Monetary Policy Minutes: What Is Monetary Policy?

Photo of Economist Dave Wheelock | St. Louis Fed

How do monetary policy and fiscal policy differ? What can (and can’t) monetary policy do? In the first segment of this three-part podcast, St. Louis Fed economist David Wheelock answers these questions and discusses how monetary policy affects us all.

The second segment covers key monetary policy variables, such as employment and inflation; he explains, for example, why the Fed targets an inflation rate of 2 percent and not 0 percent.

In the third segment, he discusses how the current low-interest rate environment affects borrowers and savers in this economy. The three parts total about 15 minutes.

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[Segment #1: What is monetary policy?]

Jennifer Beatty: Welcome to our Timely Topics podcast. I’m Jennifer Beatty, and I’m here with David Wheelock, who is vice president and deputy director of Research at the Federal Reserve Bank of St. Louis. He’s also an economic historian. 

Today, we’re diving into the topic of what monetary policy is to better understand how it affects us all in our daily life. Here’s what Dave had to say.

David Wheelock: Monetary policy refers to actions by the central bank or other monetary authority to achieve certain objectives, such as price stability, maximum employment or financial stability. And they do that by either controlling the supply of money or influencing interest rates in markets. 

Fiscal policy refers to government spending and taxing decisions. Economics textbooks and various economic models usually think of fiscal policy in terms of the size of the government budget deficit, the difference between what the government spends and its tax revenue. And so, loosely, a larger deficit, more spending relative to taxes, is associated with expansionary fiscal policy. 

So the key difference here, again, is monetary policy, actions by the central bank affecting interest rates and the money supply. Fiscal policy are actions by usually in our case the Congress that involve spending and taxing decisions. 

Jennifer Beatty: So, do they ever work together, or do they ever work against each other?

David Wheelock: With very rare exceptions, there’s never been coordination between monetary and fiscal policy. The exceptions—the biggest exception was during World War II when the government obviously spent a lot of money to finance the war, defense expenditures, and the Fed agreed to not allow interest rates on government debt to rise above a certain amount. So, basically, that meant that the Fed was financing a large part of the government expenditures. 

However, since an accord between the Fed and the Treasury in 1951, the Fed has been independent. The Fed makes its own decisions with regard to the economy. It takes into consideration all kinds of information, including the stance of government’s fiscal policy. But, basically, the Fed is looking at indicators of expected inflation, the state of the business cycle, whether we’re at full employment or whether there are a lot of unemployed resources, and tries to look at all sorts of factors when it sets monetary policy. So in that sense there’s no direct coordination. 

And it would be very difficult to coordinate anyway, because the government doesn’t implement a fiscal policy per se. Congress doesn’t sit there and think, OK, we’re this year going to have a budget deficit of a trillion dollars or 500 billion dollars because we want to achieve this sort of goal or that sort of goal. They come up with various spending and taxing plans targeting specific things—infrastructure, defense spending, health care or what have you—and then they have various tax policies—the income tax, the, you know, tariff policies, excise taxes and so forth. 

And it’s sort of the net where it just happens to work out to be the deficit. But unlike the kind of the standard Economics 101 textbook, there’s not a conscious decision, I think, to say, OK,  we’re going to expand the deficit by X in order to achieve a certain amount of stimulus in the economy per se. So in that sense there’s even less chance of coordinating monetary and fiscal policy.

Jennifer Beatty: What can monetary policy do, and what can’t it do?

David Wheelock: Monetary policy primarily affects the rate of inflation. Monetary policy is often called upon or looked toward to do a lot of things. We’re in the depths of a recession, and we ask monetary policy to help us pull out of that recession. We have high unemployment, we ask monetary policy to attack unemployment. And monetary policy has some ability to affect things like the business cycle and employment in the very short run, but that link is very tenuous, imprecise, and definitely only going to be a short run. 

