Monetary policy of the United States

Overview

The monetary policy of the United States is the set of policies that the Federal Reserve follows to achieve its twin objectives (or dual mandate) of high employment and stable inflation. The US central bank, the Federal Reserve System, colloquially known as "the Fed", was created in 1913 by the Federal Reserve Act as the monetary authority of the United States. The Federal Reserve's board of governors along with the Federal Open Market Committee (FOMC) are consequently the primary arbiters of monetary policy in the United States. The U.S. Congress has established three key objectives for monetary policy in the Federal Reserve Act: maximizing employment, stabilizing prices, and moderating long-term interest rates. Because long-term interest rates remain moderate in a stable economy with low expected inflation, the last objective will be fulfilled automatically together with the first two ones, so that the objectives are often referred to as a dual mandate of promoting maximum employment and stable prices. The Fed operationalizes its objective of stable prices as following an inflation target of 2% annual inflation on average. The Federal Reserve's main monetary policy instrument is its federal funds rate target. By adjusting this target, the Fed affects a wide range of market interest rates and in turn indirectly affects stock prices, wealth and currency exchange rates. Through these variables, monetary policy influences spending, investment, production, employment and inflation in the United States. These channels are collectively known as the monetary transmission mechanism. Effective monetary policy complements fiscal policy to support economic stability, dampening the impact of business cycles. Besides conducting monetary policy, the Fed is tasked to promote the stability of the financial system and regulate financial institutions, and to act as lender of last resort. In addition, the Fed should foster safety and efficiency in the payment and settlement system and promote consumer protection and community development.

Interest rates and transmission mechanism

Monetary policy works by stimulating or suppressing the overall demand for goods and services in the economy, which tends to respectively increase or diminish employment and inflation. The Federal Reserve's primary means to this end is adjusting the target for the Federal funds rate (FFR) suitably. Changes in the Federal funds rate targets normally affect the interest rates that banks and other lenders charge on loans to firms and households, which will in turn impact private investment and consumption. Interest rate changes also affect asset prices like stock prices and house prices, which again influence households' consumption decisions through a wealth effect. Additionally, international interest rate differentials affect exchange rates and consequently US exports and imports. Consumption, investment and net exports are all important components of aggregate demand. Hence, by lowering the federal funds rate the Federal Reserve can stimulate aggregate demand, raising employment levels and inflation when inflation falls short of the 2% annual inflation target. Conversely, when inflation is too high, the Fed can tighten monetary policy by raising the federal funds rate, which will diminish economic activity and consequently dampen inflation. The various channels summarized above through which the Federal Reserve's actions affect the general interest rate level and consequently the overall economy are collectively referred to as the monetary transmission mechanism. In some cases, the Fed may raise the FFR to the extent that the shorter term interest rates rise sufficiently to climb above their longer maturity bonds, causing an inverted yield curve. This scenario usually predates a recession, which is deflationary.

Implementation and policy tools

The Federal funds rate is a market interest rate, being the rate at which banks and credit unions lend reserve balances to each other overnight on an uncollateralized basis. The Fed consequently does not determine this rate directly, but has over time used various means to influence the rate. Until the 2008 financial crisis, the Fed relied on open market operations, i.e. selling and buying securities in the open market to adjust the supply of reserve balances so as to keep the FFR close to the Fed's target. However, since 2008 the actual conduct of monetary policy implementation has changed considerably, using instead various administered interest rates (i.e., interest rates that are set directly by the Fed rather than being determined by the market forces of supply and demand) as the primary tools to steer short-term market interest rate towards the Fed's policy target, which from December 2008 has been expressed as a range of 25 basis points. The present implementation regime, which has evolved since the 2008 financial crisis, is referred to as an "ample-reserves regime" as opposed to the earlier limited-reserves regime. In 2019, the Fed announced that it would continue to use this implementation regime over the longer run. The Fed's central policy tools are the interest on reserve balances rate (IORB) and the overnight reverse repurchase agreement offering rate (ON RRP rate). They are administered rates which the Fed pays on funds that commercial banks hold in their reserve balance accounts at the Fed and funds that large nonbank financial institutions deposit at the Fed, respectively. These rates set a floor on the rates at which banks are willing to lend excess cash to other private market participants. At the same time, the Fed operates a discount window in which it lends funds to banks at the discount rate (a third administered rate), which puts a ceiling on the federal funds rate, as banks are unlikely to borrow elsewhere at a higher interest rate than the discount rate. Open-market operations are no longer used to steer the FR, but still form part of the over-all monetary policy toolbox, as they are used to always maintain an ample supply of reserves. The Fed began forward guidance in January 2012 to communicate policy intentions. To sum up, the policy instruments in the current ample-reserves regime are:

