The following is a
digest of several
pages on the website of the San Francisco Federal Reserve Bank.
Goals of U.S.
Monetary policy has
two basic goals:
to promote "maximum" output and employment and to promote "stable"
These goals are prescribed in a 1977 amendment to the Federal Reserve
Tools of monetary
The Fed cannot
control inflation or
influence output and employment directly. Instead it affects them
indirectly, mainly by raising or lowering short-term interest
The Fed affects interest rates through open market operations and the
rate. Both of these methods work through the market for bank
known as the federal funds market.
lags on policy actions
The Fed's job would
if monetary policy had swift and sure effects. Policy makers
set policy, see its effects, and then adjust the settings until they
any discrepancy between its goals and economic developments. But
the lags in monetary policy are long, and the future effects of policy
actions are uncertain. Therefore the Fed must anticipate the
of its policy actions well into the future.
If forecasting models
accurate, it would be a simple matter to calculate the Fed funds rate
to achieve the Fed's goals. Forecasting models do make a
to the formulation of policy, but they often turn out to be wrong, and
cannot be relied on as the sole basis for policy decisions. The
bank must develop other strategies to overcome the problems of long
and uncertain effects.
the money supply
When the Fed began
in the 1970s, it focused mainly on M1 which comprises currency and
deposits. The desirable properties of M1 resulted from the
on banks paying explicit interest on those deposits. Since
did not earn interest, they tended to keep only as much in M1 as they
for their transactions. M1 was therefore a good predictor of
The deregulation of
rates in the early 1980s blurred the distinction between transactions
savings balances. Starting in 1981, banks were allowed to pay
nationwide on checkable deposits, and the public began to leave some of
its savings-type balances in M1. As a consequence, its
with aggregate spending began to deteriorate.
By 1983 those
problems caused the Fed
to switch policy consideration from M1 to M2, which added certain time
and savings deposits to M1. The rationale was that M2 was broad
to include many of the portfolio substitutions that had disrupted
For example, when interest rates on small time deposits rose, consumers
would substitute from checking to time deposits, which would cause M1
decline, but not affect M2.
In the 1990s,
however, M2 began to
experience the same types of problems M1 had, apparently due to
and innovation. As a consequence, M2 and the monetary aggregates
in general now play only a minor role in the formulation of monetary
Since the Fed has no
target like the monetary aggregates to use as the primary guide to
it relies on many economic variables for the best course of
Among the indicators that are considered are real interest rates, the
rate, nominal and real GDP growth, commodity prices, exchange rates,
various interest rate spreads, including the term structure of interest
rates, and inflation expectations surveys.
These variables are
indicators of the
future as well as the current state of the economy and inflation.
The lag between a policy action and an economic result makes it
that some indicators be related to future developments. For
if the Fed waited to shift its policy stance until inflation actually
that would allow inflationary momentum to develop and make the task of
controlling inflation that much harder and more costly in terms of job
Why real interest
rates are hard to interpret
interest rates are
a natural variable to consider as a policy indicator since they are
by the Fed and they are a key link in the transmission mechanism of
policy. But it is not always obvious when real rates are "high"
"low." The reason is that real rates are figured as the nominal
minus expected future inflation that is hard to predict. Unless
interest rates are extremely high or low relative to historical
it can be difficult to interpret the implications of observed market
rates for future economic developments.
Why the unemployment
rate is hard to interpret
Inflation tends to
rise or fall depending
on the unemployment rate. However it is difficult to know with
when unemployment is at a practical minimum. For example, it can
be affected in uncertain ways by changes in the structure of the labor
market, as when it rose temporarily in the 1970s as more women sought
If the unemployment
rate is very high
or low relative to historical experience, the implications for future
are fairly obvious. However unemployment rates in the
range are usually difficult to interpret.
influencing the economy
and inflation are
influenced not only by monetary policy, but also by such factors as
taxing and spending policies, the price of key natural resources,
of the financial markets, the introduction of new technologies, and
In order to have the
on the economy, the Fed must take into account the influences of these
and other factors and either offset them or reinforce them as
This isn't easy because sometimes these developments occur
and because the size and timing of their effects are difficult to
As a result, each
must process all the available information according to his or her own
best judgment and with the advice of the best research available.
Members then discuss and debate the policy options at FOMC meetings
the objective of reaching a consensus on the best course of action.