So, and over time, the only thing that monetary policy can really affect is the rate of inflation. That’s why we say that inflation control—price stability—is really the paramount goal of monetary policy or should be the paramount goal of monetary policy, because that’s really the best that the monetary authority can do to promote a healthy economy, maximum employment and economic growth.

[Segment #2: Employment and inflation]

Jennifer Beatty: During this interview, we’ve asked economist Dave Wheelock to explain key monetary policy variables, such as employment and inflation, and how that affects jobs and the cost of living for us all. Here’s what he had to say.

David Wheelock: Inflation control—price stability—is really the paramount goal of monetary policy or should be the paramount goal of monetary policy, because that’s really the best that the monetary authority can do to promote a healthy economy, maximum employment and economic growth.

Jennifer Beatty: Why not full employment? Is that not a mandate of the Fed?

David Wheelock: The Fed’s mandate is maximum sustainable employment. And maximum doesn’t necessarily mean full. Just technically, there’s always some residual unemployment in the economy. People are changing jobs for various reasons. And we expect that in a dynamic economy, that there are flows of people in and out of the labor market. And so there’s always—the concept of full employment is really associated with a low but positive rate of unemployment, say 4 percent or 5 percent, what have you. But, again, the ability of the Fed to control the unemployment rate is very loose. It’s much looser than with regard to inflation. And, certainly, you can’t create employment simply by, you know, putting more money into the economy. When the FOMC, the Federal Open Market Committee, establishes its annual policy statement, public statement—and they started doing that under Chairman Bernanke four or five years ago—they say, okay, we will have a specific target for the rate of inflation of 2 percent. 

But, because the links between monetary policy and employment are so tenuous or so imprecise, we cannot have an explicit numerical target for the unemployment rate or the growth of employment, simply because the links aren’t that tight to enable us to meaningfully target a specific number for employment.

Jennifer Beatty: I have a couple of questions on inflation since we’re touching on it so specifically. The Fed’s current target is around 2 percent. It’s targeting around 2 percent inflation. Why? Why not target 0 percent? Why is targeting positive inflation and, you know, rising prices—why is that good?

David Wheelock: Well, let me say at the outset that economists disagree about this. Our former president before Jim Bullard, William Poole, he always said that the Fed’s target should be zero properly measured. And that properly measured is an important caveat because one reason that central banks like the Fed have tended to settle on a numerical target that’s above zero is that measuring inflation precisely is very difficult. 

We use price indexes which are necessarily summaries involving baskets of goods, not necessarily all goods in the economy. And those indexes, although they’ve been improved a lot over the years, they do have some slight upward bias. So, when the observed rate of inflation is, say, 1 or 2 percent, that’s really—the true measure is actually probably lower than that, closer to zero. So just simply measurement bias would be one reason to target a positive rate. 

Another reason that the Fed—and, again, there’s disagreement even within the Fed on this—but some people think that it’s better to have a positive rate because interest rates tend to be proportional to the rate of inflation. So the higher the rate of inflation, you tend to have a higher level of interest rates. 

A higher level of interest rates gives the Fed a little more room to cut in the event of a recession. So it’s a bit of a cushion that allows monetary policy to operate a little more through its traditional interest rate channel than—if we were zero interest rates it would be lower. There would be less scope to cut, because you can’t cut the nominal rate below zero, or at least not much below zero.

Jennifer Beatty: You can’t, yeah.

David Wheelock: Some countries have experimented with negative rates, but that’s a different line. And then there are other reasons that some people—not necessarily anyone at the St. Louis Fed buy into—but some people think that the effect of deflation of a given size would be more harmful for the economy than a positive rate of inflation of the same number. So, in other words, the costs of a negative 2 percent inflation rate, or a 2 percent deflation rate, would be higher than the costs of a 2 percent positive inflation rate. So you want to err on the side of having a positive number.

Jennifer Beatty: Yeah, that’s interesting. So why is that? I mean, as a consumer, wouldn’t I like it that a car is going to be cheaper down the road than it is today, or a house? So why is deflation worse?