Interest on reserve balances (IORB) - an administered interest rate paid on funds that commercial banks hold in their reserve balance accounts at the Fed Overnight reverse repurchase agreement (ON RRP) facility - the Fed's offer to many large nonbank financial institutions to deposit funds at the Fed and earn interest Discount window - the Fed's lending to banks at the discount rate Open market operations - the Fed's buying and selling of securities to maintain an ample supply of reserves Reserve requirements, which have formerly been used as a policy tool to manipulate the money supply and in turn market interest rates, are no longer used as a policy tool, and indeed in March 2020 were effectively abolished when the Fed's reserve requirement ratios were set to zero.

Money supply

Monetary policy also generally affects the money supply. At times, changes in money supply measures have been closely related to important economic variables like GDP growth and inflation, and the Federal Reserve has earlier used these measures as an important guide in the conduct of monetary policy. In recent decades, however, these relationships have been quite unstable, and the importance of the money supply in this respect has consequently diminished over the years. Today, the Federal Open Market Committee reviews money supply data as just one part of a wide array of various financial and economic data which form the background for the Committee's monetary policy decisions, The economy's aggregate money supply is the total of

M0 money, or monetary base - "dollars" in currency and bank money balances credited to the central bank's depositors, which are backed by the central bank's assets, plus M1, M2, M3 money - "dollars" in the form of bank money balances credited to banks' depositors, which are backed by the bank's assets and investments. The money supply thus has different components, generally broken down into "narrow" and "broad" money, reflecting the different degrees of liquidity ('spendability') of each different type, as broader forms of money can be converted into narrow forms of money (or may be readily accepted as money by others, such as personal checks). For example, demand deposits are technically promises to pay on demand, while savings deposits are promises to pay subject to some withdrawal restrictions, and Certificates of Deposit are promises to pay only at certain specified dates; each can be converted into money, but "narrow" forms of money can be converted more readily. The Federal Reserve presently directly controls only the most narrow form of money, physical cash outstanding; the Federal Reserve indirectly influences the supply of other types of money. Until 2020, the Federal Reserve also used reserve requirements, enabling it to directly ensure a minimum of reserve balances of commercial banks, which together with outstanding cash makes up the monetary base (known also as M0). In March 2020, however, the Fed reduced reserve requirement ratios to zero, effectively abandoning this instrument and relying instead on interest rates on reserves to influence commercial banks' behavior. Broad money includes money held in deposit balances in banks and other forms created in the financial system. Basic economics also teaches that the money supply shrinks when loans are repaid; however, the money supply will not necessarily decrease depending on the creation of new loans and other effects. Other than loans, investment activities of commercial banks and the Federal Reserve also increase and decrease the money supply. Discussion of "money" often confuses the different measures and may lead to misguided commentary on monetary policy and misunderstandings of policy discussions.

Structure of modern US institutions

The Fed is largely concerned with policies related to the issuance of loans (including reserve rate and interest rates), along with other policies that determine the size and rate of growth of the money supply (such as buying and selling government bonds), whereas the Treasury deals directly with minting and printing as well as budgeting the government.

