PF 2 PDF
PF 2 PDF
PF 2 PDF
The goals of monetary policy are spelled out in the Federal Reserve Act,
which specifies that the Board of Governors and the Federal Open Mar-
ket Committee should seek "to promote effectively the goals of maxi-
m u m employment, stable prices, and moderate long-term interest rates."
Stable prices in the long run are a precondition for maximum sustainable
output growth and employment as well as moderate long-term interest
rates. W h e n prices are stable and believed likely to remain so, the prices
of goods, services, materials, and labor are undistorted by inflation and
serve as clearer signals and guides to the efficient allocation of resources
and thus contribute to higher standards of living. Moreover, stable prices
foster saving and capital formation, because when the risk of erosion of
asset values resulting from inflationand the need to guard against such
lossesare minimized, households are encouraged to save more and busi-
nesses are encouraged to invest more.
Beyond influencing the level of prices and the level of output in the near
term, the Federal Reserve can contribute to financial stability and better
economic performance by acting to contain financial disruptions and pre-
venting their spread outside the financial sector. Modern financial systems
are highly complex and interdependent and may be vulnerable to wide-
scale systemic disruptions, such as those that can occur during a plunge
in stock prices. The Federal Reserve can enhance the financial system's
resilience to such shocks through its regulatory policies toward banking
institutions and payment systems. If a threatening disturbance develops,
Depository the Federal Reserve can also cushion the impact on financial markets and
institutions have the economy by aggressively and visibly providing liquidity through open
market operations or discount window lending.
accounts at their
Reserve Banks, and
they actively trade H o w M o n e t a r y Policy A f f e c t s the E c o n o m y
balances held in The initial link in the chain between monetary policy and the economy
these accounts in the is the market for balances held at the Federal Reserve Banks. Depository
institutions have accounts at their Reserve Banks, and they actively trade
federal funds market balances held in these accounts in the federal funds market at an interest
at an interest rate rate known as the federal funds rate. The Federal Reserve exercises con-
known as the federal siderable control over the federal funds rate through its influence over the
supply of and demand for balances at the Reserve Banks.
funds rate.
The F O M C sets the federal funds rate at a level it believes will foster
financial and monetary conditions consistent with achieving its monetary
policy objectives, and it adjusts that target in line with evolving economic
developments. A change in the federal funds rate, or even a change in
expectations about the future level of the federal funds rate, can set off a
chain of events that will affect other short-term interest rates, longer-term
interest rates, the foreign exchange value of the dollar, and stock prices.
In turn, changes in these variables will affect households' and businesses'
spending decisions, thereby affecting growth in aggregate demand and the
economy.
It is for these reasons that market participants closely follow data releases
and statements by Federal Reserve officials, watching for clues that the
economy and prices are on a different trajectory than had been thought,
which would have implications for the stance of monetary policy.
G u i d e s to M o n e t a r y Policy
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. For this reason, some have suggested that
the Federal Reserve pay close attention to guides that are intermediate
between its operational targetthe federal funds rateand the economy.
Among those frequently mentioned are monetary aggregates, the level
and structure of interest rates, the so-called Taylor rule (discussed on page
23), and foreign exchange rates. Some suggest that one of these guides be
selected as an intermediate targetthat is, that a specific formal objective
be set for the intermediate target and pursued aggressively with the policy
instruments. Others suggest that these guides be used more as indictors,
to be monitored regularly; in other words, the Federal Reserve could
establish a reference path for the intermediate variable that it thought to
be consistent with achieving the final goals of monetary policy, and actual
outcomes departing appreciably from that path would be seen as suggesting
that the economy might be drifting off course and that a policy adjustment
might be necessary.
Monetary Aggregates
Ordinarily, the rate of money growth sought over time would be equal
to the rate of nominal GDP growth implied by the objective for infla-
tion and the objective for growth in real GDP. For example, if the ob-
jective for inflation is 1 percent in a given year and the rate of growth in
real GDP associated with achieving maximum employment is 3 percent,
then the guideline for growth in the money stock would be 4 percent.
However, the relation between the growth in money and the growth in
nominal GDP, known as "velocity," can vary, often unpredictably, and
this uncertainty can add to difficulties in using monetary aggregates as a
guide to policy. Indeed, in the United States and many other countries
with advanced financial systems over recent decades, considerable slip-
page and greater complexity in the relationship between money and GDP
have made it more difficult to use monetary aggregates as guides to policy.