David Wheelock: Absolutely. But the way you asked the question, it makes it clear that we need to distinguish between prices of individual goods and services and the general price level for the economy as a whole. So, sure, we’d all like cars to be cheaper, computers to be cheaper, coffees to be cheaper down the road. But when the general level of prices is falling, then it’s also pulling down incomes as well. And so you’re not going to have sustained lower prices for very long until you see incomes falling as well. So you really would be—

Jennifer Beatty: So you’d be making less.

David Wheelock: You’d be making less.

Jennifer Beatty: The money that you save for retirement would be worth less in the future.

David Wheelock: Well, that’s interesting. If you save money, if you’re a saver and have deflation, then the value of that money is actually going up, because it will buy more stuff in the future than it does today. So that’s why we say deflation in that sense tends to be good for people who have money in the bank, people who are lenders.   

People who borrow money though suffer when there’s deflation, because most interest rates are fixed in nominal terms. You borrow money to buy a car loan, 10 percent, say, just to pick a number. If your income starts falling though, then the pain of having to repay that 10 percent interest rate loan is going up, and so that’s a consequence of deflation. 

So deflation and inflation have distributional impacts. Generally, deflation harms people who borrow money more than savers, whereas inflation harms people who save more than deflation. But it’s more complicated than that.

[Segment #3: Savers and borrowers]

Jennifer Beatty: During this interview, we asked economist Dave Wheelock about how the current interest rate environment affects those of us that are savers and borrowers in this economy. Here’s what he had to say.

David Wheelock: Deflation and inflation have distributional impacts. Generally, deflation harms people who borrow money more than savers, whereas inflation harms people who save more than deflation. But it’s more complicated than that.

Jennifer Beatty: So, another question for you is who benefits in a low interest rate environment—is it borrowers or savers? And, given this low interest rate environment, one can assume that borrowers benefit because they can borrow money at low rates. But what about the people that are near retirement that have saved their money for a rainy day? What happens to them? How does a low interest rate environment such as this affect them?

David Wheelock: Well, very obviously, in a low nominal interest rate environment, the rate of return on savings accounts is going to be lower, as is the cost of car loans or mortgage loans, what have you. So, in that sense, borrowers benefit more than savers from low nominal interest rates. But, ultimately, what benefits both borrowers and savers in the economy as a whole is a healthy, growing economy.   

And so this sort of gets back to your question about what monetary policy can and can’t do. Monetary policy is not very good about distributional differences across different sectors of the economy. But what we can do by promoting this stable price environment is make our best contribution to a healthy, growing economy. A healthy, growing economy is one in which there is, you know, good growth of GDP, full employment. Those sorts of things tend to go hand in hand with a higher real interest rate. You know, again, we have to make this distinction between nominal interest rates and the real interest rate.

Jennifer Beatty: And the difference is inflation?

David Wheelock: And the difference is inflation. So if we have low nominal rates but also low inflation, that’s better than a low nominal rate and high rate of inflation. So I go back to the 1970s. We had relatively high nominal interest rates in the 1970s. Savers could earn 5, 7, 10 percent on savings accounts. But we also had an inflation rate of 7, 10, 13 percent. So the money in the savings account, although it was earning, say 5 percent, was depreciating in value because of inflation, because the inflation rate was higher than 5 percent. So they were actually losing money. 

OK, we come 20, 30 years later where inflation is down to 2 percent and maybe interest rates are down on a savings account to 3 percent. But you’re actually making money, because even at 3 percent, because inflation is lower, your savings is earning something. So, again, you have to consider inflation as well as the nominal interest rate when deciding whether you’re well off as a saver or a borrower in a particular environment.

Jennifer Beatty: Alright, great. Dave, thanks so much for your time. It’s really been great. 

You can learn about Dave’s research by visiting his website, which you can find by going to and then clicking on “Research and Data,” and from there clicking on “Economists.” Thanks for listening to the St. Louis Fed’s Timely Topics podcast.