Federal Reserve

Monetary policy in the US is determined and implemented by the US Federal Reserve System, commonly referred to as the Federal Reserve. Established in 1913 by the Federal Reserve Act to provide central banking functions, the Federal Reserve System is a quasi-public institution. Ostensibly, the Federal Reserve Banks are 12 private banking corporations; they are independent in their day-to-day operations, but legislatively accountable to Congress through the auspices of Federal Reserve Board of Governors. The Board of Governors is an independent governmental agency consisting of seven officials and their support staff of over 1800 employees headquartered in Washington, D.C. It is independent in the sense that the Board currently operates without official obligation to accept the requests or advice of any elected official with regard to actions on the money supply, and its methods of funding also preserve independence. The Governors are nominated by the President of the United States, and nominations must be confirmed by the U.S. Senate. There is very strong economic consensus that independence from political influence is good for monetary policy. The Federal Open Market Committee (FOMC) is composed of the Federal Reserve Board of Governors and 5 out of the 12 Federal Reserve Bank presidents; the monetary policy is implemented by all twelve regional Federal Reserve Banks. The presidents of the Federal Reserve Banks are nominated by each bank's respective Board of Directors, but must also be approved by the Board of Governors of the Federal Reserve. The Chairman of the Federal Reserve Board is generally considered to have the most important position, followed by the president of the Federal Reserve Bank of New York. The Federal Reserve System is primarily funded by interest collected on their portfolio of securities from the US Treasury, and the Fed has broad discretion in drafting its own budget, but, historically, nearly all the interest the Federal Reserve collects is rebated to the government each year. The Federal Reserve's present-day dual mandate monetary policy objectives to keep prices stable and unemployment low has replaced past practices under a gold standard where the main concern was the gold equivalent of the local currency, or under a gold exchange standard where the concern is fixing the exchange rate versus another gold-convertible currency (previously practiced worldwide under the Bretton Woods Agreement of 1944 via fixed exchange rates to the U.S. dollar). The Fed operationalizes its goal of a stable price level as a 2% annual inflation target. In August 2020, after undershooting its 2% inflation target for years, the Fed announced it would be allowing inflation to temporarily rise higher, in order to target an average of 2% over the longer term.

U.S. Treasury

The Treasury is the ultimate agency on fiscal policy and is responsible for printing & minting federal reserve notes and treasurys. A United States Treasury security is an IOU from the US Government. It is a government debt instrument issued by the United States Department of the Treasury to finance government spending as an alternative to taxation. Treasury securities are often referred to simply as "Treasuries". Since 2012 the management of government debt has been arranged by the Bureau of the Fiscal Service, succeeding the Bureau of the Public Debt.

Private commercial banks

When money is deposited in a bank, it can then be lent out to another person. If the initial deposit was $100 and the bank lends out $100 to another customer the money supply has increased by $100. However, because the depositor can ask for the money back, banks have to maintain minimum reserves to service customer needs. If the reserve requirement is 10% then, in the earlier example, the bank can lend $90 and thus the money supply increases by only $90. The reserve requirement therefore acts as a limit on this multiplier effect. Because the reserve requirement only applies to the more narrow forms of money creation (corresponding to M1), but does not apply to certain types of deposits (such as time deposits), reserve requirements play a limited role in monetary policy.

Money creation

As of May 2026, the US government maintains over US$2460.1 billion in cash money (primarily Federal Reserve Notes) in circulation throughout the world, up from a sum of less than $30 billion in 1959. Below is an outline of the process which is currently used to control the amount of money in the economy. The amount of money in circulation generally increases to accommodate money demanded by the growth of the country's production. The process of money creation usually goes as follows:

Banks go through their daily transactions. Of the total money deposited at banks, significant and predictable proportions often remain deposited, and may be referred to as "core deposits". Banks use the bulk of "non-moving" money (their stable or "core" deposit base) by loaning it out. Banks have a legal obligation to keep a certain fraction of bank deposit money on-hand at all times. In order to raise additional money to cover excess spending, Congress increases the size of the National Debt by issuing securities typically in the form of a Treasury Bond (see United States Treasury security). It offers the Treasury security for sale, and someone pays cash to the government in exchange. Banks are often the purchasers of these securities, and these securities currently play a crucial role in the process. The 12-person Federal Open Market Committee, which consists of the heads of the Federal Reserve System (the seven Federal governors and five bank presidents), meets eight times a year to determine how they would like to influence the economy. They create a plan called the country's "monetary policy" which sets targets for things such as interest rates. Every business day, the Federal Reserve System engages in Open market operations. If the Federal Reserve wants to increase the money supply, it will buy securities (such as U.S. Treasury Bonds) anonymously from banks in exchange for dollars. If the Federal Reserve wants to decrease the money supply, it will sell securities to the banks in exchange for dollars, taking those dollars out of circulation. When the Federal Reserve makes a purchase, it credits the seller's reserve account (with the Federal Reserve). The money that it deposits into the seller's account is not transferred from any existing funds, therefore it is at this point that the Federal Reserve has created High-powered money. By means of open market operations, the Federal Reserve affects the free reserves of commercial banks in the country. Anna Schwartz explains that "if the Federal Reserve increases reserves, a single bank can make loans up to the amount of its excess reserves, creating an equal amount of deposits". Since banks have more free reserves, they may loan out the money, because holding the money would amount to accepting the cost of foregone interest. When a loan is granted, a person is generally granted the money by adding to the balance on their bank account. This is how the Federal Reserve's high-powered money is multiplied into a larger amount of broad money, through bank loans; as written in a particular case study, "as banks increase or decrease loans, the nation's (broad) money supply increases or decreases." Once granted these additional funds, the recipient has the option to withdraw physical currency (dollar bills and coins) from the bank, which will reduce the amount of money available for further on-lending (and money creation) in the banking system. In many cases, account-holders will request cash withdrawals, so banks must keep a supply of cash handy. When they believe they need more cash than they have on hand, banks can make requests for cash with the Federal Reserve. In turn, the Federal Reserve examines these requests and places an order for printed money with the US Treasury Department. The Treasury Department sends these requests to the Bureau of Engraving and Printing (to make dollar bills) and the Bureau of the Mint (to stamp the coins). The U.S. Treasury sells this newly printed money to the Federal Reserve for the cost of printing. This is about 6 cents per bill for any denomination. Aside from printing costs, the Federal Reserve must pledge collateral (typically government securities such as Treasury bonds) to put new money, which does not replace old notes, into circulation. This printed cash can then be distributed to banks, as needed. Though the Federal Reserve authorizes and distributes the currency printed by the Treasury (the primary component of the narrow monetary base), the broad money supply is primarily created by commercial banks through the money multiplier mechanism. One textbook summarizes the process as follows:

