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MONEY

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HOW IT WORKS

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Formulating
Monetary Policy

The following is a digest of several pages on the website of the San Francisco Federal Reserve Bank. 

Goals of U.S. monetary policy 

Monetary policy has two basic goals: to promote "maximum" output and employment and to promote "stable" prices.  These goals are prescribed in a 1977 amendment to the Federal Reserve Act. 

Tools of monetary policy

The Fed cannot control inflation or influence output and employment directly.  Instead it affects them indirectly, mainly by raising or lowering short-term interest rates.  The Fed affects interest rates through open market operations and the discount rate.  Both of these methods work through the market for bank reserves, known as the federal funds market. 

Effects of lags on policy actions 

The Fed's job would be straightforward if monetary policy had swift and sure effects.  Policy makers could set policy, see its effects, and then adjust the settings until they eliminated 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 effects of its policy actions well into the future. 

If forecasting models were sufficiently accurate, it would be a simple matter to calculate the Fed funds rate needed to achieve the Fed's goals.  Forecasting models do make a contribution 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 central bank must develop other strategies to overcome the problems of long lags and uncertain effects. 

Targeting the money supply

When the Fed began targeting money in the 1970s, it focused mainly on M1 which comprises currency and checkable deposits.  The desirable properties of M1 resulted from the prohibition on banks paying explicit interest on those deposits.  Since consumers did not earn interest, they tended to keep only as much in M1 as they needed for their transactions.  M1 was therefore a good predictor of aggregate spending, 

Effects of financial deregulation

The deregulation of deposit interest rates in the early 1980s blurred the distinction between transactions and savings balances.  Starting in 1981, banks were allowed to pay interest nationwide on checkable deposits, and the public began to leave some of its savings-type balances in M1.  As a consequence, its relationship 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 enough to include many of the portfolio substitutions that had disrupted M1.  For example, when interest rates on small time deposits rose, consumers would substitute from checking to time deposits, which would cause M1 to decline, but not affect M2. 

In the 1990s, however, M2 began to experience the same types of problems M1 had, apparently due to deregulation and innovation.  As a consequence, M2 and the monetary aggregates in general now play only a minor role in the formulation of monetary policy. 

Policy indicators 

Since the Fed has no reliable intermediate target like the monetary aggregates to use as the primary guide to policy, it relies on many economic variables for the best course of action.  Among the indicators that are considered are real interest rates, the unemployment rate, nominal and real GDP growth, commodity prices, exchange rates, and 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 important that some indicators be related to future developments.  For example, if the Fed waited to shift its policy stance until inflation actually increases, that would allow inflationary momentum to develop and make the task of controlling inflation that much harder and more costly in terms of job losses. 

Why real interest rates are hard to interpret 

Short-term real interest rates are a natural variable to consider as a policy indicator since they are influenced by the Fed and they are a key link in the transmission mechanism of monetary policy.  But it is not always obvious when real rates are "high" or "low."  The reason is that real rates are figured as the nominal rate minus expected future inflation that is hard to predict.  Unless real interest rates are extremely high or low relative to historical experience, it can be difficult to interpret the implications of observed market interest 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 precision 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 jobs. 

If the unemployment rate is very high or low relative to historical experience, the implications for future inflation are fairly obvious.  However unemployment rates in the intermediate range are usually difficult to interpret. 

Other factors influencing the economy

Output, employment, and inflation are influenced not only by monetary policy, but also by such factors as government taxing and spending policies, the price of key natural resources, health of the financial markets, the introduction of new technologies, and economic developments abroad, 

In order to have the desired effect on the economy, the Fed must take into account the influences of these and other factors and either offset them or reinforce them as needed.  This isn't easy because sometimes these developments occur unexpectedly, and because the size and timing of their effects are difficult to estimate.

As a result, each FOMC policymaker 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 with the objective of reaching a consensus on the best course of action.

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