Academic journal article Current Politics and Economics of the United States, Canada and Mexico

Monetary Policy and the Federal Reserve: Current Policy and Conditions *

Academic journal article Current Politics and Economics of the United States, Canada and Mexico

Monetary Policy and the Federal Reserve: Current Policy and Conditions *

Article excerpt

Introduction

Congress has delegated responsibility for monetary policy to the Federal Reserve (the Fed), but retains oversight responsibilities to ensure that the Fed is adhering to its statutory mandate of "maximum employment, stable prices, and moderate long-term interest rates."1 The Fed has defined stable prices as a longer-run goal of 2% inflation (as measured by the Personal Consumption Expenditures price index).2 The Fed's responsibilities as the nation's central bank fall into four main categories: monetary policy, provision of emergency liquidity through the lender of last resort function, supervision of certain types of banks and other financial firms for safety and soundness, and provision of payment system services to financial firms and the government.3

The Fed's monetary policy function is one of aggregate demand management-stabilizing business cycle fluctuations. The Federal Open Market Committee (FOMC), consisting of 12 Fed officials, meets periodically to consider whether to maintain or change the current stance of monetary policy.4 The Fed's conventional tool for monetary policy is to target the federal funds rate-the overnight, interbank lending rate. It influences the federal funds rate through open market operations, transactions that have traditionally involved Treasury securities.

This report provides an overview of monetary policy and recent developments, a summary of the Fed's actions following the financial crisis, and ends with a brief overview of the Fed's regulatory responsibilities.

The Current Policy Stance

In December 2008, in the midst of the financial crisis and the "Great Recession," the Fed lowered the federal funds rate to a range of 0% to 0.25%. This was the first time rates were ever lowered to what is referred to as the zero lower bound. They remained there until the Fed began raising rates on December 16, 2015. The Fed anticipates that this increase will be the first step in a series that will incrementally tighten monetary policy. When the Fed raises rates, it usually increases them by 0.25 or 0.5 percentage points at a time.

Although monetary policy is now less stimulative than it had been at the zero lower bound, the Fed is still adding stimulus to the economy as long as rates are below what economists call the "neutral rate" (or the long-run equilibrium rate).5 The Fed's forward guidance on its expectations for future rates is that the Fed intends to keep stimulative policy in place for some time- it currently "expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run."6

As the economic recovery consistently proved weaker than expected, the Fed repeatedly pushed back the timeframe for raising interest rates. As a result, the economic expansion was in its seventh year and the unemployment rate was already near the Fed's estimate of full employment when it began raising rates. This was a departure from past practice-by contrast, in the previous two economic expansions, the Fed began raising rates within three years of the preceding recession ending.

The Fed's unprecedented policy stance has been controversial. Because the recent recession was unusually severe, economists disagree about both how much slack remains in the economy today and how quickly the Fed should remove monetary stimulus. The unemployment rate is projected to be slightly below the Fed's estimate of full employment in 2016, but other labor market measures indicate that an employment gap remains. The Fed has indicated that the economy is currently on a path to achieve maximum employment, and inflation will return to 2% in the medium term.

Economists who argue that the Fed should not raise rates too quickly contend that a large output gap (i.e., the difference between actual output and potential output) still exists and note that the Fed's preferred measure of inflation has been slightly below its 2% goal since 2013 (or 2012 if food and energy prices are omitted). …

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