"The Fed" controls the money supply in the United States by controlling the amount of loans made by commercial banks. New loans are usually in the form of increased checking account balances, and since checkable deposits are part of the money supply, the money supply increases when new loans are made ... This type of money is convertible into cash when depositors request cash withdrawals, which will require banks to limit or reduce their lending. The vast majority of the broad money supply throughout the world represents current outstanding loans of banks to various debtors. A very small amount of U.S. currency still exists as "United States Notes", which have no meaningful economic difference from Federal Reserve notes in their usage, although they departed significantly in their method of issuance into circulation. The currency distributed by the Federal Reserve has been given the official designation of "Federal Reserve Notes".

Uncertainties

A few of the uncertainties involved in monetary policy decision making are described by the federal reserve:

While these policy choices seem reasonably straightforward, monetary policy makers routinely face certain notable uncertainties. First, the actual position of the economy and growth in aggregate demand at any time are only partially known, as key information on spending, production, and prices becomes available only with a lag. Therefore, policy makers must rely on estimates of these economic variables when assessing the appropriate course of policy, aware that they could act on the basis of misleading information. Second, exactly how a given adjustment in the federal funds rate will affect growth in aggregate demand—in terms of both the overall magnitude and the timing of its impact—is never certain. Economic models can provide rules of thumb for how the economy will respond, but these rules of thumb are subject to statistical error. Third, the growth in aggregate supply, often called the growth in potential output, cannot be measured with certainty. In practice, as previously noted, monetary policy makers do not have up-to-the-minute information on the state of the economy and prices. Useful information is limited not only by lags in the collection and availability of key data but also by later revisions, which can alter the picture considerably. Therefore, although monetary policy makers will eventually be able to offset the effects that adverse demand shocks have on the economy, it will be some time before the shock is fully recognized and—given the lag between a policy action and the effect of the action on aggregate demand—an even longer time before it is countered. Add to this the uncertainty about how the economy will respond to an easing or tightening of policy of a given magnitude, and it is not hard to see how the economy and prices can depart from a desired path for a period of time. The statutory goals of maximum employment and stable prices are easier to achieve if the public understands those goals and believes that the Federal Reserve will take effective measures to achieve them. Although the goals of monetary policy are clearly spelled out in law, the means to achieve those goals are not. Changes in the FOMC's target federal funds rate take some time to affect the economy and prices, and it is often far from obvious whether a selected level of the federal funds rate will achieve those goals.

Opinions of the Federal Reserve

The Federal Reserve is lauded by some economists, while being the target of scathing criticism by other economists, legislators, and sometimes members of the general public. The former Chairman of the Federal Reserve Board, Ben Bernanke, is one of the leading academic critics of the Federal Reserve's policies during the Great Depression.

Achievements

One of the functions of a central bank is to facilitate the transfer of funds through the economy, and the Federal Reserve System is largely responsible for the efficiency in the banking sector. There have also been specific instances which put the Federal Reserve in the spotlight of public attention. For instance, after the stock market crash in 1987, the actions of the Fed are generally believed to have aided in recovery. Also, the Federal Reserve is credited for easing tensions in the business sector with the reassurances given following the 9/11 terrorist attacks on the United States.