Conducting Monetary Policy
One of the most important jobs of the Federal Reserve is to keep our economy healthy. It does this by managing the nation’s system of money and credit—in other words, conducting monetary policy.
Experience has shown us that the economy performs well when inflation is low. When inflation is low—and is expected to remain low—interest rates are usually low as well. Such an environment fosters low unemployment and allows the economy to achieve its growth potential. Free from the disruptive effects of high and variable inflation, consumers and producers make economic decisions with confidence and wisdom.
The ability to maintain a low inflation rate is a long-term measure of the Fed’s success. To achieve this, the Fed sets a variety of intermediate targets, including monetary aggregates, reserve aggregates and interest rates, to gauge the impact of its policies on the economy.
The actions that the Fed takes today influence the economy and the inflation rate for some time to come. Consequently, policymakers must be forward-looking and must take pre-emptive action to head off inflation before it gathers momentum.
HOW MONETARY POLICY WORKS
The Fed can use three tools to carry out its monetary policy goals: the discount rate, reserve requirements and open market operations. All three affect the amount of funds in the banking system. The discount rate is the interest rate Reserve banks charge banks for short-term loans. Discount rate changes are made by Reserve banks and the Board of Governors. Reserve requirements are the portions of deposits that banks must hold in reserve, either in their vaults or on deposit at a Reserve bank. The Board of Governors has sole authority over changes to reserve requirements. By far, the most frequently used tool is open market operations, which involve the buying and selling of U.S. government securities. As we learned earlier, this tool is directed by the FOMC and carried out by the Federal Reserve Bank of New York. We’ll have to get technical to explain how this works.
After each FOMC meeting, the Committee issues a directive to the domestic trading desk at the New York Fed. This directive reflects the Committee’s policy goals: easing, tightening or maintaining the growth of the nation’s money supply. Several times a week, the domestic trading desk buys or sells Treasury securities on the open market. The term “open market” means that the Fed doesn’t decide on its own which securities dealers it will do business with. Rather, various securities dealers compete on the basis of price. When the Fed wishes to increase reserves, it buys securities; when it wishes to reduce reserves, it sells securities. Because open market operations greatly affect the amount of money and credit banks have on hand, open market operations ultimately affect interest rates and the performance of the U.S. economy.
GATHERING DATA
Research economists at all 12 Reserve banks, as well as at the Board of Governors, contribute to the policymaking process. Generally speaking, economists at Reserve banks are monitoring the economies of their districts and studying relationships among national economic indicators. The primary duty of the economists is to prepare their Reserve bank president for his or her participation in FOMC meetings.
Members of the research staff gather, analyze and disseminate information about the economy. Just before each FOMC meeting, for example, researchers survey key industry contacts and assemble a report called the Beige Book, which can often highlight meaningful trends in economic activity before they show up in national statistics. The Beige Book serves as an up-to-the-minute resource for FOMC discussions and is widely reported on in the press.
The loan and deposit data that Reserve banks collect from banks and bank holding companies are some of the most critical statistics the Fed gathers. Such information is used in analyzing regional and national bank performance, credit demand and other banking topics.
Figuring out what to make of all this information is the hard part, of course. At the Board of Governors, economists are funneling data into forecasting models to predict the outcome of various economic scenarios. All the while, all economists are looking for key pieces of information that will contribute to better monetary policy. The variety of research interests around the Federal Reserve System fosters a diversity of views and influences wider economic thought.
SPREADING THE WORD
The Federal Reserve shares the viewpoints that emerge from its research. Besides producing publications for audiences of all kinds, Fed speakers address numerous groups on the economic outlook, participate in professional forums, conduct educational seminars for area teachers, provide economic backgrounders for local reporters, give tours of Federal Reserve banks and lend videos and DVDs about the economy to classrooms. Web sites at each Reserve bank and the Board of Governors broaden the reach of the Federal Reserve’s economic expertise.