In addition, the narrow and broader aggregates often give very different
signals about the need to adjust policy. Accordingly, monetary aggregates
have taken on less importance in policy making over time.
The Components of the Monetary Aggregates
M2 M1
Savings deposits and money market deposit accounts
Small time deposits(footnote1Timedepositsinamountsof
less than $100,000, excluding balances in
IRA and Keogh accounts at depository institutions. end footnote)
Retail money market mutual fundbalances(footnote2
Excludes balances held in IRA and Keogh accounts with money market
mutual funds end footnote)
M3 M2
Large time deposits
Institutional money market mutual fund balances
Repurchase agreements
Eurodollars
Interest Rates
Interest rates have frequently been proposed as a guide to policy, not only
because of the role they play in a wide variety of spending decisions but
also because information on interest rates is available on a real-time basis.
Arguing against giving interest rates the primary role in guiding monetary
policy is uncertainty about exactly what level or path of interest rates is
consistent with the basic goals of monetary policy. The appropriate level
of interest rates will vary with the stance of fiscal policy, changes in the
pattern of household and business spending, productivity growth, and
economic developments abroad. It can be difficult not only to gauge the
strength of these forces but also to translate them into a path for interest
rates.
The slope of the yield curve (that is, the difference between the interest
rate on longer-term and shorter-term instruments) has also been suggested
as a guide to monetary policy. Whereas short-term interest rates are
strongly influenced by the current setting of the policy instrument,
longer-term interest rates are influenced by expectations of future short-
term interest rates and thus by the longer-term effects of monetary policy
on inflation and output. For example, a yield curve with a steeply positive
slope (that is, longer-term interest rates far above short-term rates) may be
a signal that participants in the bond market believe that monetary policy
has become too expansive and thus, without a monetary policy correc-
tion, more inflationary. Conversely, a yield curve with a downward slope
(short-term rates above longer rates) may be an indication that policy is
too restrictive, perhaps risking an unwanted loss of output and employment.
However, the yield curve is also influenced by other factors, including
prospective fiscal policy, developments in foreign exchange markets, and
expectations about the future path of monetary policy. Thus, signals from
the yield curve must be interpreted carefully.
The "Taylor rule," named after the prominent economist John Taylor, is
another guide to assessing the proper stance of monetary policy. It relates
the setting of the federal funds rate to the primary objectives of monetary
policythat is, the extent to which inflation may be departing from
something approximating price stability and the extent to which out-
put and employment may be departing from their maximum sustainable
levels. For example, one version of the rule calls for the federal funds rate
to be set equal to the rate thought to be consistent in the long run with
the achievement of full employment and price stability plus a component
based on the gap between current inflation and the inflation objective
less a component based on the shortfall of actual output from the full-
employment level. If inflation is picking up, the Taylor rule prescribes
the amount by which the federal funds rate would need to be raised or,
if output and employment are weakening, the amount by which it would
need to be lowered. The specific parameters of the formula are set to
describe actual monetary policy behavior over a period when policy is
thought to have been fairly successful in achieving its basic goals.
Although this guide has appeal, it too has shortcomings. The level of
short-term interest rates associated with achieving longer-term goals, a
key element in the formula, can vary over time in unpredictable ways.
Moreover, the current rate of inflation and position of the economy in
relation to full employment are not known because of data lags and diffi-
culties in estimating the full-employment level of output, adding another
layer of uncertainty about the appropriate setting of policy.
Some have advocated taking the exchange rate guide a step further and
using monetary policy to stabilize the dollar's value in terms of a par-
ticular currency or in terms of a basket of currencies. However, there
is a great deal of uncertainty about which level of the exchange rate is
most consistent with the basic goals of monetary policy, and selecting the
wrong rate could lead to a protracted period of deflation and economic
slack or to an overheated economy. Also, attempting to stabilize the ex-
change rate in the face of a disturbance from abroad would short-circuit
the cushioning effect that the associated movement in the exchange rate
would have on the U.S. economy.
Conclusion
Such an eclectic approach enables the Federal Reserve and other central
banks to use all the available information in conducting monetary policy.
This tack may be especially important as market structures and economic
processes change in ways that reduce the utility of any single indictor.
However, a downside to such an approach is the difficulty it poses in
communicating the central bank's intentions to the public; the lack of a
relatively simple set of procedures may make it difficult for the public to
understand the actions of the Federal Reserve and to judge whether those
actions are consistent with achieving its statutory goals. This downside
risk can be mitigated if the central bank develops a track record of achiev-
ing favorable policy outcomes when no single guide to policy has proven
reliable.