: Historically, the main operation of a central bank was to provide a lending facility and serve as a “lender of last resort” to the banking system in the event of a liquidity shortage.

The central bank is there to provide that supply of liquidity.

I would point out that, as the Fed showed during the financial crisis, the discount window can be important if banks are finding a need to borrow reserves or if there is disruption in financial markets such that there's a sudden liquidity shortage or freezing of markets.

In the financial crisis, the Fed came up with a number of programs to try to provide liquidity to specific aspects of financial markets to keep the gears of the financial system well-lubricated, with the goal of keeping the economy going as best we could. For example, the Fed set up a facility to support the commercial paper market. Recently, the Fed recently announced it would establish a new Commercial Paper Funding Facility to support the flow of credit to firms during the coronavirus pandemic.